Difference between Profit and Cash Flow in Business Finance

This report discusses the difference between profit and cash flow in business finance and how it impacts the financial results of a company. It explains the meaning of working capital, receivables, inventory, and payables. It also explores the effect of change in working capital on cash flow and provides steps to improve cash flow through effective management of working capital.

Business Finance

TABLE OF CONTENTS
PART 1.......................................................................................................................................4
a. Difference between profit and cash flow...........................................................................4
b. Meaning of working capital, receivables, inventory and payables....................................4
c. Effect of change in working capital on cash flow of the business.....................................5
How company is managed that might affect its financial results...........................................5
Steps that can be taken to improve the cash flow by effective management of working
capital.....................................................................................................................................6
PART 2.......................................................................................................................................9
Different methods of preparing budget..................................................................................9
Application of budgeting methods on Second Sight Plc for future plan..............................11
Analysing the appropriate method of budgeting..................................................................12
REFERENCES.........................................................................................................................13

EXECUTIVE SUMMARY
In this report, an introduction to basic financial terms is given with respect to MDL
Ltd. It states about the impact of change in working capital on the cash flow of the business
along with the relevant steps that can be taken for improving the cash flow position of the
MDL Ltd.

PART 1
i.
a. Difference between profit and cash flow
Profit: Profit is the amount that is left after meeting all the cost and expenditure for a period.
There are three types of profits, which are, gross profit, operating profit and net profit. The
profit margin is sued to evaluate how well company is using its revenue. Increasing revenue
and reducing cost leads to increase in profits (Kenton, 2019). It is the amount of income that
is left after subtracting all the necessary expenses pertaining to the period. There are
situations like where businesses are profitable but may not be having enough cash.
Cash flow: it is the amount of money that flows through the business that can be inflow r
outflow (Lewellen and Lewellen, 2016). Cash inflow means receiving amount from the
customers who are buying the company’s products. Cash outflow refers to the making
payment for the purchases or expenses made by the business. Cash flow from operating
activity represents the cash generated from the main business of the company.
Profit Cashflow
Profit is the net income that is arrived after
deducting all the cost from the revenue for
specific period.
Cash flow is the actual amount of money
that is flowing in and out of the business.
It is based on the accrual basis of
accounting.
It is derived from cash basis of accounting.
Profit measures the ongoing sustainability
of the business.
Cash flow measures the ability of the
business to pay off its bills.
b. Meaning of working capital, receivables, inventory and payables
Working capital: It refers to the difference between current assets and current liabilities. It
helps in determining the financial health of the business in terms of liquidity (What Is
Working Capital? 2020). It can be both positive and negative but positive working capital
represents better operational efficiency of the business. The size and composition of working
capital defers from industry to industry. It represents short term asset investments.
Receivables: It can be defined as the amount of money that the customer owes to the
company by selling products and services of the company on credit. It recorded at the time of
commencement of sales and not when amount is received (Definition of 'Accounts

Receivable'. 2020). Any uncertainty related to the collection is then recorded as bad debts or
the provision for the same is created.
Inventory: It refers to the stock of goods and materials that is used by the businesses in the
production and selling purpose (Miller and et.al, 2016). It is the most important asset for the
business as it is the primary source of revenue. There are different methods of inventory
valuation such as LIFO, FIFO and weighted average (Inventory. 2019).
Payables: It indicates the amount of money that the company owes to its creditors and other
suppliers form whom it has purchased material on credit (Accounts Payable. 2020). In large
organizations, there is a separate department for it which handles making payments to
creditors. An effective management of it is very important as it affects the working capital
c. Effect of change in working capital on cash flow of the business
The impact of change in working capital can be easily seen in the cash flow of the
company. There are two types of working capital positive and negative. The positive outcome
states that there is a cash inflow for that period and in contrast, the negative outcome means
the company has spent more cash. If there is an increase in working capital it shows that the
company is investing more on the short-term assets and resources which results into decrease
in cash flow (Shubita, 2019). The decrease in working capital means that business has
dependent heavily on the short-term borrowings for financing its business requirement which
has resulted into increase in cashflow. For instance, raw material is purchased for cash will
have no impact over working capital because both cash and material are the current assets but
it will result into reduction in the amount of cash by the amount of raw material purchased.
Therefore, it is very important for analysing the working capital.
ii.
How company is managed that might affect its financial results
Mediterranean Delights Ltd (MDL) is having reasonable amount of profit for carrying
out its business activities. But the company has increased its borrowings to £18 million. MDL
has also acquired 40% stakes in the Italian company and has also invested more for acquiring
its share at the cost of £10 million. The company is also involved in the legal dispute of about
£2 million. There is also an equal chance of getting into another dispute as the company has
refused to pay Valetta for providing low standard materials to it. MDL is currently having a
huge stock of materials and other supplies and the company things it will be useful after
resolving the disputes. MDL is also not effective in terms of collecting money from the
customers. After analysing the complete situation of the company, it can be said that MDL is

