Forecasting and

managing cash flow

Chapter 16
Chapter overview

The differences between cash flow and profit and the

importance of cash flow to businesses
The uses, construction, interpretation, and
amendment of cash-flow forecasts
The causes of cash-flow problems
The methods that businesses can use to improve their
cash-flow positions; how to select the best method
Why businesses forecast
cash flow
16.1
What is cash flow?

Cash flow is the movement of cash into and out

of a business over a period of time
A potentially profitable enterprise can fail due to
poor management of cash flow
Cash flow and profits are two very different
concepts
If over a given period of time, a businesss
revenues are greater than its expenditures, it
made a profit
A business can survive without making a profit for a
short period of time
Cash flow is about the timing of payments and
receipts
What is cash flow?

Unless a business manages the timing of its payments

and receipts carefully, it may operate profitably but
run out of cash regularly

The first months and years of trading and those during

major expansions are the most risky
Financial institutions demand evidence of planned
management of cash before lending money
Where and how the money will be spent
Cash Flow Exercise: Costa
Coffee
In pairs, list the cash inflows and cash outflows that Costa
Coffee may have.
Cash inflows
Payments from customers
Interest on bank accounts,
savings, and investments
Franchise fees, royalty
payments, etc.
Merchandise
Receipt of bank loans or
overdrafts
Cash outflows
Purchase of stock, raw
materials or tools
Wages, rents and daily
operating expenses
Purchase of fixed assets -
PCs, machinery, office
furniture, etc.
Loan repayments
Dividend payments
Income tax, corporation
tax, VAT and other taxes
Reduced overdraft
facilities
The distinction between
cash flow and profits
Profit is the surplus of sales revenue over total costs
Just because a business is profitable does not mean it
will hold large sums of cash, or even have enough
This happens because:
May sell on credit
May hold large amounts of expensive inventory (i.e.
jewelers)
May have used large amounts of cash to pay for non-
current assets
Even a profitable business may find itself short of cash
Possibly unable to settle bills when they are due
Can lead to insolvency
The distinction between
cash flow and profits
In the long term, a business has to make a profit
Funds have been invested and returns are expected

A business can survive for some time without making

profits, but cash will have to be managed carefully

Two main reasons why businesses forecast cash flows:

1. To support applications for loans
Almost all new enterprises require loans to become
established and during expansion
Banks are more likely to lend to those with evidence of
financial planning
Gives the bank more confidence the firm can make repayments
Case Study: Saab runs out of
cash
1. Explain why cash-flow forecasting would have been a
very important activity for Saab.
The company has become insolvent and this is likely due to
poor cash-flow management. By forecasting it could
identify possible times of difficulty and take action
In order to make regular large-scale investments on
development, it would need to ensure sufficient finance
2. Discuss why a company that earns revenues of more
than $1 billion dollars in a year might run out of cash.
If inflows are delayed, a business may become insolvent
Saab didnt hold sufficient cash to pay suppliers so had to
cease trading with them, but its products were still popular
Math moment

Calculate the average number of cars produced per

employee at Saab in a year.

Labor productivity = number of units of output produced

by time period / average number of employees

32,000 cars / 3,200 employees = 10 cars per employee

per year
The distinction between
cash flow and profits
1. To support applications for loans
2. To help avoid unexpected cash-flow crises
20% of firms fail within 2 years of starting trading
Many fail due to cash-flow difficulties
Even large firms encounter cash flow problems
Planning can help avoid these difficulties
Can ensure firms do not suffer from periods where they are
short on cash and unable to pay debts
Forecasting allows identification of times where there might
not be enough cash available
Allows for arrangements to be made
The importance of maintaining
sufficient cash-flow balances

Not holding sufficient cash can lead to insolvency

Working capital is needed to pay for supplies
Cash inflows are needed to ensure financial
obligations can be met
Some businesses will need larger cash reserves than
others
Supermarkets can trade confidently holding relatively
small cash balances
Customers pay at the time of purchase and frequently in
cash

House builders may need greater cash reserves

Face a longer cash cycle (time between cash outflows and
inflows)
The importance of maintaining
sufficient cash-flow balances

Businesses judged to have insufficient reserves of cash

may experience difficulties raising capital
Potential investors or shareholders may be concerned
The business might be deemed too great a risk
Case Study: Chinese
companies short of cash
1. Explain why shareholders may be reluctant to invest in
companies that are thought to suffer from cash-flow
problems.
If the company becomes insolvent, suppliers might not be
paid losing some or all of their investment
May not be able to raise finance needed to undertake
profitable investments reducing dividends
2. Evaluate why the construction, steel manufacture and
machine building industries might have been
particularly hit by the cash problems.
All need substantial cash to operate
Construction companies have long cash cycles (months-
years between buying land and selling property)
Steel manufacturers have large demand for cash to finance
non-current assets
Cash-flow forecasts in
practice
16.2
Constructing cash flow
forecasts
A cash flow forecast is a document that records a
businesss anticipated inflows and outflows of cash
over some future period, frequently one year

