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Spec mapping: AQA 7138 Unit 3.1.4 — Financial Management (refer to the official AQA specification document for exact wording). This lesson develops the most analytically important distinction in the unit — the difference between profit (the accounting story of value created in a period) and cash flow (the operational story of money moving in and out). Confusion between the two is the most frequent cause of small-business failure and one of the most commonly mis-handled A-Level topics. We work the conceptual difference, the structural causes of divergence, the forecasting discipline that contains it, and the evaluative judgements an examiner expects.
Connects to:
Definition: Profit is the difference between total revenue and total costs over an accounting period, measured on the accruals basis — revenue is recognised when it is earned (typically when goods are delivered or services rendered) and costs are recognised when they are incurred, regardless of when cash actually changes hands. Cash flow is the actual movement of money into and out of the business's bank account in real time.
The two concepts measure fundamentally different things. They use different timing conventions, treat capital expenditure differently, and respond differently to non-cash items like depreciation. An A-Level student who can hold these two concepts apart while explaining how they interact has already cleared the most important conceptual hurdle in Unit 3.1.4.
| Dimension | Profit | Cash flow |
|---|---|---|
| What it measures | Surplus of revenue over costs in a defined accounting period | Actual receipts and payments through the bank account |
| Timing convention | Accruals basis — revenue matched to the period it is earned in | Cash basis — recorded when money moves |
| Treatment of credit sales | Revenue recognised at delivery, even if customer pays 60 days later | No cash impact until customer actually pays |
| Treatment of depreciation | Charged against profit each year over asset's life | No cash impact — cash left when the asset was bought |
| Treatment of capital expenditure | Spread across asset life via depreciation, not expensed at purchase | Full cash outflow at point of purchase |
| Treatment of inventory build | Cost of sales charged only when inventory is sold | Full cash outflow at point of purchase from supplier |
| Headline formula | Profit = Total revenue − Total costs (Annex 7 formula 20) | Net cash flow = Cash inflows − Cash outflows |
Two formulae from Annex 7 are useful to keep alongside the definitions:
Revenue = Selling price per unit × Number of units sold (Annex 7 formula 10 — provided in the exam formula sheet)
Contribution per unit = Selling price − Variable cost per unit (Annex 7 formula 11 — provided in the exam formula sheet)
Both are profit-side metrics — they say nothing about whether the cash has actually arrived. The Annex 7 efficiency formulae below are cash-side metrics — they describe how long money is tied up in working capital.
Receivable days = (Receivables ÷ Revenue) × 365 (Annex 7 formula 17 — provided in the exam formula sheet)
Payable days = (Payables ÷ Cost of sales) × 365 (Annex 7 formula 16 — provided in the exam formula sheet)
These two efficiency measures are the bridge between the profit story and the cash story.
The most counterintuitive truth in Unit 3.1.4 is that being profitable and being solvent are different things. A business is insolvent when it cannot meet its debts as they fall due. A profitable business that has lent out all its cash to customers on 90-day credit terms can be insolvent on the day a supplier's invoice falls due, despite a healthy operating-profit margin on its income statement.
The technical term for this is overtrading — growing faster than the cash position can sustain. It is one of the leading causes of small-business failure, even (especially) when the underlying trading model is profitable.
Customer credit terms. A business records the sale and recognises the profit on delivery, but the cash arrives later. The longer the credit period, the wider the gap. A business selling £100k of goods per month on 60-day terms is, on average, owed £200k by customers at any given moment — capital that sits as an asset on the balance sheet but is unavailable to pay this month's bills. The Annex 7 receivable days calculation quantifies this: if receivable days = 60 and revenue = £1.2m, then receivables = £197k tied up at any time.
Inventory build-up. Buying raw materials and finished goods consumes cash now; the cost of sales (and matching revenue) is only recognised when the inventory is sold. A business that builds inventory ahead of a seasonal peak ties up cash for weeks or months before that cash returns through the sales cycle.
Capital expenditure. Buying a £200k piece of equipment is a full £200k cash outflow on day one but is recognised in the profit calculation only as ~£20k of depreciation each year over the asset's 10-year life. The £180k difference is real cash that has left the business but has not yet appeared in the profit calculation.
Payable terms. When suppliers shorten their payment terms (or refuse credit), the business must pay sooner — squeezing cash even though nothing has changed on the profit side. The Annex 7 payable days calculation quantifies how much cash is being financed by supplier credit; when that source contracts, cash flow tightens immediately.
Loan repayments and dividends. Repayment of loan principal and payment of dividends are cash outflows that do not appear as expenses in the profit calculation. A heavily geared business may be profitable but cash-strapped because the bulk of operating cash flow is being absorbed by debt service.
Bright Spark Electronics wins a contract to supply £500k of goods to a large national retailer. Headline numbers:
The profit story is excellent — a 24 % gross margin on a substantial new contract. The cash story is dangerous. Over the first six months, Bright Spark pays £380k in supplier and labour costs but receives almost nothing from the retailer until month four (the first invoiced delivery clears its 90-day window). If Bright Spark begins the contract with only £100k in the bank, it faces a peak working-capital requirement of approximately £280k that it does not have.
