Why Cash Is Important to a Business
Cash is the money available to a business for making payments.
→ Businesses need cash to pay for their day-to-day activities.
→ Cash may be needed to pay:
→ wages and salaries
→ suppliers
→ rent
→ electricity and other bills
→ taxes
→ loan repayments
→ purchases of non-current assets
Cash and Profit Are Not the Same
→ A business can make a profit but still have a shortage of cash.
→ Profit is based on revenue and costs, while cash flow is based on money actually entering and leaving the business.
Example:
→ A business sells goods worth $50,000 on credit.
→ The sale increases revenue and may contribute to profit.
→ However, if customers do not pay until next month, the business has not yet received the $50,000 in cash.
→ The business could therefore have a cash-flow problem even though it is profitable.
What Is Cash Flow?
Cash flow is the movement of cash into and out of a business over a period of time.
→ Cash inflow = cash coming into the business.
→ Cash outflow = cash leaving the business.
Cash Inflows
Examples include:
→ cash sales
→ payments from customers who bought on credit
→ loans received
→ owners’ investment
→ sale of assets
→ other receipts
Cash Outflows
Examples include:
→ payments to suppliers
→ wages
→ rent
→ utilities
→ advertising
→ loan repayments
→ purchase of non-current assets
→ tax payments
What Is a Cash Flow Forecast?
A cash flow forecast is a prediction of the cash inflows and cash outflows a business expects over a future period.
→ It is usually prepared for several months ahead.
→ It helps the business predict whether it will have enough cash to meet its payments.
Why Cash Flow Forecasts Are Important
Identifying Cash Shortages
→ A forecast can show when cash is likely to fall below the amount needed to make payments.
→ The business can take action before the shortage occurs.
Identifying Cash Surpluses
→ A forecast can show when the business is likely to have excess cash.
→ The business may then use the money to invest, repay loans or purchase assets.
Planning Finance
→ If a cash shortage is forecast, the business can arrange an overdraft or another source of finance in advance.
Making Business Decisions
→ Managers can use the forecast when deciding whether to purchase equipment, increase production or expand.
Avoiding Financial Problems
→ A business that cannot pay its bills on time may lose the confidence of suppliers and lenders.
→ Cash flow forecasting helps reduce this risk.
Main Features of a Cash Flow Forecast
A simple cash flow forecast normally includes:
→ cash inflows
→ cash outflows
→ net cash flow
→ opening balance
→ closing balance
Cash Inflow
Cash inflow is the total cash expected to enter the business during a period.
Examples:
→ cash sales
→ customer payments
→ loans
→ sale of assets
Cash Outflow
Cash outflow is the total cash expected to leave the business during a period.
Examples:
→ wages
→ rent
→ supplier payments
→ advertising
→ equipment purchases
Net Cash Flow
Net cash flow shows the difference between total cash inflows and total cash outflows.
Formula:
Net Cash Flow = Total Cash Inflows − Total Cash Outflows
Example
Cash inflows = $30,000
Cash outflows = $24,000
Net cash flow = $30,000 − $24,000 = $6,000
→ The business has a positive net cash flow of $6,000.
If:
Cash inflows = $20,000
Cash outflows = $27,000
Net cash flow = $20,000 − $27,000 = −$7,000
→ The business has a negative net cash flow of $7,000.
Opening Balance
The opening balance is the amount of cash available at the beginning of a period.
→ The opening balance for one month is normally the closing balance from the previous month.
Closing Balance
The closing balance is the amount of cash the business expects to have at the end of the period.
Formula:
Closing Balance = Opening Balance + Net Cash Flow
Example
Opening balance = $10,000
Net cash flow = $4,000
Closing balance = $10,000 + $4,000 = $14,000
If net cash flow is negative:
Opening balance = $10,000
Net cash flow = −$4,000
Closing balance = $10,000 − $4,000 = $6,000
Completing a Cash Flow Forecast
Consider this simple forecast:
| January | |
|---|---|
| Cash inflows | $25,000 |
| Cash outflows | $18,000 |
| Net cash flow | ? |
| Opening balance | $8,000 |
| Closing balance | ? |
Step 1: Calculate Net Cash Flow
Net cash flow = $25,000 − $18,000 = $7,000
Step 2: Calculate Closing Balance
Closing balance = $8,000 + $7,000 = $15,000
Completed forecast:
| January | |
|---|---|
| Cash inflows | $25,000 |
| Cash outflows | $18,000 |
| Net cash flow | $7,000 |
| Opening balance | $8,000 |
| Closing balance | $15,000 |
Amending a Cash Flow Forecast
A forecast may need to be changed when business circumstances change.