required to take initiatives otherwise it will become difficult to manage the situation and the
negative impact associated with it. The company needs to be hard enough for effectively
recover money from the customers and should also look for investors to invest in the business
which will help in reducing its debt. Also, the company should stop investing till the situation
comes under control otherwise, it will be left with no cash, resulting in negative working
capital.
iii.
Steps that can be taken to improve the cash flow by effective management of working capital
It is very important for every organization to effectively manage its working capital
for efficiently running the business. The essential steps that can be taken by the company for
improving its working capital which will lead to positive cash flow management.
 The company should encourage its customers for paying the remaining amount on
time by offering them various discounts and incentives. And with that, the company
is required to motivate its collection team to be very effective and hard working for
timely collection of the due amount.
 MDL Ltd. should implement an automated system which will help in managing the
account receivables by reminding its customers the due date to make the payment.
 The company should communicate with other suppliers and can negotiate for better
pricing if the current supplier is not coming to a favourable term (Smith, 2018).
 MDL Ltd. should evaluate the amount of interest it is required to pay on loans and if
possible can modify the terms of contract with respect to interest rate and payment of
instalment. This will help the company in reducing the burden of debt and interest
payment and a significant amount can be saved which is then added to the working
capital.
 The company maintain a good relationship with its suppliers and customers as they
are the only ones who can be helpful at the time of crisis. It will help in avoiding any
disputes that may arise in future.
 MDL Ltd. should avoid the situation of overstocking of the goods and should make
efforts to sell the finished gods as soon as possible because it will help in reducing the
inventory management cost such as handling and carrying cost.
 It should use electronic payment system which will help in in ensuring that timely
payments are done and also helps in avoiding the situation of delay payments which
will attract penalty (Babatunde and Akeju, 2016).

 The company should look for better payment terms with the suppliers and the vendors
as it will help the company in effectively management the payment system. Also, the
company is required to maintain the balance between the accounts receivable and
accounts payables.

EXECUTIVE SUMMARY
This report presents about the different types of budgeting methods that can be
implemented by the businesses along their strengths and weaknesses. Based on the complete
evaluation, it is recommended that Second Sight Plc should go for activity-based budgeting
method for its business expansion plan.

PART 2
i.
Different methods of preparing budget
Budget is the formal document which states about the estimated revenue and
expenditure for a particular period. Basically, an incremental budget is prepared which is on
the basis of last year’s budget and the actual performance. In the next year’s budget, the
incremental amount is added to the budget while preparing it. There are different types of
budgets, a detailed description is given below.
Traditional budgeting approach
In this approach, the budget is prepared by taking last year budget as the base and
only significant changes are done which includes inflation, market situations etc (Petroia,
2017). It completely relies on the past year’s budget. This approach is not useful for the
newly established businesses as it requires last year’s data.
Strengths
 It helps in easy management of the business-related activities as it provides the base
for reference.
 This approach promotes decentralization so that every one can look into the budget.
 It helps in better identification of the problems so that effective decisions can be
taken.
Weaknesses The major weakness is that it can lead to budget slack because anyone can make
changes in the budget as per the requirement. It completely relies on eth previous year’s budget and cannot be used by new
businesses. This approach is sometimes a tie consuming process in identifying the things with the
expected expenditure.
Other alternative budgeting methods
Rolling budgets
This can also be said as the continuous budget which is updated on a regular basis as
and when the earlier budget expires (Bhimani, Sivabalan and Soonawalla, 2018). It can be
considered as an extension of the previous budget. Using this method, businesses always
have the budget for next future year. It is also termed as budget rollover.
Strengths

 It can be prepared easily because it is an extension of previous budget.
 This approach is effective enough in identifying the strength and weaknesses of the
business.
 This budget is very flexible so the changes can be made of unexpected events.
Weaknesses
 Preparing this budget requires highly skilled employees.
 This method is mainly useful in the organizations where the conditions keeps on
changing.
 This approach can be little costly.
Zero based budgets
In this budgeting technique, budget is prepared from the scratch, the zero level. The
previous year budget is not at all taken into account and all the expenditure is justified. While
preparing budget, the each and every cost that is required to be incurred by the different
departments are analysed on account of needs and costs (Sowards and Harzbecker Jr, 2018).
After doing all this, the final budget is prepared and resources are allocated to each
department for implementing their plans and strategies.
Strengths
 It helps in identifying the resources available with the business.
 It assists in building an effective relationship with the other departments.
 This technique eliminates the unnecessary activities which adds no value to the
business.
Weaknesses
 This method is very time consuming as everything starts from zero level.
 It is a very costly method.
 This method requires highly skilled and professional personnel.
Activity-based budgets
Budget under activity-based approach takes into account the overhead cost. This
budget does not use past year’s data but it carries out complete cost analysis. Based on the
analysis, resources are allocated to the different activities (Mora and Triana, 2018). This
method is effective in bringing efficiency in the various business activities and it is prepared
after justifying the cost with the cost drivers.
Strengths
 This approach is very effective in removing an unwanted activity which will help in
reducing the costs.

