the difference between cash and profits

Numerical Illustration (continued)

Cash generated = £8,000 (cash sales) – £6,000 (cash purchases) = £2,000. Profit = £5,000 (includes £4,000 credit sales and £1,000 depreciation). Thus the business is profitable but only generates £2,000 of cash during the month.

5.2 Sources of Finance

Classification

• Internal – equity (e.g., retained earnings, share capital)
• Internal – debt (e.g., profit‑sharing loans from owners)
• External – equity (e.g., share issue, venture capital, angel investors, crowd‑funding)
• External – debt (e.g., bank overdraft, term loan, debenture, trade credit, factoring, hire‑purchase)
• Hybrid (e.g., leasing, hire‑purchase)
• Public / Government (e.g., grants, subsidies, micro‑finance)

Expanded Table of Sources

Choosing the Right Source – Checklist

• Cost – interest rate, dividend expectations, fees.
• Control – impact on ownership and decision‑making.
• Flexibility – repayment terms, ability to vary draw‑down.
• Risk – security required, covenant restrictions, impact on solvency.

5.3 Cash‑Flow Forecasting

Purpose

To predict the cash position over a future period, ensuring that the business can meet its obligations, avoid shortages, and plan for investment.

Basic Forecast Formats

• Weekly forecast – useful for very short‑term cash‑management (e.g., retail, hospitality).
• Monthly forecast – most common for small‑to‑medium enterprises.
• Annual forecast – aids strategic planning and budgeting.

Key Elements (any horizon)

1. Opening cash balance (carried forward from the previous period).
2. Cash receipts – cash sales, collections from trade receivables, loans, investment income.
3. Cash payments – purchases, wages, rent, interest, tax, loan repayments, capital purchases.
4. Closing cash balance = Opening + Receipts – Payments.

One‑Month Forecast Example (same retailer)

Formula used:
Closing Cash = Opening Cash + Cash Receipts – Cash Payments

Methods to Improve Cash Flow

• Speed up receipts – offer early‑payment discounts, use electronic invoicing, factor receivables.
• Extend payables – negotiate longer credit terms with suppliers.
• Control inventory – adopt just‑in‑time ordering to reduce stock holding.
• Review overheads – cut non‑essential variable costs.
• Use short‑term finance – overdraft or revolving credit line for temporary gaps.

5.4 Costing Basics

• Fixed costs – do not vary with output (e.g., rent, salaries).
• Variable costs – change directly with output (e.g., raw materials, direct labour).
• Contribution margin – Revenue – Variable Costs.
• Full costing (absorption) – All fixed and variable production costs are allocated to units produced.
• Break‑even point – The level of sales where total revenue equals total costs (profit = 0).

Break‑even calculation (using the retailer example):

Assume: Fixed costs £2,000, selling price £20, variable cost £12.

5.5 Budgets and Variance Analysis

• Budgets – quantitative plans for a future period (sales, cash, production, profit).
• Types: incremental, flexible, zero‑based.
• Variance – the difference between budgeted and actual figures; indicates where performance deviates.

Example – Cash Receipts Variance

An unfavourable variance signals less cash than expected, prompting a review of credit policy or collection procedures.

Key Take‑aways

• Cash measures liquidity; profit measures overall performance.
• Working capital bridges the time lag between cash inflows and outflows.
• Short‑ and long‑term finance serve different purposes and have distinct risk profiles.
• Choosing finance involves weighing cost, control, flexibility and risk.
• Cash‑flow forecasts and budgets prevent cash shortages and enable performance monitoring through variance analysis.
• Costing (fixed/variable, contribution, break‑even) underpins pricing, budgeting and investment decisions.