Example
A business originally expected:
→ Cash inflows = $40,000
→ Cash outflows = $30,000
Expected net cash flow = $10,000
The business then discovers that a supplier payment of $5,000 must be made earlier than expected.
→ New cash outflows = $35,000
New net cash flow = $40,000 − $35,000 = $5,000
→ The closing balance will therefore be $5,000 lower than originally forecast.
Interpreting a Cash Flow Forecast
When interpreting a cash flow forecast, look for:
→ positive or negative net cash flow
→ changes in closing balance
→ months with low cash balances
→ months with cash shortages
→ periods of cash surplus
→ reasons for changes in cash flow
Positive Net Cash Flow
→ Cash inflows are greater than cash outflows.
→ The closing balance increases.
Negative Net Cash Flow
→ Cash outflows are greater than cash inflows.
→ The closing balance decreases.
→ This does not necessarily mean the business is making a loss.
Cash Flow Problem
A cash-flow problem occurs when a business does not have enough cash available to meet its payments when they are due.
Example:
| March | |
|---|---|
| Opening balance | $5,000 |
| Cash inflows | $12,000 |
| Cash outflows | $20,000 |
| Net cash flow | −$8,000 |
| Closing balance | −$3,000 |
→ The forecast shows a negative closing balance.
→ The business may not have enough cash to pay its bills.
→ Action is needed before the shortage occurs.
Overcoming a Short-Term Cash Flow Problem
A short-term cash-flow problem does not necessarily mean that the business is failing.
→ The business may be able to improve its cash position using several methods.
Bank Overdraft
An overdraft allows a business to withdraw more money from its bank account than it currently has, up to an agreed limit.
→ This provides cash immediately.
Advantages
→ Quick access to finance.
→ Useful for temporary cash shortages.
→ Flexible because the business can use only what it needs.
Disadvantages
→ Interest and bank charges may be high.
→ The bank may reduce or withdraw the overdraft facility.
→ It increases the business’s liabilities.
Delaying Supplier Payments
→ The business may negotiate with suppliers to pay later.
→ This keeps cash in the business for longer.
Example:
→ Instead of paying a supplier immediately, the business negotiates payment in 60 days.
→ The business can use the cash for other urgent payments.
Possible problem:
→ Suppliers may refuse.
→ The business may lose early-payment discounts.
→ Repeated late payments could damage supplier relationships.
Asking Customers to Pay More Quickly
→ The business can encourage customers to pay outstanding amounts sooner.
Possible methods include:
→ offering a small discount for early payment
→ sending invoices promptly
→ reminding customers when payment is due
→ introducing stricter credit terms
→ requesting deposits or advance payments
Example:
→ A business offers customers a 2% discount if they pay within 10 days rather than 30 days.
→ Customers may pay sooner, improving the business’s cash position.
Delaying the Purchase of Non-Current Assets
→ The business can postpone buying expensive equipment, vehicles or machinery.
→ This prevents a large cash outflow in the short term.
Example:
→ A business planned to buy a new delivery van for $40,000 next month.
→ If the business has a temporary cash shortage, it could delay the purchase until its cash position improves.
Possible problem:
→ The business may lose the benefits of the new asset.
→ Old equipment may continue to have high maintenance costs.
Comparing Methods of Solving a Short-Term Cash Flow Problem
| Method | How it improves cash flow | Possible disadvantage |
|---|---|---|
| Bank overdraft | Provides additional cash | Interest and charges |
| Delay supplier payments | Keeps cash in the business for longer | May damage supplier relationships |
| Ask customers to pay faster | Brings cash into the business earlier | Customers may dislike tighter terms |
| Delay non-current asset purchases | Prevents a large cash outflow | Business may lose benefits of the new asset |
Choosing the Most Appropriate Solution
The best solution depends on the cause, size and length of the cash-flow problem.
→ Small, temporary shortage → an overdraft may be suitable.
→ Customers paying too slowly → encourage faster customer payments.
→ Large supplier payments due soon → negotiate longer payment terms.
→ Planned equipment purchase causing the shortage → delay the purchase if it will not seriously affect operations.
→ A business may use more than one method to overcome a short-term cash-flow problem.
Example Decision
A business forecasts a cash shortage next month because customers are taking too long to pay, but the business expects strong cash inflows the following month.
→ Asking customers to pay more quickly could improve the cash position without taking on long-term debt.
→ If this is not enough, a short-term overdraft could provide additional finance until the expected customer payments are received.