Without arranging additional finance — overdraft, working-capital loan, or invoice discounting — Bright Spark could become insolvent in month two, despite winning what is, on paper, a £120k profit contract. The contract that should have grown the business kills it.
This is exactly the trap that cash flow forecasting (Annex 8 sophisticated concept #16) exists to surface in advance. A 12-month rolling cash-flow forecast built before the contract was accepted would have flagged the peak working-capital gap and forced the question: do we have the finance in place to bridge it?
Depreciation is the most pedagogically important non-cash item because it is the cleanest demonstration that profit and cash are different.
Definition: Depreciation is the accounting recognition that a non-current asset (equipment, vehicles, fixtures) loses value over time as it is used. It is charged as an expense against profit each year over the asset's useful life. Crucially, depreciation involves no cash outflow — the cash left when the asset was originally purchased.
Worked example. A business buys a £100k delivery vehicle with a five-year useful life and zero residual value. Using straight-line depreciation, £20k is charged against profit each year.
| Year | Cash outflow for vehicle | Depreciation charged against profit |
|---|---|---|
| 1 | £100,000 | £20,000 |
| 2 | £0 | £20,000 |
| 3 | £0 | £20,000 |
| 4 | £0 | £20,000 |
| 5 | £0 | £20,000 |
| Total | £100,000 | £100,000 |
Over the asset's whole life, the totals match — but the timing is completely different. In year 1, profit looks artificially strong (only £20k charged against it) while cash looks artificially weak (£100k has just left the business). In years 2–5, the reverse is true — profit is suppressed by £20k of depreciation each year while no cash has gone anywhere. This timing mismatch is the structural reason why operating cash flow and operating profit diverge for businesses with significant capital expenditure.
The exam-relevant implication is that depreciation can be added back when reconciling operating profit to operating cash flow — it was deducted from profit but did not move cash, so adding it back restores the cash-side picture.
The working-capital cycle is the operational mechanism that determines how long cash is tied up between paying for inputs and receiving payment for outputs.
flowchart LR
Cash["Cash in the bank"] -->|"pay supplier<br/>(payable days)"| Inventory["Raw materials / inventory"]
Inventory -->|"production lead time"| FG["Finished goods"]
FG -->|"sell on credit"| Receivables["Receivables<br/>(money owed by customers)"]
Receivables -->|"customer pays<br/>(receivable days)"| Cash
style Cash fill:#15803d,color:#fff
style Receivables fill:#dc2626,color:#fff
The longer the loop, the more cash is tied up in working capital. The standard diagnostic is the cash conversion cycle:
Cash conversion cycle (days) = Inventory days + Receivable days − Payable days
A business with 45 inventory days, 60 receivable days and 30 payable days has a 75-day cycle — it is financing 75 days' worth of operations from its own cash before any customer payment arrives. Compressing the cycle (by holding less inventory, collecting receivables faster, negotiating longer payable terms) is the most direct way to free up cash without affecting profit.
This connects directly to the current ratio (Annex 8 financial concept #7) and acid test ratio (Annex 8 concept #8) covered in the liquidity-ratios lesson later in this course:
Current ratio = Current assets ÷ Current liabilities (Annex 7 formula 18 — provided in the exam formula sheet)
Acid test ratio = (Current assets − Inventory) ÷ Current liabilities (Annex 7 formula 19 — provided in the exam formula sheet)
Both are cash-side health checks. They tell you whether the business has enough liquid assets to meet its short-term liabilities, regardless of whether it is profitable on the income statement.
A cash flow forecast is a structured month-by-month projection of expected cash inflows and outflows, typically rolling 12 months ahead. It is the operational tool that prevents the overtrading trap.
| Jan | Feb | Mar | |
|---|---|---|---|
| Cash inflows | |||
| Cash sales | 10,000 | 12,000 | 15,000 |
| Credit sales receipts | 8,000 | 10,000 | 12,000 |
| Other income | 500 | 500 | 500 |
| Total inflows | 18,500 | 22,500 | 27,500 |
| Cash outflows | |||
| Raw materials | 7,000 | 8,000 | 9,000 |
| Wages | 6,000 | 6,000 | 6,500 |
| Rent | 3,000 | 3,000 | 3,000 |
| Other costs | 1,500 | 1,500 | 2,000 |
| Total outflows | 17,500 | 18,500 | 20,500 |
| Net cash flow | 1,000 | 4,000 | 7,000 |
| Opening balance | 5,000 | 6,000 | 10,000 |
| Closing balance | 6,000 | 10,000 | 17,000 |
The closing balance for one month becomes the opening balance of the next. The forecast surfaces any month in which closing balance is projected to dip below zero (or below the agreed overdraft limit) — that is the trigger to act in advance, not after the fact.
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