Chapter 22: Cash Flow Forecasting and Working Capital (Cash flow forecasts…
Chapter 22: Cash Flow Forecasting and Working Capital
Why cash is important to a business
Cash Flow: The cash inflows and outflows over a period of time.
Cash Inflow (the sums of money received by a business during a period of time)
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 (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
Cash outflow (the sums of money paid out by a business during a period of time)
purchasing goods or materials for cash
paying wages, salaries and other expenses in cash
purchasing fixed assets
by paying creditors of the business - other firms who supplied items to the business but who were not paid immediately
If business has too little cash or even runs out of it completely - it will face major problems:
unable to pay workers, suppliers, landlord, government
production of goods and services will stop - workers will not work for nothing and suppliers will not supply if they are not paid
the business may be forced into 'liquidation' - selling up everything it owns to pay its debts
Cash Flow Cycle: Shows the stages between paying out cash for labour, materials, etc. and receiving cash from the sale of goods.
1) cash needed to pay for
2) materials, wages, rent, etc.
3) goods produced
4) goods sold
5) cash payment received for goods sold
6) return to step 1
The longer the time taken to complete these stages, the greater will be the firm's need for working capital and cash
The cycle helps us to understand the importance of planning for cash flows. What would happen if:
a business did not have enough cash at stage 1? not enough materials and other requirements could be purchased and so output and sales would fall
a business insisted on its customer paying cash at stage 4 because the business was short of money? It might lose the customer to a competitor who could offer credit
a business had insufficient cash to pay its bills such as rent and electricity? It would be in a liquidity crisis and it might be forced out of business by its creditors
Cash flow is not the same as profit
Profit: The surplus after total costs have been subtracted from sales revenue
Can profitable businesses run out cash?
Yes and this is a major reason for businesses failing. This is called insolvency.
How is this possible?
allowing customers too long a credit period, perhaps to encourage sales
purchasing too many 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.
Cash is the most liquid asset
Lack of cash can cause a liquidity problem
Cash flow forecasts: 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.
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
Uses of cash flow forecast
starting up a business
when planning to start business, the owner will need to know
how much cash will be needed in the first few months
of operation. This is
a very expensive time for new businesses
as premises have to be purchased or rented, machinery must be purchased, inventory must be built up and promotion costs will be necessary.
Many businesses fail because owners do not realise how much cash is needed in the first few crucial months
running an existing business
Any business can run out of cash and require an overdraft, perhaps because of an expensive fixed assets being bought or a fall in sales.
Borrowing money needs to be planned in advance so that the lowest rates of interest can be arranged.
Telling the bank today that a loan is needed tomorrow could lead to bank
refusing the loan
because of poor business planning or
charging high rates of interest
. if the business exceeds the
t from the bank without informing the bank manager first, the bank could insist that the
overdraft is repaid immediately
and this could force the business to close.
keeping the bank manager informed
Banks provide loans to businesses. However, before bank managers will lend any money,
they need to see the firm's cash flow forecast
. This is particularly of a new business also for an existing one. The bank manager will need to see
how big a loan or overdraft is needed, when it is needed, how long it is needed for and when it might be repaid
managing cash flow
too much cash held in the bank account of a business means that this
capital could be better used
in other areas of the business. If it seems that the business is likely to have a very high bank balance, the accountant could decide to
pay off loans to help to reduce interest charges
. Another option would be to
pay creditors quickly to take advantage of possible discounts
Opening cash (or bank) balance
: The amount of cash held by the business at the start of the month.
Net cash flow
: The difference , each month, between inflows and outflows.
Closing cash (or bank) balance
: The amount of cash held by the business at the end of each month. This becomes next month’s opening cash balance.
Shows forecasted cash inflows and cash outflows
help managers plan ahead
can forecast likely level of overdraft required
How can cash flow problems be overcome?
1) increasing Bank Loans
how it works
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
2) Delaying Payments to Suppliers
how it works
cash outflows will decrease in the short term
suppliers could refuse to supply. Supplier could offer lower discounts for late payments
3) Asking debtors to pay more quickly - or insisting on only "cash sales"
how it works
cash inflows will increase in the short term
customers may take their custom to another business that still offers them time to pay - i.e. trade credit
4) Delay or cancel purchases of capital equipment
how it works
cash outflows for purchase of equipment will decrease
the long term efficiency of the business could decrease without up-to-date equipment
In the longer term, a business with cash flow difficulties will have to take other decisions to solve the problem. These could include:
attracting new investors, for example by selling more company shares - but will this affect ownership of the business?
cutting costs and increasing efficiency - but will this be popular with employees and could product quality be affected?
developing new products that will attract more customers - this could take a long time and needs cash in the short term to pay for development
Importance of working capital (the capital available to a business in the short term to pay for day-to-day expenses)
working capital = current assets - current liabilities
having enough working capital assists in raising the credit reputation of a business. no business can run effectively without a sufficient quantity of working capital. It is crucial to retain the right level of working capital.
May be held in different forms:
cash is needed to pay day-to-day costs and buy inventories
the value of a firm's debtors is related to the volume of production and sales. To achieve higher sales there may be a need to offer additional credit facilities.
the value of inventories is also a significant part of working capital. not having enough inventories may cause production to stop. on the other hand, a very high inventory level may result in high opportunity costs.
Overall success of a business depends upon its working capital position. So, it should be handled properly because it shows the efficiency and financial strength of company.