Lesson 1, Topic 1
In Progress

1.2 The relationship between cash flow and profit are explained with examples within a business.

ryanrori January 13, 2021

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Profit is not included in the amount of money a business owner pays himself/herself. Many new entrepreneurs forget to count the costs of their time and take out a regular salary. Or when times are tough the salary is the first thing they forget.

Profit is not the difference between the costs of the product or service and the price being charged for it. In addition to the costs of the product sold you must account for the fixed costs that are paid regularly each month, no matter what. These include such items as rent or mortgage payments, utilities, regular salaries, insurance, etc.

Next you must remember to plan for the variable costs of running the business that fluctuate with the success of the business and resulting needs for advertising, staffing, supplies, etc. The fixed costs and the variable costs together are known as overheads. Overheads, as well as the costs of the products sold, are subtracted from the income from sales before profit can be made.

Read the following article from the SBA Woman’s Business online Centre

The Importance of Cash Management

Catherine’s business is growing and she’s making a good profit. However, she never seems to have enough money to pay her bills. This month she had to pay the business insurance premium with her credit card. What is wrong with this picture?

Catherine has what is known as a “cash flow problem. ” That means that the cash flowing into her business is out of synch with the cash moving out. The result is that she is temporarily caught short when her bills come due. Catherine needs to plan ahead so she will know whether or not she will have enough cash available when she needs it.

How many of you have had something similar happen to you? Business analysts report that poor management is the major reason why most businesses fail. It would probably be more accurate to say that business failure is due to poor cash management. So how can you manage your cash situation better? In this section we’ll take a look at the cash flow process to find out.

WHAT IS CASH?

Cash is ready money in the bank or in the business. It is not inventory, it is not accounts receivable (what you are owed), and it is not property. These might be converted to cash at some point in time, but it takes cash on hand or in the bank to pay suppliers, to pay the rent, and to meet the payroll. Profit growth does not necessarily mean more cash — as we will see.

A lesson that all entrepreneurs learn is the difference between profit and cash. Profit is the amount of money you expect to make if all customers pay on time and if your expenses are spread out evenly over the time period being measured. However, it is not your day-to-day reality. Cash is what you must have to keep the doors of your business open, while you are busy trying to make a profit. Over time, a company’s profits are of little value if they are not accompanied by positive net cash flow. You can’t spend profit; you can only spend cash.

WHAT IS CASH FLOW?

Cash flow simply refers to the flow of cash into and out of a business over a period of time. Watching the cash inflows and outflows is one of the major management tasks of an owner. The outflow of cash is measured by those cheques you will write every month to pay salaries, suppliers, and creditors. The inflows are the cash you receive from customers, lenders, and investors.

POSITIVE CASH FLOW

If the cash coming “in” to the business is more than the cash going “out” of the business, the company has a positive cash flow. A positive cash flow is very good and the only worry here is what to do with the excess cash. Like good health, a positive cash flow is something you’re most aware of if you don’t have it.

NEGATIVE CASH FLOW

If the cash going “out” of the business is more than the cash coming “in” to the business, the company has a negative cash flow. A negative cash flow can be caused by a number of reasons. For example: too much or obsolete inventory or poor collections on your accounts receivable (what your customers owe you) can cause you to be short of cash. If the company can’t borrow additional cash at this point, the company may be in serious trouble.

WHAT ARE THE COMPONENTS OF CASH FLOW?

A Cash Flow Statement is typically divided into three components so that you can see and understand the sources and uses of cash. These components include internal and external sources:

Operating Cash Flow

Operating cash flow, often referred to as working capital, is the cash flow generated from internal operations. It is the cash generated from sales of the product or service of your business. It is the real lifeblood of your business, and because it is generated internally, it is under your control.

Investing Cash Flow

Investing cash flow is generated internally from non-operating activities. This component would include investments in plant and equipment or other fixed assets, nonrecurring gains or losses, or other sources and uses of cash outside of normal operations.

Financing Cash Flow

Financing cash flow is the cash to and from external sources, such as lenders, investors and shareholders. A new loan, the repayment of a loan, the issuance of stock and the payment of dividends are some of the activities that would be included in this section of the cash flow statement.

HOW DO I PRACTICE GOOD CASH MANAGEMENT?


Catherine might have been able to avoid using her credit card to pay an “unexpected” bill if she had been practicing good cash management. Good cash management is simple. It means:

  • Knowing when, where, and how your cash needs will occur,
    • Knowing what the best sources are for meeting additional cash needs; and,
    • Being prepared to meet these needs when they occur, by keeping good relationships with bankers and other creditors.

The starting point for avoiding a cash crisis is to develop a cash flow projection. Smart business owners know how to develop both short-term (weekly, monthly) cash flow projections to help them manage daily cash, and long-term (annual, 3-5 year) cash flow projections to help them develop the necessary capital strategy to meet their business needs. They also prepare and use historical cash flow statements to gain an understanding about where all the money went.

Long-term debt 

Debt financing is capital that entrepreneurs borrow and must repay with interest. Most entrepreneurs need some debt financing because very few of them have enough personal savings for the complete start-up costs. It is important to analyse different kinds of loans that are available and to know about the differences between the loans. For example, if you want to buy a house you apply for a special loan called a mortgage loan. Similarly, there are special loans to finance a start-up business.

Long-term debt refers to loans that will be paid after a period of at least one year. This repayment agreement means, that as long as the business honours its part of the agreement, the lender will not have the right to demand quicker repayment. Should the business not honour its agreement, for example by not paying the monthly interest, the loan usually becomes repayable on demand. The new business man will have to ensure that it will be possible to meet the obligations timeously and to the letter, otherwise he may have to find other funds to repay the loan.

Short term finance

Short term debt or current liabilities are mainly creditors, bank overdrafts and payments on hire purchase due in the next year. The maximum amount of finance from this source is determined on the one hand by the current ratio: current assets to current liabilities and the amount that the bank and suppliers are prepared to allow a new business.

Examples of short term finance:

  1. Bank overdraft – A bank overdraft facility is a short term fluctuating loan granted by a commercial bank to a business, with a predetermined amount as maximum limit.
    1. Creditors or trade financing – This is financing the business obtains from its suppliers. Early in the life of the business this type of credit will not be easy to find, as the business has no record, as yet, of prompt payment. Still, this form of finance should not be neglected, as it is inexpensive and convenient.
    1. Other short term financing – There are other sources of short term financing such as invoicing debtors or short term loans from persons or businesses.