The meaning and importance of cash flow, the difference between cash flow and profit, how to construct and interpret a cash-flow forecast, and the causes and solutions of cash-flow problems.

What this dot point is asking

AQA wants you to explain what cash flow is and why it matters, distinguish cash flow from profit, build and read a cash-flow forecast, and identify the causes and solutions of cash-flow problems.

What is cash flow?

Inflows include cash sales, payments from credit customers (debtors), loans received and money the owner puts in. Outflows include payments to suppliers, wages, rent, loan repayments, tax and the purchase of equipment. Good cash flow lets a business pay its bills, wages and suppliers on time, which is what keeps the doors open. A business that cannot pay its debts when they fall due is insolvent, and insolvency, not a lack of profit, is the most common immediate cause of small-business failure. This is why AQA stresses that managing cash is a survival issue, especially for start-ups and seasonal businesses.

Cash flow versus profit

The difference comes down to timing. Profit is recorded when a sale is made, even if the customer pays 60 days later. Cash flow only records the money when it actually arrives. So a manufacturer can win a large order (profit on paper) but pay for the materials, labour and delivery weeks before the customer settles the invoice. In that gap the business needs cash to keep trading. Three things commonly cause a profitable business to run short of cash:

• Generous credit terms to customers, so sales are made but cash arrives late.
• Overtrading, where a fast-growing business buys ever more stock and materials before the cash from earlier sales has come in.
• Tying cash up in stock or fixed assets, money that is now sitting on the shelves or in machinery rather than in the bank.

A worked feel for the gap: a firm sells goods for $50{,}000$ in March that cost $30{,}000$ to make. The profit is $20{,}000$. But if it paid the $30{,}000$ to suppliers in March and the customer pays in May, the firm is $30{,}000$ down in March and April even though the deal is profitable. That two-month cash gap is exactly what a forecast is built to expose.

Constructing a cash-flow forecast

Reading a forecast is about spotting the lowest closing balance and acting before it turns negative. A forecast is an estimate, so its weakness is that real inflows can be lower and outflows higher than predicted; sensible businesses build in a buffer.

Solving cash-flow problems

The right fix depends on the cause and on how quickly cash is needed.

Each fix has a trade-off. An overdraft is quick but expensive. Chasing customers brings cash in but can sour relationships. Delaying supplier payments helps now but can damage trust and future credit terms. In an evaluation answer, AQA wants you to choose the option that best matches the firm's situation and to say why the alternative is weaker.

Try this

Q1. A month has inflows of $5{,}000$ and outflows of $6{,}000$. State the net cash flow. [1 mark]

• Cue. $5{,}000 - 6{,}000 = -1{,}000$.

Q2. Explain one way a business could solve a cash-flow problem. [2 marks]

• Cue. Arrange an overdraft, or chase customer payments to bring cash in sooner.