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What Is Cash Flow?

Cash flow should not be confused with 'profit' - these are two different things. Profit refers to the difference between the total revenue (TR) and total cost (TC) over a period of time.

Most businesses, when starting up, will have to spend money to get things set up. In the example of the fruit business, the students had to spend out money on buying some of the main things they needed to run the business - the shed, the lab coats, the display boxes and the money box. These represented their 'fixed costs' - the costs that do not depend on the level of output or sales.

Buying in the fruit each day represents a variable cost to Fruit28 - the more fruit they buy, the higher the cost. The display boxes, however, are used over and over again; their cost does not depend on the amount produced or sold - they are called fixed costs. Copyright: Penelope Berger, from stock.xchng.

When Fruit28 had the basic things needed to conduct its business, they obviously needed to buy some stock - fruit. The amount of fruit bought each week depends to a large extent on the sales. Some weeks, they might need more apples; in others, they might need less pears, depending on the level of demand.

The fruit they buy represents their 'variable costs' - these are the costs that depend on the amount produced (Output) or the amount sold.

There are other costs that they have to consider but which are not quite so easily classified. For example, Fruit 28 has to pay an uncle to deliver the fruit to them each morning. If they reduce the amount of fruit they buy, they still have to pay the delivery charge whether he delivers fifty apples or ten!

Such costs are sometimes called 'semi-fixed costs'.

Money flowing out of the business

It should be clear from what we have said so far that the business will have to pay out money in order to carry out its activities. This is its 'expenditure'.

A business has a responsibility to pay all sorts of bills in carrying out its activities. In our simple example we have tried to keep the amount of information to a minimum. In a real business the firm will be paying out for all sorts of things. This will include paying wages to staff, insurance premiums, interest on loans, rent for premises, postage costs, heating, lighting, telephone bills, payments for paper, computers, photocopiers, water bills, rates and so on.

Some of these costs have to be paid monthly, others perhaps every three months, some might be paid yearly and in some cases costs might be incurred every day. In many cases, the business will know when it has bills that it has to pay.

The people to whom a business owes money are called the 'creditors'. If you enter into an agreement as a business with a creditor, you have an obligation to pay them. If you do not pay then the creditor could take you to court to force you to pay your debts. If this happens with lots of creditors then this could be the thing that causes the firm to become insolvent.

Money flowing into a business

To balance this out, the firm receives money from selling its goods and services. In our simple example, Fruit28 receives revenue from selling fruit. The revenue they receive depends on the amount they sell (Q) and the price that they charge (P). We can say therefore that Total Revenue (TR) = P x Q.

Bills will arise for all sorts of things - they all represent a flow of money out of the business and the business has to make sure it has enough cash to cover these debts when they are due. Copyright: Patryk, from stock.xchng

Fruit28 might expect to receive revenue from their sales each day. Some businesses do not receive their revenue on such a regular basis. It will depend on the agreements they have with their customers. If a business is involved in selling goods to another business, for example, there might be an agreement that they will receive payment for goods supplied every 28 days, or possibly 3 months; it might be 6 months or even annually.

A firm will normally send an invoice to its customers to notify them how much they owe. The people who owe money to a firm are called 'debtors'. Payments do not always arrive when they should, however, which can be the start of the cause of cash flow problems

Some firms might see revenue rise at certain times of the year but at other times sales might be very slow. Toy shops for example, might expect to receive the vast majority of the revenue from sales in the period from September to December. The period from February to August might be very slow.

Revenue, therefore, does not come in at the same time as costs have to go out. This is the main problem facing firms and the whole point about cash flow. A firm has to manage its cash to ensure that it has enough money coming in to pay its bills. If it cannot pay a bill for some reason, it could perhaps negotiate with the creditor to delay the payment. However, it cannot keep doing this!

The diagram above helps to understand this idea of a 'flow'. If the money coming into the business is more than that going out, the business will have a surplus of cash.

If there is a problem in getting the money in from debtors (people who owe the business money) then the firm might face problems in paying its creditors (the people it owes money to). Many businesses, especially small ones, find that getting the money they are owed is not always easy. If they cannot pay their debts however, this can force the firm to have to close down.

In our diagram, WH Smith's revenue is a lot more stable but there might be slight increases in August/September (when students go back to school) and around Christmas time. For Mowlem, they receive a spike in revenue every three months but nothing in between!

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