While most business owners and self-employed professionals know that cash flow and profit are two (very) different things, there is often an assumption that if one is fine, so is the other.
Unfortunately, this misconception can be a core driver in insolvency, where a company appears profitable but doesn't have the requisite working capital to meet its obligations.
In this guide, SAS Accounting clarifies how cash flow and profit differ, why both are equally important, and how to manage cash flow deficits.
Cash Flow Explained
Profit, of course, is the money remaining when all expenses have been accounted for, but cash flow can be less well understood.
As a summary:
- Cash flow refers to the incoming and outgoing money of a business.
- A positive cash flow shows an increase in liquid assets (i.e. cash at the bank).
- Deficits highlight that the company cannot settle debts, reinvest in new projects, or even cover daily expenses.
Cash flow is an essential metric because a business might make a yearly profit, but will be in serious trouble if it can't pay staff wages, mortgage or rental costs or clear supplier invoices.
How Can a Business Have a Cash Flow Deficit Yet Remain Profitable?
There are countless scenarios where a company has a healthy bottom line but a creditor ledger in arrears.
A few examples include:
- Having all the finances tied up in fixed assets, without a buffer to cover running costs or unexpected expenses.
- Operating with a large debtor balance. Raising a high-value invoice will instantly impact the profit and loss, but until the value is remitted, it won't be available for the business to spend.
- Seasonal fluctuations. Say a company manufacturers equipment worth £1 million annually, and the components cost £400,000. They might make a £600,000 profit, but if they need to buy the parts up front and require six months of production time, they may not have any funds in the interim.
A loss-making business will, in time, see an impact on the cash flow, but a short-term blip in profitability or one loss-making year won't cause a company to decline as quickly as a cash flow deficit.
Cash Flow Challenges in the UK Business Sector
Almost every organisation will create regular accounting reports, such as management accounts, quarterly P&Ls, or a forecast for year-end accounts - far fewer have a cash flow budget.
If you trade in a stable industry and don't have any specific peak periods, it may be that you can rely on having sufficient funds available to cover any regular cost, with a contingency for unexpected outgoings.
For most companies, that isn't likely, so a cash flow budget is important.
It helps to indicate when you will have enough cash in the bank to pay your bills, when your debtor balances will fall due, and help you match the two, making informed decisions about timing expenses.
Fast growth can also be a double-edged sword.
An early-stage business won't normally have a large amount of liquid assets and could secure a lucrative contract - without the capacity to cover the costs of serving that agreement.
How to Tackle a Projected Cash Flow Deficit
There are several ways to approach a poor cash flow and either set up supportive financing structures or change how you organise outgoings.
Much depends on the company's nature and the reasons behind the cash-flow deficit.
Strategic internal changes could include:
- Reducing client payment terms.
- Using online invoicing or automated follow-ups for late payments.
- Allowing clients to pay through diverse methods, such as accepting credit card or PayPal payments as well as a conventional bank transfer.
- Reinforcing credit control and accounts receivable processes.
- Cutting expenses or planning them for optimal periods when your cash flow balance will be higher.
- Setting aside a cash reserve during peak trading as a backup for the quieter seasons.
Before taking any action, the first step is always to create a cash flow budget, so you are equipped with the information you need to spot the flaws in your cash flow and find suitable solutions.
Financing for Small Business Cash Flow
Cash flow financing may also be suitable, such as:
- Asset or invoice finance (factoring), where the lender charges interest and management fees to allow you to borrow against your factored invoices before they fall due for payment.
- Merchant cash advances, where a proportion of the debt is deducted directly from your monthly or weekly revenue.
- Working capital or revolving credit facilities could be an overdraft or a specific cash flow lending product. These loans provide a fixed credit limit you can borrow from whenever you need an inflow of cash.
A standard term loan could be appropriate if you have a one-off cash flow blip but is less likely to be a long-term way of plugging a gap in your cash flow.
Prioritising Cash Flow vs Profit
The reality is that profit and cash flow are both influential factors in business finance management - one without the other simply isn't sustainable.
However, the takeaway is that - while cash flow isn't a mandatory reporting requirement for smaller businesses - it carries just as much weight as a healthy balance sheet and a strong P&L.
Please get in touch if you would like more advice on managing cash flow deficits, creating a cash flow budget, or using Xero reporting tools to monitor your liquid assets.
The SAS team is available on the usual number or will be happy to chat at one of our contact mornings if you are in the local area.