Chapter 27 Forecasting cash flows

Question 1

What is Cash flow?

Answer 1

Cash flow is the sum of cash payment s to a business (inflows) less the sum of cash payments (outflows)

Question 2

When does liquidation occur?

Answer 2

Liquidation occurs when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors

Question 3

What is insolvent?

Answer 3

Insolvent means when a business cannot meet its short-term debts

Question 4

What is cash?

Answer 4

Cash refers to notes, coins and money stored in a bank account

Question 5

What is Profit?

Answer 5

Profit is the amount left over once all costs have been deducted from sales revenue

Question 6

How to calculate profit?

Answer 6

Profit = Sales Revenue – Total Costs

Question 7

Cash-flow forecasting – what are the benefits?

Answer 7

1 By showing periods of negative cash flow, plans can be put into place to provide additional finance
2 If negative cash flows appear to be too great, then plans can be made for reducing these
3 A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash-flow forecast – and the assumptions that lie behind it

Question 8

Cash-flow forecasting – what are the limitations?

Answer 8

1 Mistakes can be made in preparing the revenue and cost forecasts or they may be drawn up by inexperienced entrepreneurs or staff
2 Unexpected cost increases can lead to major inaccuracies in forecasts. Fluctuations in oil prices lead to the cash-flow forecasts of even major airlines being misleading.
3 Wrong assumptions can be made in estimating the sales of the business, perhaps based on poor market research, and this will make the cash inflow forecasts inaccurate

Question 9

What are The causes of cash-flow problems?

Answer 9

1 Lack of planning
2 Poor credit control
3 Allowing customers too long to pay debts
4 Expanding too rapidly
5 Unexpected events

Question 10

The causes of cash-flow problems: Explain Lack of planning

Answer 10

Cash-flow forecasts help greatly in predicting future cash problems for a business. However, they do not solve cash-flow problems by themselves – but they are an essential part of financial planning and can help prevent cash-flow problems from developing.

Question 11

The causes of cash-flow problems: Explain Poor credit control

Answer 11

The credit-control department of a business keeps a check on all customers’ accounts – who has paid, who is keeping to agreed credit terms and which customers are not paying on time. If this credit control is inefficient and badly managed, then debtors will not be ‘chased up’ for payment and potential bad debts will not be identified.

Question 12

The causes of cash-flow problems: Explain Allowing customers too long to pay debts

Answer 12

In may trading situations, businesses will have to offer trade credit to customers in order to be competitive. Assume a customer has a choice between two suppliers selling very similar products. If on insists on cash payment ‘on delivery’ and the other allows two months’ trade credit, then customers will go for credit terms because it improves their cash flow. However, allowing customers too long to pay means reducing short-term cash inflows, which could lead to cash-flow problems.

Question 13

The causes of cash-flow problems: Explain Expanding too rapidly

Answer 13

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.

Question 14

The causes of cash-flow problems: Explain Unexpected events

Answer 14

A cash-flow forecast can never be guaranteed to be 100% accurate. Unforeseen events increases in cost – a breakdown of a delivery van that needs to be replaced, or a dip in predicted sales income, or a competitor lowering prices unexpectedly – could lead to negative net monthly cash flows.

Question 15

How can you improve cash flow?

Answer 15

1 Increase cash inflows

2 Reduce cash outflows

Question 16

What are the different ways to increase cash inflows?

Answer 16

1 Overdraft
2 Short-term loan
3 Sale of assets
4 Sale and leaseback
5 Reduce credit terms to customers
6 Debt factoring

Question 17

Ways to increase cash inflows and their possible drawbacks: Explain Overdraft

Answer 17

Overdraft: Flexible loans on which the business can draw as necessary up to an agreed limit

• Interest rates can be high – there may be an overdraft arrangement fee
• Overdrafts can be withdrawn by the bank and this often causes insolvency

Question 18

Ways to increase cash inflows and their possible drawbacks: Explain Short-term loan

Answer 18

Short-term loan: A fixed amount can be borrowed for an agreed length of time

• The interest costs have to be repaid
• The loan must be repaid by the due date

Question 19

Ways to increase cash inflows and their possible drawbacks: Explain Sale of assets

