AQA A-Level Business (7138)

## Learning Outcomes

- Understand the difference between **cash flow**, **liquidity** and profit
- Identify the main parts of a **cash flow forecast**
- Calculate **net cash flow** and **closing balance** accurately
- Explain why a profitable business can still face cash shortages
- Calculate and interpret the **current ratio** and **acid-test ratio**
- Analyse causes of cash flow problems and methods of improving cash flow
- Evaluate liquidity data in context using realistic business factors

## AQA A-Level Business (7138) Syllabus

For the AQA A-Level Business (7138), you are expected to understand cash flow and liquidity, with a focus on the following syllabus points:

- Know that **cash flow** is the movement of money into and out of a business over time
- Identify the structure and purpose of a **cash flow forecast**
- Calculate **net cash flow** and **closing balance** from forecast data
- Explain why timing matters, especially when sales are made on credit
- Understand **liquidity** as the ability to meet short-term debts as they fall due
- Calculate and interpret the **current ratio** and **acid-test ratio**
- Distinguish between a business being profitable and a business being liquid
- Evaluate methods of improving cash flow, including their possible drawbacks

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What is the difference between cash flow and profit?
2. How do you calculate net cash flow and closing balance?
3. Why might a business with rising sales still face a cash shortage?
4. What is the difference between the current ratio and the acid-test ratio?
5. Name two methods a business could use to improve its cash flow.

## Introduction

Cash flow and liquidity are central parts of financial management because survival depends on having enough cash at the right time. A business may have strong sales and even make profit, but if cash has not yet arrived when wages, rent or suppliers must be paid, it can still face serious trouble.

This topic is tested through both calculation and analysis. You need to be able to complete forecast figures, interpret liquidity ratios and then judge what the figures mean in context. Strong answers do not stop at the numbers. They explain the likely causes, risks and suitable actions.

> **Key Term: cash flow**
> The flow of money into and out of a business in a given time period.

### Cash flow forecasting and why timing matters

A **cash flow forecast** predicts expected inflows and outflows over future periods, usually month by month. It helps managers see whether the business is likely to run short of cash and whether action is needed.

> **Key Term: cash flow forecast**
> A prediction of expected cash inflows and cash outflows over a future period.

Typical headings in a forecast are:

- opening balance
- cash inflows
- cash outflows
- net cash flow
- closing balance

The key point is timing. Cash is recorded when it is actually received or paid, not when a sale is made or a cost is incurred. This is why credit sales can cause pressure. A business may make a sale today but receive the cash 30, 60 or 90 days later.

> **Key Term: trade credit**
> A period of time allowed before payment is due for goods or services bought.

Businesses forecast cash flow for several reasons:

- to identify cash shortages before they happen
- to plan borrowing or overdraft use
- to support applications for loans
- to plan around seasonal demand
- to avoid insolvency caused by running out of cash

A forecast can also identify excessive cash holdings. Too much cash may suggest funds are sitting idle instead of being used for stock, equipment or growth.

> **Test Tip:** In calculation questions, always check whether a sale is a cash sale or a credit sale. Students often place the inflow in the wrong month.

A business can have a negative net cash flow in one month but still a positive closing balance if it started the month with enough cash. Equally, a positive net cash flow does not guarantee a positive closing balance if the opening balance was already heavily negative.

### How to calculate net cash flow and closing balance

Two formulas are essential:

- **Net cash flow = total cash inflows - total cash outflows**
- **Closing balance = opening balance + net cash flow**

The closing balance for one month becomes the opening balance for the next month.

> **Key Term: net cash flow**
> The difference between total cash inflows and total cash outflows in a period.
>
> **Key Term: closing balance**
> The cash position at the end of a period after net cash flow has been added to the opening balance.

Here is a worked example.

A small retailer has the following forecast for June:

- Opening balance = **£1,200**
- Cash inflows = **£8,500**
- Cash outflows = **£9,100**

Step 1: Calculate net cash flow

Net cash flow  
= total cash inflows - total cash outflows  
= **£8,500 - £9,100**  
= **-£600**

So June has a negative net cash flow of **£600**.

