Chapter 23 : Cash flow forcasting and working capital

The cash flow of a business

is the cash inflows and outflows over a period of time

If a business has too little cash – or even runs out of it completely – it will face major problems, such as:

» being unable to pay workers, suppliers, landlord, government

» production of goods and services will stop – workers will not work for no pay and suppliers will not supply goods if they are not paid

» the business may be forced into ‘liquidation’ – selling up everything it owns to pay its debts.

Cash inflows

are the sums of money received by a business during a period of time.

Cash outflows

are the sums of money paid out by a business during a period of time

How can cash flow into a business (cash inflow)? Here are five of the most common ways:

» The sale of products for cash.

» Payments made by debtors – debtors are customers who have already purchased products from the business but did not pay for them at the time.

» Borrowing money from an external source – this will lead to cash flowing into the business (it will have to be repaid eventually).

» The sale of assets of the business, for example, unwanted property. » Investors, for example, shareholders in the case of companies, putting more money into the business

How can cash flow out of a business (cash outflow)? Here are five of the most common ways:

» Purchasing goods or materials for cash.

» Paying wages, salaries and other expenses in cash.

» Purchasing non-current (fixed) assets

. » Repaying loans.

» By paying creditors of the business – other firms which supplied items to the business but were not paid immediately.

A cash flow cycle shows

the stages between paying out cash for labour, materials, and so on, and receiving cash from the sale of goods.

Profit

is the surplus after total costs have been subtracted from revenue.

( Cash flow is not the same as profit )

Can profitable businesses run out of cash? Yes – and this is a major reason for businesses failing. It is called insolvency.

How is this possible?

By:

• allowing customers too long a credit period, perhaps to encourage sales • purchasing too many non-current (fixed) assets at once

• expanding too quickly and keeping a high inventory level. This means that cash is used to pay for higher inventory levels. This is often called overtrading.

A cash flow forecast

is an estimate of future cash inflows and outflows of a business, usually on a month-by-month basis. This then shows the expected cash balance at the end of each month.

• Starting up a business

• Keeping the bank manager informed

• Managing an existing business

• managing cash flow

A cash flow forecast can be used to tell the manager:

» how much cash is available for paying bills, repaying loans or for buying fixed assets

» how much cash the bank might need to lend to the business in order to avoid insolvency

» whether the business is holding too much cash which could be put to a more profitable use. Managers use cash flow forecasts to help them find out the future cash position of their business.

Uses of cash flow forecasts

Cash flow forecasts are useful in the following situations

» starting up a business

» running an existing business

» keeping the bank manager informed

» managing cash flow.

Net cash flow

is the difference, each month, between inflows and outflows.

Closing cash (or bank) balance

is the amount of cash held by the business at the end of each month. This becomes next month’s opening cash balance.

Opening cash (or bank) balance

is the amount of cash held by the business at the start of the month.

Increasing bank loans ( Method of overcoming cash flow problem)

++ Bank loans will inject more cash into the business

• Interest must be paid – this will reduce profits

• The loans will have to be repaid eventually – a cash outflow

Delaying payments to suppliers

++ Cash outflows will decrease in the short term

• Suppliers could refuse to supply

• Suppliers could offer lower discounts for late payments

Asking debtors to pay more quickly – or insisting on only ‘cash sales’

++ Cash inflows will increase in the short term

• Customers may purchase from another business that still offers them time to pay (trade credit)

Delay or cancel purchases of capital equipment

++ Cash outflows for purchase of equipment will decrease

• The long-term efficiency of the business could decrease without up-to-date equipment

Working capital

is the capital available to a business in the short term to pay for day-to-day expenses

Working capital = Current assets – Current liabilities