‹ Back to Business topics

5.2.1 The importance of cash and cash flow forecasts

Why cash is important to a business

Cash is the money a business can spend straight away: notes and coins, plus money in the bank.

Why a business needs cash:

• To pay its bills: wages, suppliers, rent and other costs must be paid on time.
• To keep operating: without enough cash for day-to-day expenses, the business may not be able to operate.
• To keep suppliers’ trust: suppliers that are paid late may stop deliveries or want payment in advance.
• To avoid extra borrowing costs: even a short shortage of cash may mean borrowing, which adds interest.
• To survive: a business that runs out of cash and cannot pay its debts will fail, even if it is making a profit.

What a cash flow forecast is and why it is important

Cash flow forecast: An estimate of the timing and amount of cash inflows and outflows over a future period.

Why a cash flow forecast is important:

• Spots cash shortages in advance: the business can see which months will be short of cash and take action, e.g. cut back on spending.
• Helps arrange finance: the business knows how much it may need to borrow, and when, e.g. the size of an overdraft.
• Supports loan applications: it shows banks and investors whether the business will have enough cash to repay a loan.
• Helps planning: the business can manage its cash better, e.g. by timing large purchases for months with spare cash.
• Shows spare cash: if a large surplus is forecast, the cash could be put to better use.
• Helps decision making: it shows whether the business can afford plans such as expanding.

Main features of a cash flow forecast

• Cash inflow: cash received by the business, e.g. cash sales, payments from credit customers, loans received and money from selling non-current assets.
• Cash outflow: cash paid out by the business, e.g. wages, rent, payments to suppliers, loan repayments and buying non-current assets.
• Net cash flow: Difference (each month) between cash inflows and cash outflows.
• Opening balance: Amount of cash held at the start of the month/trading period.
• Closing balance: how much cash the business expects to have at the end of a specific period, e.g. a month. A negative closing balance warns of a cash shortage.

How the figures link together:

Net cash flow = total cash inflows – total cash outflows

Closing balance = opening balance + net cash flow

The closing balance of one month becomes the opening balance of the next month. Negative figures are shown in brackets, e.g. (500) means –$500.

Amending or completing a simple cash flow forecast

Exam questions often leave gaps in a forecast, e.g. March’s net cash flow and April’s closing balance.

Completing missing figures:

• March net cash flow: $9 000 – $7 000 = $2 000.
• April closing balance: April’s opening balance is March’s closing balance of ($2 500). So –$2 500 + $4 500 = $2 000.

Amending a forecast:

If one figure changes, every figure after it that depends on it must be worked out again. For example, if February’s sales are $1 000 higher than expected, February’s net cash flow becomes ($5 000). February’s closing balance becomes ($3 500), March’s becomes ($1 500), and April’s becomes $3 000.

Interpreting a simple cash flow forecast

What to look for:

• Negative closing balances: these are the months when the business will run out of cash and must take action.
• The biggest figures: the largest inflows and outflows.
• Patterns: seasonal changes, trends or one-off items, such as buying equipment.
• How long the problem lasts: a shortage for only a short time may be covered by an overdraft.
• Past data: whether the forecast matches earlier years, and if not, why.

Common causes of a cash flow problem:

• Customers are given too long to pay, or pay late
• Suppliers are paid too quickly, or give no trade credit
• Poor planning or unexpected costs
• Holding too much inventory
• Growing too quickly
• Low or seasonal sales
• High expenses, or large spending on assets or expansion

How a short-term cash flow problem may be overcome

Overdraft

Arranging with the bank to take out more money than is in the account, up to a set limit, to cover the shortage.

Advantages:

• Quick to arrange
• Interest is only paid on the amount used

Disadvantages:

• High interest rates add to costs
• The bank can ask for it to be repaid at short notice

Delaying supplier payments

Agreeing longer credit terms with suppliers, e.g. 60 days instead of 30, so cash leaves the business later.

Advantages:

• No interest to pay
• Reduces cash outflows in the months that are short of cash

Disadvantages:

• Discounts for paying early may be lost
• Suppliers may stop deliveries if payments are late

Asking customers to pay more quickly

Cutting the time credit customers have to pay, e.g. from 60 days to 30, or offering a discount for paying early.

Advantages:

• Cash comes in sooner, which increases cash inflows in the problem months

Disadvantages:

• Customers may be upset and buy from rivals instead

Delaying the purchase of non-current assets

Putting off buying equipment, vehicles or machinery until the cash position improves.

Advantages:

• Removes a large outflow from the problem months
• Cheaper than borrowing, e.g. an overdraft or a loan, to pay for the asset

Disadvantages:

• If the asset is a replacement, the business must keep using equipment that no longer works well
• Delaying expansion could mean an opportunity is missed