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IB Business Management:
3.5 Cash flow Cash is needed to pay for daily costs such as wages and electricity charges. failure to pay suppliers, wages and utility bills may eventually result in a business being declared bankrupt. The term liquidity refers to how easily an asset can be turned into cash. Evidence from around the world has consistently shown that insufficient cash flow is the single largest from of business failure, rather than lack of profitability.
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Key learning outcomes:
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Cash flowCash is often referred to as the 'lifeblood' of a business. All businesses need finance to pay for everyday expenses such as wages and the purchase of stock. Without sufficient cash flow or working capital a business will be illiquid – unable to pay its immediate or short term debts. Either the business raises finance quickly, such as a bank loan, or it may be forced into liquidation by its creditors, the firms it owes money to.
When it comes down to it, the main difference between cash flow and working capital is the financial story they tell about your business. Whereas cash flow describes the money moving in and out of your company within a given timeframe, working capital instead compares your business's assets and liabilities. |
Key terms and definitions
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What is cash flow? |
What is working capital? |
The working capital cycleWorking capital cycle: The period of time between spending cash on the production process and receiving cash payments from customers.
The simple working capital cycle
The longer this cycle takes to complete, the more working capital a business will need.
When a business has positive working capital, this phrase means that it is bringing in cash flow and current assets, such as cash on hand (in the bank) that can cover all business liabilities. If it had negative working capital, it means that the business cannot cover the current liabilities as it has more cash flow moving out of the business than what it has moving into it.
Now, just because a business has fantastic cash flow moving into its operations it does not necessarily mean that it has positive working capital. The business may have incurred large, ongoing debts or it has invested significant amounts of money into its facilities where one slow sales season could see the business in financial trouble. |
What is free cash flow?Free cash flow is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (capital expenditures).
Free cash flow measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. In other words, free cash flow measures a company’s ability to produce what investors care most about: cash that is available to be distributed in a discretionary way. Cash flows explained |
The importance of cash flowsCash is always important – short-term and long-term. Cash flow relates to the timing of payments to workers and suppliers and receipts from customers. if a business does not plan the timing of these payments and receipts carefully, it may run out of cash even though it is operating profitably. If suppliers and creditors are not paid in time, they can force a business into liquidation of its assets if it appears to be insolvent.
Note: Cash is not the same as profit. It is very common for profitable businesses to run short of cash. On the other hand, loss-making businesses can have high cash inflows in the short-term. The diagram on the right explains the links between cash inflows – in the form of revenues – and cash outflows – the costs of production. Working capital is what keeps a business solvent. 
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Cash inflows and outflows
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The difference between cash flow and profitCash flow vs. profit: What’s the difference? There are stark differences between the two financial metrics: cash flow and profit. Cash flow is the money that flows in and out of a business throughout a given period, while profit is whatever remains from its revenue after costs are deducted. While profit will show managers the immediate success of a business, cash flow may be a more astute means of determining the company’s long-term financial outlook. In this sense, the key difference between the two metrics is time.
When managers consider cash flow vs profit, it is also important to remember that it is completely possible for a business to be profitable while having a poor cash flow. For example, if the business is a small electronics manufacturer selling wholesale products to large companies, delayed payment (which is not uncommon for large corporations) could mean that the business is unable to pay its suppliers. Even if the business has a successful product with rising sales, it could end up facing cash flow issues, and despite reaching profitability, the business may be unable to meet its financial obligations. Is cash flow more important than profit? Ultimately, cash flow and net profit measure different things. While profit is the goal – and an indicator of financial health – cash flow is the lifeblood of an organisation, keeping operations ticking over on a day-to-day basis. For a growing business, both cash flow and net profit are important, but in the short-term, cash flow is probably the number one concern. Can growth lead to cash flow problems? While it seems counterintuitive, it is possible for the growth of a business to generate issues with cash flow. For example, during a period of high growth, a company may accept too many orders without having enough cash to produce them, making it necessary to sell stock or seek a loan. That is why it is so important to understand cash flow vs profit and – in some instances – for managers to be willing to take their foot off the accelerator for the sake of a company’s long-term prospects. The relationship between investment, profit and cash flowInvestment is the purchase of capital goods or productive assets, such as machinery and business premises. The aim of such expenditure is to enable the production of goods or services that will generate future cash flow and profits for the business. These capital purchases will have a negative impact on a firm’s cash flow position in the short term, as they represent cash outflows.
