Cash Versus Profit and the Importance of Working Capital
Cash and profit are not the same thing. Profit is an accounting measure, calculated as revenue minus costs over a trading period on the income statement, and it includes sales made on credit even before the cash for them has actually been received.
Before you start
Make sure you're comfortable with these topics first:
Method
- Remember that profit measures performance over a period on the income statement, while cash measures the money actually available right now.
- Identify any timing differences in the scenario, such as sales made on credit, counted as revenue and profit before the cash is received, or cash spent on stock or assets before it appears as a cost.
- Calculate working capital using the formula: working capital = current assets - current liabilities.
- Explain what a low, or negative, working capital figure means: the business may struggle to pay its short-term debts as they fall due, even if it is profitable.
- Link cash, profit and working capital together in an explanation: a profitable business with poor working capital, too much cash tied up in stock or customer debts, can still face a cash-flow crisis.
- For an evaluate-style question, suggest how the business could improve its working capital, such as collecting customer debts faster or reducing stock levels, and weigh the effect of doing so.
Worked example
A business has current assets of 42,000 pounds, made up of 6,000 pounds cash, 20,000 pounds of stock, and 16,000 pounds owed by customers, and current liabilities of 30,000 pounds. Calculate the business's working capital, and state whether this figure suggests it should be able to pay its short-term debts.
- Apply the formula: working capital = current assets - current liabilities.
- Calculate: 42,000 - 30,000 = 12,000 pounds.
- Interpret the result: since working capital is positive, 12,000 pounds, the business has more current assets than current liabilities, suggesting it should be able to cover its short-term debts.
- Add a caution: this depends on how quickly the stock, 20,000 pounds, and customer debts, 16,000 pounds, can actually be turned into cash, since only 6,000 pounds of the current assets is already cash.
Practice questions
Try each question, then tap to reveal the answer.
Q1What is the key difference between cash and profit?Show answer
Answer: Cash is the money a business actually holds and can spend right now; profit is revenue minus costs over a trading period, and it can include sales made on credit before the cash has actually been received.
Q2State the formula for working capital.Show answer
Answer: Working capital = current assets - current liabilities.
Q3Give one example of a current asset and one example of a current liability.Show answer
Answer: Current asset: cash, stock, or money owed by customers. Current liability: money owed to suppliers, or a bill due within the year.
Q4A business has current assets of 25,000 pounds and current liabilities of 31,000 pounds. Calculate its working capital and state what this suggests.Show answer
Answer: 25,000 - 31,000 = -6,000 pounds; a negative working capital figure suggests the business may struggle to pay its short-term debts as they fall due.
Q5Explain, in one sentence, how a profitable business could still run out of cash.Show answer
Answer: If a large amount of its profit is tied up in unpaid customer invoices or unsold stock rather than actual cash, it may not have enough cash available to pay its own bills on time.
Q6Give one way a business could improve its working capital.Show answer
Answer: For example, chasing customers who owe money to collect payment sooner, or reducing the amount of stock it holds so less cash is tied up in it.
Q7Why is cash considered more liquid than stock, even though both can be current assets?Show answer
Answer: Cash can be used immediately to pay a debt, whereas stock must first be sold and the payment collected before it becomes usable cash, which takes time and is not guaranteed.
Exam-style questions
Written in the style of a GCSE Business exam paper, with a full mark scheme.
A business has current assets made up of 4,500 pounds cash, 12,000 pounds of stock and 9,500 pounds owed by customers. Its current liabilities are 18,000 pounds. (a) Calculate the business's total current assets. (2 marks) (b) Calculate the business's working capital. (2 marks) (c) State, using your figures, whether the business has enough working capital to cover its current liabilities. (2 marks)
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Explain why a business with a healthy net profit margin could still experience a cash-flow crisis.
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Free printable worksheet
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