Cash Flow vs Profit

This lesson examines one of the most important distinctions in A-Level Business: the difference between cash flow and profit. Understanding why a profitable business can run out of cash — and why a cash-rich business may not be profitable — is essential for AQA Paper 1 and Paper 3.

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The Critical Distinction

Students frequently confuse cash flow and profit, but they measure fundamentally different things:

	Profit	Cash Flow
What it measures	The surplus of revenue over costs in a period	The movement of money into and out of the business
Timing	Recorded when a sale is made (even if payment is not yet received)	Recorded when money actually enters or leaves the bank account
Basis	Accruals basis (revenue matched to the period it relates to)	Cash basis (actual receipts and payments)
Includes non-cash items?	Yes — depreciation is deducted from profit	No — depreciation does not involve a cash outflow
Includes capital items?	No — buying a machine is not an expense in the income statement (only depreciation is)	Yes — buying a machine requires an immediate cash outflow

Key Definition: Profit is the difference between total revenue and total costs over a period, measured on an accruals basis. Cash flow is the actual movement of money into and out of a business over a period.

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Why Profitable Businesses Can Fail

This is a classic exam question and a real-world phenomenon. A business can be highly profitable on paper yet still collapse if it runs out of cash. This is sometimes called overtrading or cash flow insolvency.

Common Reasons a Profitable Business Runs Out of Cash

1. Offering generous credit terms to customers. The business records a sale (revenue) when the goods are delivered, but the cash may not arrive for 30, 60, or even 90 days. Meanwhile, the business must pay its own suppliers and wages immediately.

2. Rapid growth (overtrading). A business wins a large new contract and must buy raw materials, hire staff, and invest in capacity before it receives any payment. The faster a business grows, the greater the cash flow gap.

3. Large capital expenditure. Purchasing new premises or machinery requires a large immediate cash outflow, even though the cost is spread over many years in the profit calculation (via depreciation).

4. Seasonal demand. A business may earn most of its revenue in December but must pay costs throughout the year. For eleven months, cash outflows may exceed inflows.

5. Poor credit control. If customers are slow to pay or default on debts, the cash position deteriorates even if sales are strong.

Worked Example: Overtrading

Bright Spark Electronics wins a contract to supply £500,000 of goods to a large retailer. The retailer demands 90-day payment terms.

• Bright Spark must spend £300,000 on components and £80,000 on labour immediately.
• The profit on the contract is £500,000 - £380,000 = £120,000.
• But Bright Spark will not receive any cash for 90 days. It needs £380,000 of cash upfront.
• If Bright Spark only has £100,000 in the bank, it faces a £280,000 cash shortfall despite the contract being highly profitable.

Without additional finance (a bank loan, overdraft, or debt factoring), Bright Spark could become insolvent — unable to pay its debts as they fall due — even though the contract will eventually deliver a healthy profit.

Exam Tip: "Cash is king" is a common business saying. In exam answers, always distinguish clearly between profit (an accounting concept) and cash (the lifeblood of day-to-day operations). A business that runs out of cash cannot pay wages, rent, or suppliers — it will cease trading regardless of how profitable it appears on paper.

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The Role of Depreciation

Depreciation is a key reason why profit and cash flow differ.