IB Docs (2) Team
Relationship between investment, profit & cash flow
The relationship between investment, profit, and cash flow (AO2)
In Business Management, the term investment refers to the purchase of fixed assets (such as equipment and machinery), with the intention of creating a financial return (profit) in the future. It is therefore often referred to as capital expenditure.
Investment often requires a large initial amount of cash (for purchasing the fixed assets), so this can have a negative impact on the organization’s net cash flow. However, in the long run, the business intends for the investment expenditure to generate a profit for the organization, and improve its net cash flow.
Despite the risks, investment expenditure is important for an organization’s survival and sustainability. By contrast, the lack of investment can negatively affect businesses as they fail to adapt to changing needs and wants in the marketplace.
Investment is the expenditure on fixed assets
Profit is the financial return from the trading activities of a business. It is found by subtracting the firm’s total costs from its total revenues. Hence, the formula for calculating profit is:
Profit = Total revenues – Total costs
Cash flow is not the same as profit because a profitable business can still face liquidity problems. This is because profit is declared if sales revenues exceed total costs of production, whereas cash flow refers to the actual movement of money in and out of the organization. The timing of these cash flows depends of the product’s working capital cycle, so whilst it might be profitable, the firm can still experience cash flow issues.
Top tip!
Remember there is a difference between a firm’s sales revenue and its cash flow, even though they are related. Cutting costs by using a cheaper supplier might reduce cash outflows, for example, but this can also reduce cash inflows if quality suffers which results in a fall in sales.
In the short run, investment expenditure will negatively affect cash flow profit due to the higher costs involved. However, in the long run, capital expenditure used to fund the expansion of a business can increase the firm's cash flows and profits. The challenge for managers is to strike the right balance between capital and revenue expenditure. This will largely depend on the business objectives of the organization (such as growth or profit).
True or False Quiz
| No. | Statement | True or False? |
| 1. | The working capital cycle refers to the time between cash needed for a firm's costs of production and the cash received from customers for the purchase of the product. | True |
| 2. | Cash received from interest paid on bank accounts would be recorded as a cash inflow. | True |
| 3. | Cash from commercial bank loans are categorised as current assets. | False - current liabilities |
| 4. | Capital expenditures are recorded as a cash outflow. | True |
| 5. | Revenue expenditures are recorded as a cash outflow. | True |
Business Management Toolkit - STEEPLE analysis
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Discuss how changes in the external environment (STEEPLE analysis) can impact an organization's investment, profit and cash flow.
Business Management Toolkit - Circular business models
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Examine how the use of circular business models can impact an organization's investment, profit and cash flow.
Ness Blackburn Bakery (NBB)
Ness Blackburn is a sole trader who own Ness Blackburn Bakery (NBB) and employs six full-time workers. The business specialises in the sale of freshly baked breads, cakes, pastries, and cookies. NBB only accepts cash payments.
Ness has produced the following cash flow forecast for his business. In December, Ness pays the workers 50% extra as an end of year bonus.
| Sept | Oct | Nov | Dec | |
| Opening balance | 200 | 1,200 | 2,000 | |
| Cash inflows | ||||
| Cash sales revenue | 20,000 | 18,500 | 19,500 | 22,500 |
| Total cash inflow | 20,000 | 18,500 | 19,500 | 22,500 |
| Cash outflows | ||||
| Direct costs | 8,000 | 7,400 | 7,800 | 9,000 |
| Expenses | 3,000 | 3,000 | 3,000 | 3,000 |
| Salaries | 8,000 | 8,000 | 8,000 | 12,000 |
| Total cash outflow | 19,000 | 18,800 | 24,000 | |
| Net cash flow | 100 | 700 | -1,500 | |
| Closing balance | 1,200 | 1,300 | 2,000 | |
| (a) | Define the term sole trader. | [2 marks] |
| (b) | State the value of the following: | |
| (i) Net cash flow in September | [1 mark] | |
| (ii) Cash outflow in October | [1 mark] | |
| (iii) Opening balance in November | [1 mark] | |
| (iv) Closing balance in December | [1 mark] | |
| (c) | Using the figures in the cash flow forecast, comment on the liquidity position of NBB. | [2 marks] |
| (d) | Calculate the profit earned by NBB for the period from September to December. | [2 marks] |
Teacher only box(a) Define the term sole trader. [2 marks]
A sole trader is a business entity owned by a single person, but can employ as many people as necessary. The owner has full control but accepts unlimited liability as there is no legal separation of the owner and the business entity itself.
Award [1 mark] if the answer shows some understanding of the term sole trader.
Award [2 marks] for an answer that shows a clear understanding of the term sole trader, similar to the example above.
(b) State the value of the following:
(i) Net cash flow in September. [1 mark]
$1,000 (i.e., $20,000 – $19,000)
(ii) Cash outflow in October. [1 mark]
$18,400 (i.e., $7,400 + $3,000 + $8,000)
(iii) Opening balance in November. [1 mark]
$1,300 (i.e., equal to the closing balance in September).
(iv) Closing balance in December. [1 mark]
$500 (i.e., -$1,500 + $2,000)
Award [1 mark] for each correct answer, up to the maximum of [4 marks].
There is no need to show the working out.
(c) Using the figures in the cash flow forecast, comment on the liquidity position of NBB. [2 marks]
The table below is for illustrative purposes only.
| Sept | Oct | Nov | Dec | |
| Opening balance | 200 | 1,200 | 1,300 | 2,000 |
| Cash inflows | ||||
| Cash sales revenue | 20,000 | 18,500 | 19,500 | 22,500 |
| Total cash inflow | 20,000 | 18,500 | 19,500 | 22,500 |
| Cash outflows | ||||
| Direct costs | 8,000 | 7,400 | 7,800 | 9,000 |
| Expenses | 3,000 | 3,000 | 3,000 | 3,000 |
| Salaries | 8,000 | 8,000 | 8,000 | 12,000 |
| Total cash outflow | 19,000 | 18,400 | 18,800 | 24,000 |
| Net cash flow | 1,000 | 100 | 700 | (1,500) |
| Closing balance | 1,200 | 1,300 | 2,000 | 500 |
Possible comments may include:
The net cash flow is negative in December ($1,500). This is largely due to the 50% extra pay that staff receive as an end of year bonus. This is only affordable due to the positive$2,000 closing balance in November.
The closing balance in December is only positive because of the positive closing balance in November. This may suggest liquidity problems in January onwards, especially if sales revenue has a seasonable dip after December.
Although profitable, the liquidity position is somewhat of a concern as net cash flow is only $100 in October (as negative in December).
Accept any other relevant comment with reference to the data in NBB’s cash flow forecast.
Award [1 mark] if there is some understanding of the liquidity position of NBB.
Award [2 marks] if the commentary demonstrates a clear understanding of the liquidity position of NBB, with good application of the data.
(d) Calculate the profit earned by NBB for the period from September to December. [2 marks]
Profit = Sales revenue – Total costs
Sales revenue = 20,000 + 18,500 + 19,500 + 22,500 = $80,500
Total costs = 19,000 + 18,400 + 18,800 + 24,000 = $80,200
Profit = $300
Note: Without paying staff an extra 50% in December, profit for the period would be $4,300.
Award [1 mark] for the correct answer and [1 mark] for showing the appropriate working out.
Teachers can download a PDF copy of this exam practice question for use with students in class.
Return to the Unit 3.7 - Cash flow homepage
Return to the Unit 3 - Finance and accounts homepage
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