Answer 19

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

Question 20

Ways to increase cash inflows and their possible drawbacks: Explain Sale and leaseback

Answer 20

Sale and leaseback: Assets can be sold, e.g. to a finance company, but the asset can be leased back from the new owner

• The leasing costs add to annual overheads
• There could be a loss of potential profit if the asset rises in price
• The assets could have been used as collateral for future loans

Question 21

Ways to increase cash inflows and their possible drawbacks: Explain Reduce credit terms to customers

Answer 21

Reduce credit terms to customers: Cash flow can be brought forward by reducing credit terms from, say, two months to one month

• Customers may purchase products from firms that offer extended credit terms

Question 22

Ways to increase cash inflows and their possible drawbacks: Explain Debt factoring

Answer 22

Debt factoring: Debt-factoring companies can buy the customers’ bills from a business and offer immediate cash – this reduces risk of bad debts too

• Only about 90-95% of the debt will now be paid by the debt-factoring company – this reduces profit
• The customer has the debt collected by the finance company – this could suggest that the business is in trouble

Question 23

What are the different ways to reduce cash outflows?

Answer 23

1 Delay payments to suppliers (creditors)
2 Delay spending on capital equipment
3 Use leasing, not outright purchase, of capital equipment
4 Cut overhead spending that does not directly affect output, e.g. production costs

Question 24

Ways to reduce cash outflows and their possible drawbacks: Explain Delay payments to suppliers (creditors)

Answer 24

Delay payments to suppliers (creditors): Cash outflows will fall in the short term if bills are paid after, say, three months instead of two months

• Suppliers may reduce may discount offered with the purchase
• Suppliers can either demand cash on delivery or refuse to supply at all if they believe the risk of not being paid is to great

Question 25

Ways to reduce cash outflows and their possible drawbacks: Explain Delay spending on capital equipment

Answer 25

Delay spending on capital equipment: By not buying equipment, vehicles, etc., cash will not have to be paid to suppliers

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

Question 26

Ways to reduce cash outflows and their possible drawbacks: Explain Use leasing, not outright purchase, of capital equipment

Answer 26

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

Question 27

Ways to reduce cash outflows and their possible drawbacks: Explain Cut overhead spending that does not directly affect output, e.g. production costs

Answer 27

Cut overhead spending that does not directly affect output: These costs will not reduce production capacity and cash payments will be reduced

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

Question 28

How is working capital managed?

Answer 28

It is managed by concentrating on the four main components of the cycle:
1 Debtors
2 Creditors
3 Inventory
4 Cash

Question 29

Managing working capital: Explain Debtors

Answer 29

Debtors can be managed in many different ways, as follows:
1 Not extending credit to customers – or extending it for shorter time periods
2 Selling claims on debtors to specialist financial institutions acting as debt factors
3 By being careful to discover whether new customers are credit worthy
4 By offering a discount to clients who pay promptly

Question 30

Managing working capital: Explain Creditors

Answer 30

Creditors are suppliers who have agreed to supply products on credit and who have not yet been paid

Credit can be managed in two main ways:
1 Increasing the range of goods and services brought on credit
2 Extend the period of time taken to pay

Question 31

Managing working capital: Explain Inventory

Answer 31

Inventory can be managed in the following ways:
1 Keeping smaller inventory levels
2 Using computer systems to record sales and, therefore, inventory levels, and ordering as required
3 Efficient inventory control, inventory use and inventory handling as to reduce losses through damage wastage and shrinkage
4 Just-in-time inventory ordering – by reducing inventory holdings using this technique, and by only producing when orders have been received, working capital tied up in inventories will be minimised. Getting goods to customers as quickly as possible will speed up the eventual payment received for these products

Question 32

Managing working capital: Explain Cash

Answer 32

Cash can be managed by:
1 Use of cash-flow forecasts – these can help the management of cash flows and working capital
2 Wise use of investment of excess cash
3 Planning for periods when there might be too little cash and arranging for overdraft facilities from the bank to avoid a liquidity crisis