finance Flashcards
(21 cards)
How does cash flow differ from net profit
(1) Timing differences
These arise because a business may not received cash straightaway from a customer and it may also delay payment for its costs.
For example, a customer may buy goods for £50,000 but be allowed to pay for those goods in 60 days.
How cash flow differs from profit:
Cash flow refers to the actual movement of money in and out of a business, while profit is the financial gain remaining after all expenses are deducted from revenue. A business can be profitable (showing a positive profit) but still experience cash flow problems, and conversely, have healthy cash flow but not be profitable.
A variety of possible cash flow objectives might be set by a business depending on its financial position and corporate strategy.
Reduce bank borrowings to a target level – perhaps by repaying amounts owed under bank loans or restricting the use of bank overdraft facilities
Minimise the time taken by customers who pay on credit to settle outstanding invoices – this is traditionally a major concern of smaller businesses and an obvious focus for a cash flow objectives
Extend the period taken to pay suppliers to maximum permitted period – e.g. paying trade creditors at the end of any agreed credit period
Building a buffer balance of cash as a precaution against unforeseen circumstances
Minimising the amounts paid out in interest charges
Reducing the seasonal swings in cash flow – perhaps by finding new uses for excess production capacity in quiet periods, or developing markets which are counter-seasonal to existing revenues
A cash flow problem:
When a business does not have enough cash to be able to pay its liabilities
cash flow problem causes:
Low profits or (worse) losses
Over-investment in capacity
Too much stock
Allowing customers too much credit
Overtrading
Unexpected changes
Seasonal demand
The keys to the ability of a business to handle cash flow problems are:
Have a reliable cash flow forecasting system
Actively manage working capital
Choose the right sources of finance for the business needs
good cash flow forecast:
Is updated regularly
Makes sensible assumptions
Allows for unexpected changes
Is reviewed regularly by senior management
Working capital management focuses on:
Striking the right balance between offering customers credit and ensuring that they pay on time
Holding an appropriate level of stocks in the business
Managing relationships with suppliers so that the maximum amount of trade credit can be obtained without damaging supplies to the business
Managing Debtors (credit control)
This isn’t easy. Credit control covers areas such as
Policies on how much credit to give and repayment terms and conditions
Measures to control doubtful debtors (chasing, threatening legal action etc)
Credit checking (only allowing credit to customers who can afford to pay!
Selling off debts to debt factors
Cash discounts and other incentives for prompt payment
Improved record keeping – e.g. accurate and timely invoicing
learn all the sources of finance and their + / -
drawba ks of ratio analysis-
Ratios deal mainly in numbers – they don’t address issues like product quality, customer service, employee morale and so on (though those factors play an important role in financial performance)
Ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios
Ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and an industry – this information is not always available
Financial information can be “massaged” in several ways to make the figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.
what is ratio analysis:
is widely used in practice in business. Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance. Venture capitalists and bankers regularly use ratios to support their analysis when they consider investing in, or loaning to businesses.
The main strength of ratio analysis is that it encourages a systematic approach to analysing performance.
What are current liabilities?
represent amounts that are owed by the business and which are due to be paid within the next twelve months. Current liabilities are normally settled from the amounts available in current assets.
what are current assets
the assets a business owns which are either cash, cash equivalents, or are expected to be turned into cash during the next twelve months.
Current assets are, therefore, very important to cash flow management and forecasting, because they are the assets that a business uses to pay its bills, repay borrowings, pay dividends and so on,
The main elements of current assets are:
Inventories
Inventories (often also called “stocks”) are the least liquid kind of current asset. Inventories include holdings of raw materials, components, finished products ready to sell and also the cost of “work-in-progress” as it passes through the production process.
For the balance sheet, a business will value its inventories at cost. A profit is only earned and recorded once inventories have been sold.
Not all inventories can eventually be sold. A common problem is stock “obsolescence” – where inventories have to be sold for less than their cost (or thrown away) perhaps because they are damaged or customers no longer demand them. For these inventories, the balance sheet value should be the amount that can be recovered if the stocks can finally be sold.
Trade and other receivables
Trade debtors are usually the main part of this category. A trade debtor is created when a customer is allowed to buys goods or services on credit. The sale is recognised as revenue (income statement) when the transaction takes place and the amount owed is added to trade debtors in the balance sheet. At some stage in the future, when the customer settles the invoice, the trade debtor balance converts into cash!
Most businesses operate with a reasonably significant amount owed by trade debtors at any one time. It is not unusual for customers to take between 60-90 days to pay amounts owed, although the average payment period varies by industry. Of course some customer debts are not eventually paid – the customer becomes insolvent, leaving the business with debtor balances that it cannot recover.
When a business is doubtful whether a customer will settle its debts it needs to make an allowance for this in the balance sheet. This is done by making a “provision for bad and doubtful debts” which effectively reduces the value of trade debtors to the total amount that the business reasonably expects to receive in the future.
Short-term investments
A business with positive cash balances can either hold them in the bank or invest them for short periods – perhaps by placing them on short-term deposit. Such investments would be shown in this category.
Cash and cash equivalents
The most liquid form of current assets = the actual cash balances that the business has! The bank account balance would be the main item in this category.
Difference between payables and receivables
the money a business owes to its suppliers and creditors for goods and services received on credit but not yet paid for.
Payables are the counterpart to receivables. While receivables are the money a business is owed by its customers, payables are the money the business owes to its suppliers
What is overtrading?
when a business expands too quickly without having the financial resources to support such a quick expansion. If suitable sources of finance are not obtained, overtrading can lead to business failure.
Importantly, overtrading can occur even a business is profitable. It is an issue of working capital and cash flow.
Overtrading is, therefore, essentially a problem of growth.
It is particularly associated with retail businesses who attempt to grow too fast.
Overtrading is most likely to occur if:
Growth is achieved by making significant capital investment in production or operations capacity before revenues are generated
Sales are made on credit and customers take too long to settle amounts owed
Significant growth in inventories is required in order to trade from the expanding capacity
A long-term contract requires a business to incur substantial costs before payments are made by customers under the contract
Classic Symptoms of Overtrading
High revenue growth but low gross and operating profit margins
Persistent use of a bank overdraft facility
Significant increases in the payables days and receivables days ratios
Significant increase in the current ratio
Very low inventory turnover ratio
Low levels of capacity utilisation
How to avoid overtrading?
Reducing inventory levels
Scaling back the pace of revenue growth until profit margins and cash reserves have improved
Leasing rather than buying capital equipment
Obtaining better payment terms from suppliers
Enforcing better payment terms with customers (e.g. through prompt-payment discounts)
Budgets and variance- flashcard!!
