30. Cash flow

Question 1

Cash flow forecasts: meaning and purpose

Answer 1

For any business to survive, having sufficient cash to pay suppliers, banks and employees is the single most important financial factor. A business could have high revenue and low expenses, but if it does not manage cash effectively, it could still have negative cash flow. Without positive cash flow, any company – no matter how promising its business model – will become insolvent and bankrupt. So cash flow is important for the liquidity of the business

Question 2

Importance of cash flow forecast for newly established businesses

Answer 2

• New business start-ups are often offered much shorter credit to pay suppliers than larger, wellestablished firms.
• Banks and other lenders will need to see evidence of a cash flow forecast before making any finance available.
• Finance is often very tight at start-up, so accurate planning is much more significant for new businesses.

Question 3

Cash inflows

Answer 3

• Owner’s own capital injection
• Bank loan payments
• Customers’ cash purchases: These are difficult to forecast as they depend on sales, so a sales forecast will be necessary. However, it can be inaccurate
• Trade receivables payments: These are difficult to forecast as they depend on two unknowns. What proportion of sales will be on credit? When will trade receivables (debtors) actually pay?

Question 4

Cash outflows

Answer 4

• Lease payment for premises
• Annual rent payment
• Electricity, gas, water and telephone bills are difficult to forecast as these will vary with many factors
• Wage payments: These forecasts will be based largely on demand forecasts and the hourly wage rate that is to be paid
• Cost of materials and payments to suppliers: The cost of materials should vary with the level of output or sales

Question 5

Benefits of cash flow forecasting

Answer 5

• They show negative closing cash flows. This means that plans can be made to source additional finance, such as a bank overdraft or the injection of more capital from the owner.
• They indicate periods of time when negative net cash flows are excessive. The business can plan to reduce these by taking measures to improve cash flow
• They are essential to all business plans. A business start-up will never gain finance unless investors and bankers have access to a cash flow forecast and the assumptions behind it.

Question 6

Limitations of cash flow forecast

Answer 6

Many factors, either internal to the business or in the external environment, can change and therefore affect the accuracy of a cash flow forecast. This means that cash flow forecasts must be used with caution and the ways in which the cash flows have been estimated should be understood. Here are the most
common limitations of forecasts:
* Mistakes can be made in preparing the revenue and cost forecasts, or they may be drawn up by inexperienced entrepreneurs or staff.
* Unexpected cost increases lead to major inaccuracies in forecasts.
* Incorrect assumptions can be made in estimating the sales of the business, perhaps based on poor market research. This will make the cash inflow forecasts inaccurate.

Question 7

Causes of cash flow problems

Answer 7

1. Lack of planning
* Cash flow forecasts help greatly in predicting future cash problems for a business. Financial planning can be used to predict potential cash flow problems so that business managers can take action to overcome them in plenty of time.

2. Poor credit control
If this credit control is badly managed, then trade receivables will not be chased for payment and potential bad debts will not be identified.

3. Allowing customers too long to pay debts
Many businesses have to offer trade credit to customers in order to be competitive. Allowing customers too long to pay means reducing short-term cash inflows, which leads to cash flow problems.

4. Expanding too rapidly
When a business expands rapidly, it has to pay for the expansion and for increased wages and materials months before it receives cash from additional sales. This overtrading can lead to serious cash flow shortages even though the business is successful and expanding.

5. Unexpected events
Unforeseen increases in costs could lead to negative net cash flows not being indicated on the original cash flow forecast. Factors such as the breakdown of a delivery truck that must be replaced or a competitor lowering prices unexpectedly will make the original cash flow forecast inaccurate.

Question 8

Methods to increase cash inflows

Answer 8

1. Overdraft
A flexible source of cash from a bank which a business can draw on as necessary up to an agreed limit.
Limitations
* Interest rates can be high and there may be an
arrangement fee.
* Overdrafts can be withdrawn by the bank,
which often causes insolvency.

2. Short-term loan
A fixed amount can be borrowed for an agreed length of time.
* The interest costs have to be paid.
* The loan must be repaid by the due date.

3. Sale of assets
Cash receipts can be obtained from selling off redundant assets, which will boost cash inflow.
* Selling assets quickly can result in a low price.
* The assets might be required at a later date for expansion.
* The assets could have been used as collateral for future loans.

4. Sale and leaseback
Assets can be sold (for example to a finance company), but the assets can be leased back from the new owner.
* The leasing costs add to annual overheads.
* There could be loss of potential profit if the assets rise in price.
* The assets could have been used as collateral for future loans.

If you suggest cutting workers and using cheaper materials, this may reduce cash outflows, but what will be the negative impact on output, sales and future cash inflows? You should attempt to evaluate the longterm impact of any suggestions you make to improve cash flow.

Question 9

Methods to decrease cash outflows

Answer 9

1. Delay capital expenditure By not buying equipment,
vehicles etc. cash will not have to be paid to suppliers.

• The efficiency of the business may fall if inefficient equipment is not replaced.
• Expansion becomes very difficult.

2. Use leasing not outright purchase, of capital equipment
The leasing company owns the asset and no large cash
outlay is required.

• The asset is not owned by the business.
• Leasing charges include an interest cost and add to annual overheads.

3. Cut overhead costs that do not directly affect output (for example promotion costs)
These costs will not reduce production capacity and cash
outflows will be reduced.

Future demand may be reduced by failing to promote the products effectively.

Question 10

Improving cash flow by managing trade receivables

Answer 10

1. Not extending credit to customers or asking customers to pay more quickly
Will customers still buy from this business? Will a major aspect of this business’s marketing mix have been removed?

Evaluation of this approach: Many customers now expect credit and will go elsewhere if it is not offered. The marketing department might argue for an increase in credit terms to customers at the same time as the finance department is trying to cut down on them.

2. Selling claims on trade receivables to specialist financial institutions called debt factors
These businesses will buy debts from other concerns that have an immediate need for cash.
Evaluation of this approach: This will involve a cost, however, as the debt factors will not pay 100% of the value. They must make a profit for themselves.

3. Finding out whether new customers are creditworthy
This can be done by requiring references, either from traders or from the bank, or by using the services of a credit enquiry agency.

4. Offering a discount to customers who pay promptly
Although cash might be paid quickly, discounts reduce the profit margin on a sale.

Question 11

Improving cash flow by managing trade payables

Answer 11

1. Purchasing more supplies on credit and not cash
If a business has a good credit rating, this may be easy, but in other circumstances it can be difficult.

• Evaluation of this approach: Discounts from suppliers for quick cash payment might be stopped. Some suppliers might refuse to offer credit terms.

2. Extend the period of time taken to pay
The larger a business is, the easier it is to insist on longer credit periods from suppliers. This will improve the business’s cash flow.

• Evaluation of this approach: Slow payment by larger businesses is often a great burden for the small businesses that supply them. Suppliers may be reluctant to supply products or to offer a good service if they consider that a business is a late payer.