Improving Cash Flow, Profits and Profitability (AQA A Level Business): Revision Note

Ways to improve cash flow

• The best way to improve cash flow is to manage the business better

  • Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action

  • Budget effectively and consider adopting zero budgeting to carefully control spending

  • Set clear financial objectives and look for ways to reduce outflows and increase inflows wherever possible

    • E.g. Global conglomerate 3M, maker of Post-it Notes announced in early 2023 that it intends to raise prices and cut about 6,000 jobs to improve its profits and cash flow position 

• A business can also have too much cash

  • If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments

  • This may represent a significant opportunity cost especially when interest rates are high

Methods to improve cash flow

Ways to improve profits and profitability

• There are several steps a business can take to improve profits and profitability

Main ways to improve profitability

Raising prices

• If costs remain the same, profitability will improve as the difference between the selling price and costs is now greater

  • Raising prices is likely to have an impact on demand so businesses must understand the price elasticity of demand for its products

    • Where demand for products is price elastic, increasing prices will result in lower revenue - in this case, profitability will be reduced

    • Where demand for products is price inelastic, increasing prices will increase revenue - in this case profitability will rise

Reducing variable costs 

• This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk

  • Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products

  • Buying stock in greater quantities may require investment in increased storage space, which will reduce the impact of the cost savings made

  • Businesses may also be able to reduce waste of raw materials and components 

Reducing other expenses 

• Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses

  • Reducing staffing levels may affect staff morale and negatively affect productivity

  • Relocation costs can outweigh some benefits of moving to a cheaper location

  • Replacing inefficient or outdated equipment may require staff training

Reducing one-off costs and interest charges 

• Delaying the purchase of fixed assets, entering leasing arrangements, or restructuring borrowing can reduce costs 

  • Delaying purchases of new fixed assets (e.g. machinery or vehicles) may negatively impact capacity utilisation as a result of increased breakdowns and maintenance of the old equipment

  • The leasing  of equipment (e.g. photocopiers) can reduce one-off purchase costs but the business never owns these assets, which weakens the balance sheet

  • Restructuring borrowing can result in lower monthly payments but requires lenders to agree to new terms, which they may not be willing to do

Difficulties improving cash flow and profit

Cash flow

• Improving cash flow is about managing the timing of money in and out

• However, late payers, excess stock, over-ambitious expansion and seasonal sales dips often delay or reduce cash inflows

Examples of difficulties improving cash flow

Profit

• Profit is the money left after all costs are paid

  • Higher profit means more cash to reinvest in better products, reward owners and staff, and build a buffer for tough times

  • Without a healthy profit, a firm can’t grow or may even shut down

• However, increasing profit is rarely straightforward; pressures outside a business’s direct control can have a significant impact

  • Costs such as raw materials, wages and energy often rise faster than prices

  • Rivals can force prices down in a price war

  • Factors like recessions or exchange rate swings cut sales values