Step 2: Calculate closing balance

Closing balance  
= opening balance + net cash flow  
= **£1,200 + (-£600)**  
= **£600**

The business ends June with **£600** in cash.

Now suppose July has:

- Opening balance = **£600**
- Cash inflows = **£7,000**
- Cash outflows = **£8,200**

Net cash flow  
= **£7,000 - £8,200**  
= **-£1,200**

Closing balance  
= **£600 + (-£1,200)**  
= **-£600**

The business now has a negative closing balance of **£600**, so it may need short-term finance.

Common student errors:

- subtracting opening balance from inflows
- forgetting that closing balance carries forward
- treating all sales as immediate cash receipts
- missing brackets or minus signs for negative figures
  > **Test Tip:** When a table has gaps, calculate in this order: total inflow, total outflow, net cash flow, then closing balance. This reduces mistakes.

### Liquidity, working capital and liquidity ratios

Liquidity is about the ability to pay short-term debts when they are due. This is different from profit. A business may be profitable on paper but still unable to pay suppliers, wages or tax on time.

> **Key Term: liquidity**
> The ability of a business to meet its short-term financial obligations as they fall due.

Liquidity depends partly on **working capital**.

> **Key Term: working capital**
> The difference between current assets and current liabilities.

Current assets include items likely to turn into cash within a year, such as cash, receivables and inventory. Current liabilities are debts due within a year, such as payables, overdrafts, tax due and short-term loans.

> **Key Term: current assets**
> Assets expected to be turned into cash within 12 months.
>
> **Key Term: current liabilities**
> Debts due for payment within 12 months.

Two important ratios are used to assess liquidity.

### Current ratio and acid-test ratio

The **current ratio** measures whether current assets are enough to cover current liabilities.

> **Key Term: current ratio**
> A liquidity ratio calculated by dividing current assets by current liabilities.

Formula:

Current ratio = current assets / current liabilities

Worked example:

- Current assets = **£90,000**
- Current liabilities = **£60,000**

Current ratio  
= **£90,000 / £60,000**  
= **1.5**

This can be written as **1.5:1**.

Interpretation: the business has **£1.50** of current assets for every **£1** of current liabilities.

The **acid-test ratio** is stricter because it removes inventory.

> **Key Term: acid-test ratio**
> A liquidity ratio calculated by dividing current assets minus inventory by current liabilities.

Formula:

Acid-test ratio = (current assets - inventory) / current liabilities

Using the same business:

- Current assets = **£90,000**
- Inventory = **£30,000**
- Current liabilities = **£60,000**

Acid-test ratio  
= **(£90,000 - £30,000) / £60,000**  
= **£60,000 / £60,000**  
= **1.0**

This can be written as **1.0:1**.

Why exclude inventory? Because stock may not be sold quickly, especially if demand falls or the goods are outdated. That means the current ratio can sometimes make liquidity look stronger than it really is.

A simple comparison:

- **Current ratio** includes inventory
- **Acid-test ratio** excludes inventory
- **Current ratio** gives a broader measure
- **Acid-test ratio** gives a more cautious measure

Common student errors:

- forgetting to subtract inventory in the acid-test ratio
- assuming one ratio is automatically “good” or “bad” without context
- writing ratios as percentages
- using non-current assets in the calculation

Interpret ratios carefully. A low ratio may suggest liquidity risk, but some businesses can operate with lower ratios if they sell quickly for cash and turn stock over fast. A very high ratio is not always positive either. It may mean too much money is tied up in stock, receivables or idle cash.

Good analysis compares:

- trends over time
- competitors
- industry norms
- the nature of the business

For example, Tesco may be able to operate with tighter liquidity than a specialist manufacturer because supermarket sales are frequent and cash arrives quickly.