 It has the benefit of exercising more control over the activities.
 The changes can be made with the change in the situation.
Weaknesses
 This method requires a team of experienced professionals.
 It is a very expensive process.
 It requires a lot of time and efforts and is also a lengthy process.
ii.
Application of budgeting methods on Second Sight Plc for future plan
The impact of different budgeting methods on the company’s performance and future
plans.
Traditional budgeting approach
Second Sight Plc is currently using this budgeting method. Under this method,
previous year’s budget is taken into account for preparing the next year’s budget. This
method is more apt for businesses having no major change in the business and the working
conditions (Chepka and Smakula, 2018). Using this method, the company can easily figure
out the any error in the actual performance and necessary changes is made in the budget.
Second Sight Plc is also taking the advantage of better decision making through this
approach.
Rolling budgets
If the Second Sight Plc implements this method, then it will be very beneficial as it is
a continuous budget which can be updated time to time as per the requirement or changing
market conditions. For instance, Second Sight Plc can prepare 12-month planning budget
from January to December (Caldeira, 2017). As the month of January completes, the budget
will add another month for the following January. In this way, the budget remains the same
for the period of 12 months but is extended to the next year. This method is useful in
determining the strength and weaknesses of the business and the changes can also be made
easily.
Zero based budgets
This method if applied by Second Sight Plc then it requires to initiate the budget
preparation from the scratch. In this, the respective personnel will require to initiate the
process by justifying each and every expense (Oraka, Sopekan and Udeh, 2016). The aim of
this method is to optimize the cost and revenue. For example, in case of a manufacturing
concern where certain activities are outsourced which increases its cost by 8%. But after the

analysis, the company is of the opinion that it can manufacture it itself which will help in
reducing the cost and implement effective control system.
Activity-based budgets
Under this, budget is prepared taking into account different activities and cost
associated with those activities. It helps in analysing the cost involved in different activities.
For example, Second Sight Plc has projected the sales for the next year of 10,000 units at the
cost of £5 each unit for processing (Khan, 2019). Therefore, the total estimated budget of the
expense will be £50,000. This method can be effectively implemented by Second Sight Plc.
Thus, this method helps in analysing the cost which helps in proper planning and
implementation process which adds value to the business.
iii.
Analysing the appropriate method of budgeting
The company Second Sight Plc. Should start using other alternative method of
budgeting because traditional method is just an adjustment in the past year’s budget. And it
only takes into consideration inflation and change in revenue. Thus, because of this limitation
the company should switch to activity-based budgeting method. This method will assist
Second Sight Plc. in identifying the cost and in relation to the different activities undertaken.
Currently, Second Sight Plc is looking for expanding its business operation in other nations
such as India, so this method will help in analysing the performance of the business and will
also help in identifying any unnecessary activities that can be eliminated which will result
into cost reduction. This method will also help in establishing the control over the various
activities which results into increasing productivity and efficiency level. Another advantage is
that it is very flexible so required changes can be made as per the changing market conditions
and situations. Therefore, this method is appropriate for Second Sight Plc for implementing it
in its business expansion plan.

REFERENCES
Books and Journals
Babatunde, A. A. and Akeju, J. B., 2016. The Impact of Working Capital Management on
Firms’ Profitability: Evidence from Nigeria. Scholars Journal of Economics, Business
and Management. pp.463-470.
Bhimani, A., Sivabalan, P. and Soonawalla, K., 2018. A study of the linkages between rolling
budget forms, uncertainty and strategy. The British Accounting Review. 50(3). pp.306-
323.
Caldeira, C. L. G., 2017. Rolling Forecasts, substitutos ou complementos do budget: o caso
da NORS (Doctoral dissertation).
Chepka, V. and Smakula, Y. R., 2018. Beyond budgeting–alternative of traditional
budgeting.
Khan, A., 2019. Budget Systems, Underlying Structures and Characteristics.
In Fundamentals of Public Budgeting and Finance (pp. 187-227). Palgrave Macmillan,
Cham.
Lewellen, J. and Lewellen, K., 2016. Investment and cash flow: New evidence. Journal of
Financial and Quantitative Analysis. 51(4). pp.1135-1164.
Miller, J. L. and et.al, 2016. Business inventory and controls. U.S. Patent Application
14/613,078.
Mora, M. L. C. and Triana, M. S. F., 2018. The Management of Process of the Budget
Area. International research journal of management, IT and social sciences. 5(2).
pp.104-112.
Oraka, A. O., Sopekan, S. A. and Udeh, F. N., 2016. Zero-based budgeting: Pathway to
sustainable budget implementation in Nigeria.
Petroia, A., 2017. On The Essence And Efficiency Of Programme Budgeting. Eastern
European Journal for Regional Studies (EEJRS). 3(2). pp.109-122.
Shubita, M. F., 2019. The impact of working capital management on cash holdings of large
and small firms: evidence from Jordan. Investment Management & Financial
Innovations. 16(3). p.76.
Smith, G., 2018. Strategic Working Capital Sourcing Strategies for the Survival of Small
Businesses.
Sowards, S. W. and Harzbecker Jr, J. J., 2018. Managing a Collection Budget. Health
Sciences Collection Management for the Twenty-First Century. p.83.
Online
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https://economictimes.indiatimes.com/definition/accounts-receivable>.
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