Cash-flow forecasts differ from one another but will

typically have 3 sections
Calculated monthly
Inflows and outflows of cash should be included in the
plan at the time they take place
Constructing cash flow
forecasts
1. Cash in
Forecasts cash inflows
Usually on a monthly basis
Includes receipts from cash and credit sales
2. Cash out (expenditure)
Includes forecasts of expenditure on rent, rates, insurance,
wages, etc.
Total expected outflow of cash is stated at the end
3. Net monthly cash flow
Subtracting total outflow of cash from total inflow
4. Opening and closing balances
Opening balance is the cash position at the start of each
month (same as ending balance from previous month)
The net monthly cash flow is added to the opening balance
The resulting figure is the closing cash balance for the month
Constructing cash flow
forecasts a case study
Steve Marshall is planning to buy a bookshop

He needs to forecast his cash-flow to identify times of

problems

Knowing when he will be short of cash allows him the

chance to arrange an overdraft or short-term loan

Banks are unlikely to advance money unless a cash-

flow forecast is constructed
Constructing cash flow
forecasts a case study
Steve has made the following forecasts:
Raised $75,000 from a bank loan and his savings
Used to buy lease on a property and to purchase books
Will also pay start-up marketing costs

Expected opening cash balance of $2,000 for June

Anticipates cash sales to rise for each of the 4 months
(from $5,750 to $9,215)
Order for $10,000payment in Sept.; books purchased in
June

Each month books are ordered from suppliers to replace

those sold
Pays his wages and that of part-time assistant--$1,500/mo
Other costs: rent, rates, heating, lighting--$1,500 in June
and July; higher in Aug. and Sept.
Constructing cash flow
forecasts a case study
Steves cash-flow forecast illustrates many key
principles
Net monthly cash flow is extremely important
Records the balance between inflows and outflows each
month
June is a good example of how he operates
Expected $5,750 from book sales
Expected to spend $94,500 on initial purchasing of books,
supplying an order, marketing, wages, and rent
June net cash flow--$80,750 - $94,500 = -$13,750
Negative figures can be shown in brackets or with a
minus figure
-$13,750
($13,750)
Constructing cash flow
forecasts a case study
Highlights a key advantage of cash-flow forecasting
Steves business will be short of cash during June, Aug.,
and Sept.

The closing balances indicate he will need maximum

additional cash of $13,855
Allows him to pay rent, wages, etc.

Knowing this in advance means Steve can take steps

to avoid a cash crisis
Constructing cash flow
forecasts a case study
Can be helpful, but involves a degree of uncertainty

Cannot be certain about accuracy of forecasts of

inflows
Most firms will base this on results of market research
Only accurate if using sufficient primary research and up-
to-date secondary research
More risky for those entering new markets where little
data exists

Forecasting cash outflows can also be difficult

Unexpected changes in price of resources
Amending cash-flow
forecasts
Changes in the business can have a substantial effect
on a cash-flow forecast
Maybe sales are lower or higher than forecast
Maybe outflows differ due to unforeseen purchases
The forecast would need to be amended
Math Moment

What would the closing balance have been in

September if cash sales in September were $12,715?

Closing balance = opening balance + net cash flow

Cash sales $12,715

Cash inflows $22,715
Net cash-flow $13,085
-$13,855 + $13,085 = -$770
Causes of cash-flow
problems
A major cause of cash-flow problems is lack of
planning
May miss out on impending crisis

Many established businesses choose not to forecast

and invariably face unforeseen problems

A number of other factors can contribute:

Overtrading
Quick expansion without organizing funds to finance it
Cash outflows often happen months before cash inflows
Allowing too much credit
Helps to win customers but if too generous can lead to cash-
flow problems
Causes of cash-flow
problems
Poor credit control
Credit control department ensures customers keep to
agreed upon borrowing limits and pay on time
If this becomes inefficient, inflows may be delayed
Can also lead to bad debt (when customers dont
ever pay)
Other factors
Sudden slump in product demand
May leave a firm with large quantities of unsold
inventory
May lead to new product development, which is
expensive
Case Study: London taxi
manufacturer bought by Chinese
company
1. Explain why a fall in demand for taxis may have
contributed to Manganese Bronzes cash-flow
difficulties.
A fall in sales will reduce cash inflows either immediately or
over time with credit sales
If the fall in sales was not expected, managers would not
have reduced cash outflows which would contribute to the
problems
2. Evaluate whether a takeover was the best way to
solve Manganese Bronzes cash-flow problems.
Would provide a major cash inflow without incurring interest
payments
May have eased relationship with its bank making it easier
to gain other sources of finance later
A short-term loan might have been better as there were
orders on the books
Why cash-flow forecasts can
be inaccurate
Inaccurate assumptions regarding future levels of sales
Can be too low or too high
A competitor increasing prices may lead to cash sales
being higher
Unexpected costs
Raw materials prices may increase
Cost of labor may rise due to increases in legal minimum
wages
Machinery can break down
Inexperience
With little experience, forecasting sales and costs
accurately is very difficult
Why cash-flow forecasts can
be inaccurate
Careful research can reduce the risks of inaccurate
forecasting
Can establish prices customers are likely to pay
Probable levels of demand
Can find costs of raw materials and labor