### Causes of cash flow problems and ways to improve cash flow

Strong exam answers explain not just what the figures are, but why they may have happened.

Common causes of cash flow problems include:

- low or falling sales
- late payment by customers
- poor credit control
- too much inventory
- seasonality
- high fixed costs
- one-off large payments
- loan repayments and interest
- overtrading
  > **Key Term: overtrading**
  > Expanding too quickly without enough working capital to support the growth.

Overtrading is a common exam theme. A business may increase sales fast, but growth often requires more stock, more staff and more spending before customers have paid. So expansion can create a cash shortage rather than solve one.

Methods of improving cash flow include:

- speeding up customer payments
- improving credit control
- reducing inventory levels
- negotiating longer payment periods with suppliers
- delaying non-essential spending
- selling unused assets
- using an overdraft
- injecting more capital
- leasing instead of buying assets
  > **Key Term: overdraft**
  > Short-term borrowing that allows a business to withdraw more money than it currently has in its bank account.

Each method has drawbacks. Chasing customers more aggressively may damage relationships. Paying suppliers later may reduce trust or lead to worse terms. Cutting stock too far may cause stockouts and lost sales. Overdrafts and loans improve short-term cash, but they add interest costs.

This is where AO3 and AO4 marks are won. Do not simply list methods. Explain how each action changes inflows or outflows, then judge whether it suits the business.

For example, a fashion retailer with slow-moving stock may benefit from stock reduction and discounting old lines. A fast-growing wholesaler suffering from late customer payments may gain more from tighter credit control or factoring than from cutting marketing.

### How to structure an evaluative answer

In 16-, 20- or 25-mark questions, use a clear judgement structure:

- **On the one hand:** explain how the forecast or ratio helps decision making
- **On the other hand:** explain limits, risks or why the figure may mislead
- **It depends on:** identify contextual factors that change the judgement

Financial evidence to use:

- size of negative closing balances
- trend in net cash flow
- size of current ratio or acid-test ratio
- proportion of cash tied up in inventory or receivables

Non-financial factors to use:

- business type
- strength of customer relationships
- market conditions
- seasonality
- supplier power
- growth stage of the business

Limitations to discuss without being generic:

- forecasts are based on estimates
- unexpected competitor action may reduce sales
- inflation or economic weakness may raise costs
- ratio data is only a snapshot at one point in time
- inventory may be hard to sell quickly
- short-term action may harm long-term reputation or growth

A strong judgement is specific. For instance: a low acid-test ratio is more worrying for a business with slow-moving stock and weak supplier relations than for a supermarket with daily cash sales.

> **Test Tip:** Evaluation is not just “there are advantages and disadvantages”. Use the data, apply it to the business, and end with a supported judgement about how serious the liquidity problem really is.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Cash flow is the movement of money into and out of a business over time
- A cash flow forecast predicts future inflows, outflows, net cash flow and closing balance
- Net cash flow equals total cash inflows minus total cash outflows
- Closing balance equals opening balance plus net cash flow
- The closing balance of one period becomes the opening balance of the next
- Timing matters because cash is recorded when received or paid, not when a sale or cost is created
- A business can be profitable but still illiquid
- Liquidity means the ability to meet short-term debts as they fall due
- Working capital equals current assets minus current liabilities
- Current ratio equals current assets divided by current liabilities
- Acid-test ratio equals current assets minus inventory divided by current liabilities
- The acid-test ratio is stricter because inventory may not be converted into cash quickly
- Causes of cash flow problems include late customer payment, excess inventory, seasonality and overtrading
- Methods of improving cash flow can help in the short term but may also create costs or relationship problems
- Liquidity ratios should be judged in context using trends, competitors and business type

## Key Terms and Concepts

- cash flow
- cash flow forecast
- trade credit
- net cash flow
- closing balance
- liquidity
- working capital
- current assets
- current liabilities
- current ratio
- acid-test ratio
- overtrading
- overdraft


Financial management - Cash flow and liquidity