Cash Flow Forecasting and Working Capital PDF

Unit 23: Cash flow forecasting and working capital Definitions: Cash flow: The cash inflows and outflows over a period of time. CASH FLOW IS NOT PROFIT! Cash inflow: The sums of money received by a business during the period of time. Cash outflow: The sums of money paid out by a business during the...

Unit 23: Cash flow forecasting and working capital Definitions: Cash flow: The cash inflows and outflows over a period of time. CASH FLOW IS NOT PROFIT! Cash inflow: The sums of money received by a business during the period of time. Cash outflow: The sums of money paid out by a business during the period of time. Cash flow cycle: The stages between paying out cash for labour, materials, etc. and receiving cash from the sale of goods and services. Cash flow forecast: An estimate of future cash inflow and outflow of a business, usually on a month-by-month basis, showing the expected cash balance at the end of each month. Net Cash Flow: The difference between inflows and outflows each month. Closing cash/bank balance: The amount of cash held by the business at the end of each month, becoming the next month's opening balance. Opening cash/bank balance: The amount of cash held by the business at the start of each month. Working capital: The capital available to the business in the short-term to pay for day to day expenses. Why cash is important to a business: Cash is a liquid asset, meaning it is available to spend immediately for goods and services. If a business has too little cash, problems such as: -​ Being unable to pay workers, suppliers, landlords, government, etc. -​ Halting of production of goods and services. -​ Business is forced into ‘liquidation’ - selling assets, in order to pay off debts. What is meant by cash flows: Being the flow of cash in and out of the business, businesses often earn cash inflow through: -​ The sale of products and services for cash. -​ Payments made by debtors - debtors being customers who already purchased products from the business but did not pay for them at the time. -​ Borrowing money from external sources - leading to cash inflow, having to be repaid eventually. -​ The sale of assets of the business, e.g unwanted property. -​ Investors, e.g shareholders putting more money into the business. Businesses also experience outflow through: -​ Purchasing goods or raw 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 that supplied items to the business that weren’t paid immediately Cash flow cycle: A diagram demonstrating the cash inflow and outflow of a business is known as a cash flow cycle. It explains why cash paid out is not immediately returned to the business. It is generally important to a business as it allows business owners to plan for the following scenarios: -​ A business that does not have cash for paying expenses, may not have enough money to pay for raw materials, resulting in output and sales falling. -​ Should the business not have enough cash for day to day expenses, and as such only accepts cash, may lose customers to a business that takes credit. -​ A business with insufficient cash to pay bills, e.g rent and electricity, the business may be forced into liquidation, and forced out of business. Cash flow is not profit! Profit is the sum of all money collected by the business through sales, while cash flow is the amount of cash that is received by the business through any means, including grants, loans, etc. and not necessarily through the sale of goods. Importantly: it is possible for a profitable business to run out of cash, which may cause a business to fail, due to insolvency, in which a business does not have enough liquidity to pay its expenses or debts. This is possible as: -​ The business allows too long of a credit period, maybe in order to encourage sales. -​ Purchasing too many non-current assets at once. -​ Expanding too quickly and keeping a high inventory level, meaning cash is used to pay for higher inventory levels, which is known as overtrading. Cash flow forecasts and their importance: Cash flow forecasts allow for a manager or owner of a business to know the following information: -​ How much cash is available for paying bills, repaying loans, or buying fixed assets. -​ How much cash the bank might need to lend the business in order to avoid insolvency. -​ Whether the business is holding too much cash which could be put to more profitable use. They are generally useful in the following situations: -​ Starting a business -​ Running an existing business -​ Keeping the bank manager informed -​ Managing the cash flow Usefulness in starting a business: The starting up of a business is generally an expensive time for business owners, due to the need to rent new properties and purchase raw materials etc., and a cash flow forecast may be necessary to help business owners know how much cash would be needed. Usefulness in running an existing business: A cash flow forecast may allow for a business to get loans in advance, and for the lowest interest rates to be arranged. Last minute loans may result in loans being refused or high interest rates. Usefulness in keeping the bank manager informed: Bank managers are generally more willing to provide loans for businesses that provide cash flow forecasts that show how the bank's money will be used by the business. ​ Usefulness in managing cash flow: A business with too much cash could decide to use it more profitably, perhaps through paying off debts, or investing in new assets, or to pay off creditors for discounted rates, etc. Cash flow forecast as shown below: In the cash flow forecast above, it can be seen that: -​ The net cash flow is (Total inflow - Total outflow) = 2,750 -​ And that the net cash flow is added to the value of the opening balance for the closing balance e.g 0 + 2,750 = 2,750, 2,750 + 1,000 = 3,750 -​ The closing balance is the opening balance for the following day. How a short-term cash flow problem might be solved: Issues in terms of cash flow may be solved through the following ways: -​ Increasing bank loans, meaning businesses inject more cash into the business, but comes with the limitations of interest having to be paid and loans also having to be repaid. -​ Delaying payments to suppliers, meaning cash outflow decreases briefly, but may cause the business to be unpopular with suppliers, resulting in refusal to supply, and lower discount rates. -​ Asking debtors to pay faster, or insisting on cash sales., meaning cash inflow increases in the short term, but customers may be lost to businesses offering credit. -​ Delaying or cancelling the purchase of capital equipment, meaning cash outflows decrease, but long term efficiency is sacrificed. In the long term, businesses with cash flow issues may have to make other decisions to solve the problem, including: -​ Attracting new investors by selling company shares -​ Cutting costs and increasing efficiency -​ Developing new products that attract more customers The concept and importance of working capital: Working capital refers to the amount of capital which is readily available to the business, i.e working capital is the money and resources used to pay off day-to-day expenses. Working capital = Current assets - current liabilities (Chapter 26) Working capital is required for a business to function properly, and allows for a business to take advantage of any opportunity presented to it. Working capital can be held in the forms of: -​ Cash needed to pay day-to-day costs and buy inventories. -​ The value of a company’s debtors (debts owed to the business) is related to the volume of production and sales, and to achieve higher sales there may be a need to offer additional credit facilities (Ways to purchase products?). -​ The value of inventories (products?) held by a business is also part of working capital, where too much inventory results in high opportunity cost, and too little results in production halting.