3.7 Cash Flow Flashcards
Cash flow
refers to the movement of an organisation’s cash inflow and cash outflows
Sales revenue
is the value of goods and/or services sold to customers.
Formula of sales revenue
Sales revenue = Price × Quantity
Profit
is the value of sales revenue after all costs have been accounted for. This is the money that the business earns.
Hence, profit is the positive difference between a firm’s sales revenue and its total costs of production.
Formula of profit
Profit = Sales revenue – Total costs
Working capital
refers to cash or other liquid assets available to an organisation for its daily operations.
Formula of working capital
Working capital = Current assets – Current liabilities
Working capital cycle diagram
Cash in - payments to suppliers/employees - goods produced - goods sold
Define the term working capital cycle
refers to the duration between the organization paying for the production costs of a good or service and it receiving the cash from customers purchasing the product.
Definition of liquidity position
indicates the extent to which a business has sufficient liquidity to continue its business activities. Being in a good liquidity position means the business can avoid bankruptcy (business closure) as the organization has sufficient liquidity to continue operating
Cash flow forecast
financial tool used to show the expected movement of cash into and out of a business, for a given period of time.
Cash inflows
the money going into the business from earnings and other sources of finance
Cash outlfows
money going out of a business to pay for its spending
Net cash flow
is the numerical difference between an organization’s total cash inflows and its total cash outflows, per time period.
Net cash flow formula
Net Cash Flow = Cash inflows – Cash outflows
What is a liquidity problem
when there is a lack of cash in the organisation because its cash inflow is less than its cash outflow,
i.e., it experiences negative net cash flow.
Reasons for cash flow forecast (3)
-banks and other lenders require a cash flow forecast to help them assess the financial health of the business seeking external sources of finance
-Help managers to anticipate and indentify periods of potential liquidity problems
- facilitate business planning
Closing balance formula
Closing balance = Opening balance + Net cash flow
Opening balance formula
Opening balance = Closing balance in previous month
what are cash flow problems
arise when an organization has insufficient funds to run its business, i.e. when net cash flow is negative
examples of cash flow problems (7)
-A lack of financial planning resulting in sales revenue being lower than expected
-Poor credit control, which can lead to bad debts (debtors who are unable to pay for their purchases that have been bought on trade credit)
-Poor cost control, resulting in costs of production being higher than budgeted
-Poor inventory control, resulting in overstocking of products (which have cost money to purchase but have yet to be sold to customers)
-Overtrading, i.e. the firm expanding too fast, which increases cash outflows, but not necessarily with the cash inflows
-Seasonal fluctuations in demand for the firm’s goods and/or services
-Unexpected events, such as a crisis or unforeseen costs that arise rapidly.
Strategies to reduce cash outflows (4)
-Negotiate with creditors and suppliers to improve trade credit terms. Securing a longer credit period helps to delay cash outflows.
-Pay for purchases of goods and services on trade credit, rather than using cash.
-Opt for leasing capital equipment instead of purchasing such assets. Although this reduces the organization’s net assets on its balance sheet, it can provide much needed liquidity for the firm.
-Reducing stock levels (inventories), as this can reduce cash outflows needed to pay for purchasing stocks. This is particularly important for organizations with a long working capital cycle.
Strategies to increase cash inflows (5)
-Raising prices of the products the business sells that have few substitutes or a high degree of brand loyalty.
-Reduce prices of the products the business sells that have a high degree of competition. This can help to attract customers from rival firms.
-Reducing the credit period helps to improve the cash flow cycle, because customers buying on credit pay within a shorten time period.
-Encourage debtors to pay their invoices early by offering discounts. This shortens the working capital cycle.
-improved marketing strategies to attract customers, raise brand awareness, boost sales and develop customer loyalty.
Strategies to seek additional sources of finance(4)
-Businesses will often rely on bank overdrafts or bank loans as additional finance when faced with a liquidity problem.
-Secure finance from sponsorships, donations or financial gifts. This can help to boost cash inflows, thereby improving the cash flow position.
-Selling shares in a limited liability company in order to raise additional sources of finance. Whilst this could bring in additional cash, it can be an expensive operation, and such option is not available to sole traders and partnerships.
-In the worst-case scenario, an organization could sell its fixed assets to raise additional finance.