The cash flow implications of investment will differ as firms move through their life cycles and as they grow. For start-up businesses, without existing financial reserves, investment comes with a high risk of insolvency. There are no guarantees that customers will buy sufficient goods and services to cover the initial costs and then provide a future profit. Cash flow may remain negative and finance providers may require repayments that the firms cannot fund. The consequence of such liquidity problems is the failure of many small firms in their first few years of operation. For established firms, there may be sufficient cash from sales revenue or from cash reserves to cover investment costs, especially where firms are achieving high profit levels. |
Why profit is not the same as cash flow
Cash flow vs. profit
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Causes of cash flow problems1. Poor financial planning. It is said that failing to plan is planning to fail. For many businesses, the lack of a disciplined approach to financial planning is an ongoing cause of cash flow shortages. Working to a detailed forecast, financial plan and budget – and reviewing and updating these important documents regularly – will mean that managers can foresee any potential cash flow shortages and take action to ensure they are well managed. This might include having a readily actionable plan to access additional funding if it is needed.
2. Declining sales or profit margins. Declining sales can have a devastating effect on an organisation's cash flow. A reduction in sales might be driven by an increase in competition from local or international competitors, a general decline in sales across an industry, or softening economic conditions. If an organisation's overheads stay the same against declining sales, it is likely to find itself in a dangerous financial situation fairly quickly. Likewise, erosion of profit margins can hit a business hard. Even if overall sales are growing, if its margins are getting smaller, its profitability will be negatively affected. Managers should continually review its gross profit margin to ensure that the pricing is competitive but does not have the business running at a loss. 3. Consistent late payments. It can put a considerable strain on an organisations cash flow if your customers consistently miss your payment deadlines. A recent report suggests that, on average, customers take about 36 days to pay invoices with 30-day terms. With this in mind, it is sensible to assume that all debtors are unlikely to pay on time and ensure that the business has a cash buffer to draw upon if needed. It is also worth considering tightening credit control processes and looking at ways to encourage customers to pay on time. 4. Poor inventory management. Poor inventory management can be a costly mistake. A glut of excess stock means that valuable cash is tied up in product that’s sitting with a business rather than its customers. Additionally, if a business buys in bulk and does not turn over its stock quickly, there is a risk that it could become obsolete and unsellable. A strategic approach to inventory management will allow a business to avoid the costs associated with poor stock management. It should have a robust inventory management system in place, monitor inventory levels carefully, undertake a physical stock take on a regular basis, and clear discontinued or obsolete stock periodically. 5. Inflexible funding facilities. Whatever a business' approach to funding, it should continually assess whether it is the right solution for it. A solution that worked for it as a start-up will not necessarily be the best choice if the business is in the expansion or maturity stages of the business lifecycle, for example. The funding options available to small businesses continue to evolve. Managers should benchmark the current funding solution against other products in the market every so often to check if there is a better fit for the business. 6. Seasonal variation. Most businesses have seasonal highs and lows. Peak periods are great for sales – but they are often associated with extra costs such as additional staff and stock. Likewise, if a business is going through a sales lull or dealing with a number of debtors who are not meeting payment terms, its finances are likely to be under pressure. It is important for managers to understand their business’ seasonal cycle – and also to appreciate that these can be disrupted due to a change in weather, supplier terms, or other external factors. For this reason, managers should ensure that the business holds a cash reserve for when times are tight; it is also worth considering applying for a funding solution that can be accessed on an as-needs basis – such as a revolving line of credit or an overdraft facility. |
Why cash flow matters and keeping track of itImproving cash flow
Ways to improve business cash flowDebt factoring explainedCredit control: Monitoring of debts to ensure that credit periods are not exceeded.
Bad debts: Unpaid customers' bills that are now very unlikely to ever be paid. |
Cash flow forecasting
Forecasting cash inflows, examples include:
Forecasting cash outflows, examples include:
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Example cash flow forecast
Key termsCash flow forecast: Estimate of the firm's future cash inflows and outflows.
Net monthly cash flow: Estimated difference between monthly cash inflows and outflows. Opening cash balance: Cash held by the business at the start of the month. Closing cash balance: Cash held at the end of the month becomes next month's opening balance. |
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IB Business Management 3.5 Cash flow
SUMMARY NOTES
IB Business Management: 3.5 Cash flow teaching and learning PowerPoint notes for HL and SL IB Business Management
PROGRESS CHECK – Test your understanding by completing the activities below
You have a range of practice activities, interactive flash cards, exam practice questions, interactive quizzes and classroom games to ensure you and your students have complete mastery of the IB Business Management requirements for the 3.5 Cash flow topic.
USE THE FLASHCARDS IN ALL STUDY MODES
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IB Business Management
3.5 Cash flow Student learning activity A 
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IB Business Management
3.5 Cash flow Student learning activity B 
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IB Business Management
3.5 Cash flow Student learning activity C 
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IB Business Management
3.5 Cash flow Student learning activity D 
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IB Business Management
3.5 Cash flow Exam practice questions 
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IB Business Management interactive quizzes and classroom games
Test how well you know the IB Business Management Finance and Accounts: Cash flow topic with the interactive self-assessment quizzes below. Each interactive quiz selects 30 questions at random from a larger question bank so keep on practicing! Aim for a score of at least 80 percent.
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