Profit is the difference between a firm’s revenue and its cost. Profit is calculated by subtracting expenditure from revenue. Cash flow is the sum of cash inflows minus the sum of cash outflows, over a given period of time. Small, expanding businesses should be concerned about both, profit and cash flow at different stages of their expansion and stabilisation. When a business starts up, it needs a monthly opening balance to begin. The business may get a loan form the bank in order to increase their opening balance. Alternatively, the business can borrow money from friends and family.
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At this point the business won’t be making any sales, so their only inflow will be from their opening balance. However, their cash outflows will be expected to be much higher than their inflows. This is because much of the money from the opening balance will be spent on materials, wages and possibly other costs such as advertisements. At this point, the business should anticipate a negative closing balance. This does not signify that the business is not doing well, simply because they haven’t had a chance to increase sales.
Managing cash flow should be much more important than making a profit as it is a more realistic goal at this stage. It is important to know how and where the cash outflows are spent and it is important to start stabilizing the business. The business should organise their perspectives into long term and short term. They should understand that in the short term it is alright to not be making a profit. It is more important to have a good cash flow to avoid problems with it in the future.
When the business starts to increase sales, their next goal should be breaking even rather than making a profit just yet. An example of a similar business could be a local newspaper which has just started up. At first the cash outflows will be imbalanced compared to cash inflows as the business will have to spend a lot of money on raw materials, advertising and paying wages. Eventually, as there will be an increase in awareness of the newspaper more people will buy it and therefore sales income will increase.
However, if the business did not manage their cash flow properly they could end up in large debt which they cannot repay and go bankrupt. This may be because they did not have a cash flow forecast and therefore didn’t anticipate shortages of cash, the timings of receipts and payments and arranged unsuitable financial support. All of these factors could halt the business from making potential profit in the future. From this example it is possible to conclude that before a business thinks about making profit, they should manage their cash flow.
Making a profit should be equally important to the business in the long term. The lack of profit will cause a shortage of cash. If profit increases, the business has a chance to increase. First of all, profit may be used to repay long term loans. For example, a travel agency has just begun to make a considerable profit. Assuming that the agency has good cash flow management, it can move into a larger office, perhaps in a better location. This may attract more customers and therefore increase sales. As a result of the profit they are able to repay their bank loan.
If on the other hand, a business makes no profit it will not be able to survive long term. For example if the travel agency took out a bank loan to move into a larger office but their sales decreased due to a sudden growth in fear of terrorism, they will not be able to pay their bank loan in time. They may also be unable to pay the rent or the workers wages. All of these factors will lead to eventual bankruptcy of the business unless they start to make a profit. The business’s first goal should be survival.
This can be managed through improving and attaining a good cash flow. Their second goal should be making a profit which will occur when cash inflow will be greater than cash outflow. It is also possible to state that during short term the business’s main concern should be attaining a positive cash flow as without a positive cash flow profit will never be made. During the long term, when positive cash flow has been stabilised their main concern should be making a profit in order to continue surviving and possibly expanding.