June 13, 2023

What Matters Most For UK Business Financial Health - Cash Flow vs Profit

The profitability of any business is a major focus, but cash will always remain king. Cash flow v profit and other key indicators should not be neglected.

Which Matters Most to UK Business Financial Health - Cash Flow vs Profit
Which Matters Most to UK Business Financial Health - Cash Flow vs Profit


Focusing on turnover and profit margins is common in every business space – but disregarding the extreme importance of cash flow can be serious, where companies without the cash reserves to keep pace with their obligations can find themselves, in the worst-case scenarios, in liquidation regardless of whether they are generating a healthy profit year on year.

Profitability is, of course, relevant. Still, there are often ways to manage loss-making periods where the business has a solid strategy or forecasting that indicates that short-term losses form part of company development that will lead to sustainable profit-making in the future.

However, sharp drops in cash flow can be disastrous and mean even organisations with sector-leading profits cannot operate, primarily where income is heavily seasonal, leaving them with long periods of reduced working capital in the interim.

Balancing the Value of Cash Flow vs Profit

The vast majority of businesses are formed with the end goal of producing profits. Indeed, profits are a fundamental aspect of trading, where profits generate the cash to pay dividends, grow shareholder wealth and ensure the company has a viable future.

From a financial management perspective, a lack of cash flow awareness is one of the most common reasons businesses fail or don't realise their financial health is in a difficult position until recovery becomes challenging.

To clarify the definitions of cash flow vs profit:

  • Net profit is the residual cash remaining when a business has deducted all costs, expenses and outlays from turnover, used to disburse dividend payments to shareholders or reinvest in business operations.
  • Cash flow signifies the cash movement into and out of the business, where a positive cash flow means the company has a credit balance in its bank account, and a negative position means the organisation is spending more cash than it has available.

While the business advisors at James Todd & Co accountants for small business always stress the vital influence of cash flow, the priorities of an organisation may also depend on their circumstances.

For example, those with secure investment backing or wealthy owners happy to inject working capital on demand can focus solely on profits without any risk of defaults – but this is rarely the case.

Why Negative Cash Flow Can Stall Otherwise Successful Businesses

The easiest way to demonstrate why cash flow is just as influential as profit is a theoretical case study. Below we look at an aerospace component manufacturer with established expertise, a secure client base, and no shortage of demand.

Example of a Cash Flow Crisis

In this scenario, our business has specialist skill and knowledge and little concern about competitors or market share due to decades of proven success, providing technical and high-precision parts with an acclaimed safety rating.

However, contracts, while worth multi-millions, usually require several months to fulfil. The business commands a 10% cash deposit upfront but finds this down payment insufficient to cover the running costs essential to finance the manufacturing process.

  • One contract is worth £3 million. The order arrives on 1st January and is deliverable on 31st December, providing 12 months of production time to meet the client’s requirements.
  • The client pays a 10% deposit, as per the purchase terms, worth £300,000 and commits to a contract whereby they intend to purchase the finished components on or before the delivery date, with a balance payable of £2.7 million.

This looks like a viable business, with £300,000 of working capital, a guaranteed income of £3 million over one trading year, and clear profitability. The issue emerges when the company needs to cover costs of £50,000 per month, including staff wages, running costs and overheads – plus an initial outlay of £1.2 million to cover the raw material inputs required.

The business model is not necessarily weak, where £3 million of revenue, less £1.2 million of direct costs, and total running costs of £600,000 per year equate to an extraordinary 40% net profit of £1.2 million.

But, with cash inputs of just £300,000, the business cannot finance raw material purchases and only has adequate cash flow to cover six months of basic running costs. If it has no cash reserves, no investment opportunities, and no financing support, it could easily face liquidation if the owners do not take appropriate steps to secure the financial backing necessary to enable the company to generate the profits it is capable of.

Reasons All UK Businesses Should Be Mindful of Cash Flow

The relevance and importance of cash flow does not detract from the need for a business to generate profits, but as a commonly overlooked indicator of financial health, there are several reasons we include a thorough cash flow audit in every onboarding process.

Problems with cash flow can suggest underlying operational issues before they otherwise come to light, and that are easily concealed beneath positive profits. Issues such as late client payments can quickly create shortages in working capital – where management accounts showing contradicting months of profitability and loss-making are an early red flag.

Positive cash inflows are essential for businesses to grow, rather than waiting for the year-end to reinvest small profit surpluses into areas such as expansion, research, workforce development or new product designs.

Sudden changes or cost pressures – a common symptom of the current spike in interest rates and operating costs - can be extremely difficult to manage for businesses without cash reserves and mean a reliance on short-term, high-interest debt, where overdraft fees and late charges can quickly reduce profits.

Investors also look for business opportunities with a healthy cash flow that shows they have a model that can scale, with the potential for reinvestment and sustainable growth rather than short-term profits.

Managing Cash Flow vs Profit

Cash flow may not be the obvious marker new business owners and entrepreneurs consider, but it can be an excellent way to evaluate where you stand and is often a more meaningful indicator than profitability alone.

Working with an accomplished business chartered accountants firm ensures you have a firm grasp of every essential metric, including cash flow vs  profit, to address financing shortfalls or recognise where working capital deficits have the potential to turn a profitable business into a liquidation scenario.

For more guidance about assessing your profits and cash flows and balancing the importance of every important financial indicator, please contact James Todd & Co accountants Chichester for advice and support from the business accountancy specialists.

Read more about James Todd & Co - Changes to UK Energy Cost Business Support from April 2023 Highlighted by UK Business Accountants

About James Todd & Co

James Todd & Co have been providing accounting services for more than 30 years across Chichester, Farnham, Lavant, and Sussex and Hampshire businesses. Their clients trust them to provide bookkeeping, financial auditing and compliance, management accounting and financial advisory services.

***

Source Company: https://www.jamestoddandco.co.uk/




Source: Digital PR
Release ID: 642853