Cash flow versus profit

To understand how cash differs from profit, the key is to master profit. On the face of it, profit is easy: total revenue - total costs. Common sense tell you that revenue = money in and costs = money out. Unfortunately that's far too much of a simplification. 

To understand the difference, it is helpful to break it down into its two components

Distinguishing revenue from cash inflows

Revenue is not the same as money in. Revenue is the value of sales made over a specified period: a day, a month or a yea. 

Whereas revenue comes from just one source (customers), cash inflows can come from many sources. It is not limited to trading. Selling an old warehouse does not generate revenue, but it does bring in cash. Similarly, taking ot a bank loan could not be classed as revenue, but it does put cash into your bank current account.

So cash inflows can be part of the revenue, but they do not have to be. Therefore cash and revenue are not the same. 

Distinguishing costs from cash outflows

Te same distinction applies to costs and cash outflows. There are many reasons why a firm might pay out cash. Paying for the business's costs is only one of them, eg. dividends, repaying a loan or making an investment. 

A profitable usiness may run out of cash, simply because it expands too anbitiously, perhaps unluckily. There are other reasons why a profitable business might run into negative cash flow. 

Seasonal factors: A fake christmas tree manufacturer will make most of their money in the winter months so have to save then for the rest of the year in order to fill demand.

Problems with credit periods: If a firm gives credit periods to its customers, there is a risk from a long dekay to a credit payment, For example, a builder who has put a great deal of money into renovating a large hurse finds that the client keeps delaying the final payment. The more serious the builder's cash flow problems become, the stronger the position of the client. So a profitable business may be thrown into a cash crisis that could threaten its survival. 

The key to appreciate that cash flow and profit are different aspects of the same thing. Cash flow and profit are linked, but they are not the same. Good financial planning requires an estimate of the likely profitability of a course of action. It then requires a careful forecast of the flows of cash in and out of the business. Profitability shows the long-term value of a financial decision; cash flow shows the short-term impact of that decision; cash flow shows the short-term impact of that decision on the firm's bank balance. 

Company cash flow is dominted by credit. Few companies pay in cash and few sell for cash; they sell for credit. Therefore the biggest difficulty is if a company loses its financial credibility. If other businesses fear that a company will close it will surely do so. Suppliers will no longer give credit, so more cash is needed simply to keep in business; and if customers are increasingly worried about your survival, they'd prefer to go elsewhere.

It's critical therefore, to avoide any suggestion that you are struggling financially. So if you need to improve cash flow you need to o it with subtelty. Beware of demanding shorter credit periods of your customers - or longer ones from suppliers. There is a reason why companies try to improve their cash flow position by cutting inventories or by speeding up their production programme. 

Credit from suppliers - Delay payment to them - They lose confidence in your solvency (demand cash upon delivery)

Short of working capital - Use debt factoring - Fees take a large chunk of profit

Use your assets - Sell underperforming assets for cash - Fewer assets for the future. 

Profit can be improved in one of three ways: raise prices (if PED isn't too high), raise sales volumes or cut costs. In reality each will be difficult because the business will already have done what is necessary to optomise revenues and profits. Therefore prices will already be set at the 'right' level and costs will already have been driven down as low as makes sense. It's unwise to make it sound easy to improve profit. 

In practise the three main difficulties are:

• Raising prices - For PE products this inevitably buts revenue, but as the % fall in sales outweighs the % price rise. But even for P inelastic products there can be concerns. If other companies can see that one high-priced brand is making big profits, they will be attracted to compete. So pushing up the price provides a nice short-term boost to profit but perhaps at the cost of a future decline in market share. 
• Boosting sales volumes - The problem is that either it is done by cutting prices or the strategy will require some addition to costs, for example, extra advertising spending, the launch of a new flavour etc. Careful analysis is required to demonstrate that boosting sales volumes will end up improving profit.

• Cutting costs - It may seem obvious that you should look for a cheaper supplier, but every business is always on the look-out for that; so there's a risk that a cheaper supplier will have negatives such as: poorer quality, worse delivery reliability and poor working conditions. Similarly, cutting fixed overhead costs by moving to a cheaper location may mean losing key staff - or storing some hostile press coverage.