The difference between cash and profit; the structure and use of a cash-flow forecast; the causes and solutions of cash-flow problems; working capital; budgets and budgetary control; and variance analysis.

What this theme is asking

Eduqas wants you to distinguish cash from profit, build and use a cash-flow forecast, identify the causes and solutions of cash-flow problems, understand working capital, and use budgets and variance analysis to plan and control. The headline idea is that a profitable business can still fail if it runs out of cash, so managing cash is as vital as making profit.

Cash versus profit

The cash-flow forecast

A forecast warns of months when cash will be tight, so the firm can arrange finance in advance, and it is required by lenders. Its weakness is that it rests on estimates, does not show profit, and must be revised as reality unfolds.

Cash-flow problems and solutions

Common causes of cash-flow problems are overtrading (growing too fast for the cash available), late payment by customers, too much stock tying up cash, seasonal swings, and unexpected costs. Solutions include arranging an overdraft or short-term loan, improving credit control (chasing debtors, shorter payment terms), negotiating longer trade credit from suppliers, reducing stock, cutting non-essential costs, and leasing rather than buying assets. The best solution matches the cause and avoids simply masking a deeper problem.

Working capital and budgets

Working capital is the finance available for day-to-day operations:

Too little working capital risks running out of cash; too much suggests cash is sitting idle. A budget is a financial plan for income or spending over a period (a sales budget, a cost budget). Budgetary control compares actual results with the budget. Variance analysis measures the difference: a favourable variance is better than budget (higher income or lower cost), an adverse variance is worse. Variances flag where action is needed and help hold managers accountable, though budgets can demotivate if set unrealistically.

Examples in context

A growing online retailer is profitable but suffers overtrading, buying stock faster than customers pay, and arranges an overdraft to bridge the gap. A seaside ice-cream shop uses a cash-flow forecast to plan for a cash-poor winter. A manufacturer uses variance analysis to spot that material costs ran $\pounds 5{,}000$ over budget (an adverse variance) and investigates supplier prices.

Try this

Q1. Opening balance $\pounds 3{,}000$, inflows $\pounds 15{,}000$, outflows $\pounds 16{,}500$. Calculate the closing balance. [3 marks]

• Cue. Net cash flow $= 15{,}000 - 16{,}500 = -\pounds 1{,}500$; closing balance $= 3{,}000 - 1{,}500 = \pounds 1{,}500$.

Q2. Explain one way a firm could improve its cash flow. [3 marks]

• Cue. Improve credit control by chasing customers and shortening payment terms, so cash arrives sooner; or negotiate longer trade credit, reduce stock, or arrange an overdraft to bridge the gap.