Accuracy can also be improved by monitoring the

operation of the forecast
Can highlight possible problems early on
Allows time for appropriate actions to be taken

Technology has made monitoring and analyzing cash

flows simpler
Methods for improving
cash flow
16.3
Methods of improving cash
flow
Businesses have to decide how to improve their cash
positionif possible

Techniques used:
Reducing costs
Reducing production costs will lead to a reduction of
cash outflow
Can have a positive effect if done correctly
May be done by using cheaper products, labor, etc.
Can result in undesirable side effects
Lower quality products may lead to reduced prices charged
to consumers
May attract adverse publicity and lead to decrease in sales
Methods of improving cash
flow
Improving the management of trade receivables and
payables
If a firm can persuade suppliers to offer credit, it can
increase payables and improve cash-flow
Delaying payments always helps
If trade credit already exists, a firm can try to extend it (i.e.
from 30 to 60 days)
Harder for newly-established businesses to negotiate credit
terms without suitable financial history

Can also improve cash flow by offering less favorable

terms for trade credit (reducing receivables)
Good control of receivables and payables means earlier
inflows of cash and fewer bad debts
Need to actively chase up customers to ensure on-time
payment
Debt factoring

Receiving cash earlier by selling its debts to a debt

factor
A debt factor is another business, typically a bank that
provides short-term loans for a fee

Under this agreement, the debt factor will pay up to

95% of the value of the debts immediately

Can assist a firms cash-flow position but reduces

profits

Many small firms believe to lose up to 5% of their

earnings means that factoring is uneconomic
It can eliminate much of their profit margin
Debt factoring

Benefits:
Immediate cash provided means lower overdraft
requirements
Will pay less interest

Cash from sales is received quicker

Usually used by small businesses
Those will turnover greater than $1 million will use
alternative techniques
Invoice discounting is where the company retains the
administration of the deal within the business
Customers wont know the firm is using a debt factoring
service
Helps retain customer confidence
1. You provide the goods/services to
your customer and invoice them
2. You send the invoice details to the
invoice finance provider
3. Funds are made available of a
certain percentage of the face
value of the invoice. Usually within
48 hours
4. Either your own credit controller or
the invoice finance providers
sales ledger service carries out the
invoice collection procedure
5. When your debtor pays, the
balance of the invoice is made
available to you less a service
fee
Math Moment

1. How much will Melaka Industries receive from the

factoring company immediately?
$770,000 x 0.8 = $616,000
2. How much will Melaka Industries receive from the
factoring company in total?
($770,000 x 0.8) + ($770,000 x 0.15) = $731,500
Arrange short-term
borrowing
Most businesses have agreed an overdraft with their
bankers
Allows the business to borrow flexibly according to its
needs up to an agreed limit
Can be expensive but economical
Only borrow when it wants and as much as it wants

May also arrange a short-term bank loan

Less flexible
Firm will have the full amount available whether it is all
required or not
Will make monthly repayments with interest
Sale and leaseback

Constitutes an arrangement where the seller of an

asset leases back the same asset from the new owner

Provides significant cash inflow but commits the firm to

regular payments to lease the asset

Becoming increasingly popular in order to strengthen

cash positions
Case Study: Nokias sale
and leaseback plans
1. Explain two other ways in which Nokia may have
raised $200-$300 million.
As a public limited company it could have sold shares on
the local stock exchange
It may have been able to get a loan but it may have been
tricky due to recent cash inflow position
2. Discuss whether the advantages of this sale and
leaseback plan outweigh the disadvantages.
Short-term it will increase cash-flow inputs dramatically
Doesnt weaken financial position due to borrowing
Will weaken its balance sheet in the long term
Leasing

Purchasing a range of needed assets by renting an

asset rather than buying it
The finance company still owns the asset
Non-current assets that may be leased include
vehicles, photocopiers, computers, etc.
Some lease agreements allow for the asset to be
purchased at a low price at the end of the lease
period
Helps avoid spending large amounts of cash at one
time
Leasing arrangements can be costly in the long-term
Hire purchase

Obtaining credit for the purchase of a non-current

asset
The business pays a percentage of the purchase price as
a deposit and the remainder in installments over an
agreed period
The purchaser only becomes the owner once the final
payment is made
Can improve cash-flow position as it delays outflow
Used to finance relatively expensive assets such as
vehicles
Likely that the overall cost will be higher using this
method
If the business defaults on payment, it does not own
the asset
Choosing the most effective
method of improving cash flow

There is no single best method

A number of factors will influence the methods a

business might employ:
1. The extent to which the business is established
New businesses have fewer options
May not be able to persuade suppliers to grant it
credit
May not be able to impose payment terms on
customers
May not own assets for sell and leaseback
May not be able to get loans from banks
Choosing the most effective
method of improving cash flow

2. The businesss level of profitability

Firms that generate low profit margins may struggle
to use certain methods
May struggle to negotiate loans from banks
Profitable businesses are more able to use
techniques such as debt factoring
3. The type of business
Businesses with large property portfolios may use
sale and leaseback