3.1 Making a profit and generating cash
What is the main objective of business activity?
Generally speaking, the main reason for the existence of a business is to make a profit for the owner(s) over a defined period. (There are, of course, other objectives that a business might have and the business has to work within the laws and customs of society.)
Profit over a period is achieved by trading successfully, i.e. a business is able to sell goods or services for more than the expenses incurred in producing them in the same period. A loss over a period, on the other hand, is when a business is only able to sell goods or services for less than the expenses incurred in producing them in the same period. If we say that the start of a period is time 0 and the end-date of a period is time 1 then the profit or loss for this length of time can be expressed by the formula:
Profit or loss 1–0 =Income 1–0 –Expenses 1–0
Income is a wider concept than sales as it includes all earnings in a period. Income thus includes interest received, rent received, etc. as well as cash and credit sales.
What is the difference between making a profit and generating cash in an accounting period?
Profit is when income earned, by cash or credit, is greater than expenses incurred, by cash or credit, in the same accounting period.
Generating cash over an accounting period, by contrast, is when cash inflows are greater than cash outflows in the same period. Cash inflows and outflows in a period may be completely unrelated to income and expenses as they may be based, for example, on a financial event that is unrelated to income and expenses, such as the owner introducing capital into the business or drawing capital out of the business.
What is the formula to work out how much cash is generated in a period?
To work out how much cash is generated in a period we need to work out the difference between the cash balance at the end of a period (time 1) and the cash balance at the beginning of a period (time 0). This can be expressed in the formula:
Cash generated 1–0 = Cash 1 – Cash 0
The next activity should give you an insight into the common situation in business where the profit made in a period is not the same as the cash generated in the same period.
Andrew and Barry have recently started exactly the same business – buying and selling music CDs. They each started their trade on 1 January 20X1 with £1,000 entirely borrowed from the bank. Both Andrew and Barry bought their CDs for cash but Andrew decided to allow his customers to buy CDs on credit as he believed this would generate more sales.
In the first week of trading Andrew bought CDs for £800, all cash, and sold them all for £1,600 – all on credit. Barry, on the other hand, bought CDs for £400, all cash, and sold them all for £800 cash.
(a) Assuming that Andrew and Barry had no other income and expenses in the week, use the formula Profit 1–0 = Income 1–0 – Expenses 1–0 to calculate each of their profit for the week.
Andrew’s profit for the week = £1,600 – £800 = £800
Barry’s profit for the week = £800 – £400 = £400
(b) Assuming that Andrew and Barry had no other transactions in the week, use the formula Cash generated 1–0 = Cash 1 – Cash 0 to calculate each of their cash generated for the week.
Andrew’s cash generated for the week = (£1,000 – £800) – £1,000 = –£800 (i.e. £800 of cash is lost in the week)
Barry’s cash generated for the week = (£1,000 + £800 – £400) – £1,000 = £400
(c) What do your answers to (a) and (b) tell you about the effect of credit sales on profit earned and cash generated in a business?
The answers tell us that credit sales may generate more profit in a period (Andrew’s profit compared to Barry’s) at the expense of losing cash (Andrew’s negative generation of cash compared to Barry’s).
From the activity above we have seen that it is possible for a business to make a profit in a period but lose cash in the same period. The reason for this is that the different transactions in the activity above had different effects on profit earned and cash generated in the same period. The next activity should help you to better understand this.
Use the box below to complete answers for Table 13. Indicate the effect (either none, increase or decrease) on profit and/or cash of the following eight transactions. The first four transactions relate to the transactions completed in Activity 17 while the last four transactions refer to likely further transactions of the businesses in Activity 17.
|Effect on profit||Effect on cash|
|1. Receipt of a loan|
|2. Buying stock for cash|
|3. Making a cash sale|
|4. Making a credit sale|
|5. Receiving cash from a debtor|
|6. Buying stock on credit|
|7. Payment for stock bought on credit|
|8. Repayment of a loan|
|Effect on profit||Effect on cash|
|1. Receipt of a loan||none||increase|
|2. Buying stock for cash||none*||decrease|
|3. Making a cash sale||increase**||increase|
|4. Making a credit sale||increase**||none|
|5. Receiving cash from a debtor||none||increase|
|6. Buying stock on credit||none*||none|
|7. Payment for stock bought on credit||none||decrease|
|8. Repayment of a loan||none||decrease|
* It is only when stock is sold that there is an effect on profit. Later in this section you will see that when stock is sold the value of the stock that is sold becomes an expense called cost of sales. At that stage there is an effect on profit, but only an effect on cash if the goods or stock is sold for cash not credit.
** This increase in profit assumes the normal situation where goods are sold for more than they are bought – such as the example of the CDs in Activity 17. If goods are sold for less than they are bought then the effect will be a decrease in profit.
How does making a profit in a business relate to the capital of a business?
We have already learnt that the capital of a business is the value of the investment in the business by the owner(s). If the business makes a profit then the value of the investment by the owner (or capital) increases. The best way to understand how this works is to look at the effect of profit on the accounting equation.