Chapter 27 Forecasting cash flows Flashcards
What is Cash flow?
Cash flow is the sum of cash payment s to a business (inflows) less the sum of cash payments (outflows)
When does liquidation occur?
Liquidation occurs when a firm ceases trading and its assets are sold for cash to pay suppliers and other creditors
What is insolvent?
Insolvent means when a business cannot meet its short-term debts
What is cash?
Cash refers to notes, coins and money stored in a bank account
What is Profit?
Profit is the amount left over once all costs have been deducted from sales revenue
How to calculate profit?
Profit = Sales Revenue – Total Costs
Cash-flow forecasting – what are the benefits?
1 By showing periods of negative cash flow, plans can be put into place to provide additional finance
2 If negative cash flows appear to be too great, then plans can be made for reducing these
3 A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to a cash-flow forecast – and the assumptions that lie behind it
Cash-flow forecasting – what are the limitations?
1 Mistakes can be made in preparing the revenue and cost forecasts or they may be drawn up by inexperienced entrepreneurs or staff
2 Unexpected cost increases can lead to major inaccuracies in forecasts. Fluctuations in oil prices lead to the cash-flow forecasts of even major airlines being misleading.
3 Wrong assumptions can be made in estimating the sales of the business, perhaps based on poor market research, and this will make the cash inflow forecasts inaccurate
What are The causes of cash-flow problems?
1 Lack of planning 2 Poor credit control 3 Allowing customers too long to pay debts 4 Expanding too rapidly 5 Unexpected events
The causes of cash-flow problems: Explain Lack of planning
Cash-flow forecasts help greatly in predicting future cash problems for a business. However, they do not solve cash-flow problems by themselves – but they are an essential part of financial planning and can help prevent cash-flow problems from developing.
The causes of cash-flow problems: Explain Poor credit control
The credit-control department of a business keeps a check on all customers’ accounts – who has paid, who is keeping to agreed credit terms and which customers are not paying on time. If this credit control is inefficient and badly managed, then debtors will not be ‘chased up’ for payment and potential bad debts will not be identified.
The causes of cash-flow problems: Explain Allowing customers too long to pay debts
In may trading situations, businesses will have to offer trade credit to customers in order to be competitive. Assume a customer has a choice between two suppliers selling very similar products. If on insists on cash payment ‘on delivery’ and the other allows two months’ trade credit, then customers will go for credit terms because it improves their cash flow. However, allowing customers too long to pay means reducing short-term cash inflows, which could lead to cash-flow problems.
The causes of cash-flow problems: Explain Expanding too rapidly
When a business expands rapidly, it has to pay for the expansion and for increased wages and materials months before it receives cash from additional sales. This overtrading can lead to serious cash-flow shortages – even though the business is successful and expanding.
The causes of cash-flow problems: Explain Unexpected events
A cash-flow forecast can never be guaranteed to be 100% accurate. Unforeseen events increases in cost – a breakdown of a delivery van that needs to be replaced, or a dip in predicted sales income, or a competitor lowering prices unexpectedly – could lead to negative net monthly cash flows.
How can you improve cash flow?
1 Increase cash inflows
2 Reduce cash outflows
What are the different ways to increase cash inflows?
1 Overdraft 2 Short-term loan 3 Sale of assets 4 Sale and leaseback 5 Reduce credit terms to customers 6 Debt factoring
Ways to increase cash inflows and their possible drawbacks: Explain Overdraft
Overdraft: Flexible loans on which the business can draw as necessary up to an agreed limit
- Interest rates can be high – there may be an overdraft arrangement fee
- Overdrafts can be withdrawn by the bank and this often causes insolvency
Ways to increase cash inflows and their possible drawbacks: Explain Short-term loan
Short-term loan: A fixed amount can be borrowed for an agreed length of time
- The interest costs have to be repaid
- The loan must be repaid by the due date
Ways to increase cash inflows and their possible drawbacks: Explain Sale of assets
Sale of assets: Cash receipts can be obtained from selling off redundant assets, which will boost cash inflow
- Selling assets quickly can result in a low price
- The assets might be required at a later date for expansion
- The assets could have been used as collateral for future loans
Ways to increase cash inflows and their possible drawbacks: Explain Sale and leaseback
Sale and leaseback: Assets can be sold, e.g. to a finance company, but the asset can be leased back from the new owner
- The leasing costs add to annual overheads
- There could be a loss of potential profit if the asset rises in price
- The assets could have been used as collateral for future loans
Ways to increase cash inflows and their possible drawbacks: Explain Reduce credit terms to customers
Reduce credit terms to customers: Cash flow can be brought forward by reducing credit terms from, say, two months to one month
- Customers may purchase products from firms that offer extended credit terms
Ways to increase cash inflows and their possible drawbacks: Explain Debt factoring
Debt factoring: Debt-factoring companies can buy the customers’ bills from a business and offer immediate cash – this reduces risk of bad debts too
- Only about 90-95% of the debt will now be paid by the debt-factoring company – this reduces profit
- The customer has the debt collected by the finance company – this could suggest that the business is in trouble
What are the different ways to reduce cash outflows?
1 Delay payments to suppliers (creditors)
2 Delay spending on capital equipment
3 Use leasing, not outright purchase, of capital equipment
4 Cut overhead spending that does not directly affect output, e.g. production costs
Ways to reduce cash outflows and their possible drawbacks: Explain Delay payments to suppliers (creditors)
Delay payments to suppliers (creditors): Cash outflows will fall in the short term if bills are paid after, say, three months instead of two months
- Suppliers may reduce may discount offered with the purchase
- Suppliers can either demand cash on delivery or refuse to supply at all if they believe the risk of not being paid is to great
Ways to reduce cash outflows and their possible drawbacks: Explain Delay spending on capital equipment
Delay spending on capital equipment: By not buying equipment, vehicles, etc., cash will not have to be paid to suppliers
- The efficiency of the business may fall if outdated and inefficient equipment is not replaced
- Expansion becomes very difficult
Ways to reduce cash outflows and their possible drawbacks: Explain Use leasing, not outright purchase, of capital equipment
Use leasing, not outright purchase, of capital equipment: The leasing company owns the asset and no large cash outlay is required
- The asset is not owned by the business
- Leasing charges include an interest cost and add to annual overheads
Ways to reduce cash outflows and their possible drawbacks: Explain Cut overhead spending that does not directly affect output, e.g. production costs
Cut overhead spending that does not directly affect output: These costs will not reduce production capacity and cash payments will be reduced
- Future demand may be reduced by failing to promote the products effectively
How is working capital managed?
It is managed by concentrating on the four main components of the cycle: 1 Debtors 2 Creditors 3 Inventory 4 Cash
Managing working capital: Explain Debtors
Debtors can be managed in many different ways, as follows:
1 Not extending credit to customers – or extending it for shorter time periods
2 Selling claims on debtors to specialist financial institutions acting as debt factors
3 By being careful to discover whether new customers are credit worthy
4 By offering a discount to clients who pay promptly
Managing working capital: Explain Creditors
Creditors are suppliers who have agreed to supply products on credit and who have not yet been paid
Credit can be managed in two main ways:
1 Increasing the range of goods and services brought on credit
2 Extend the period of time taken to pay
Managing working capital: Explain Inventory
Inventory can be managed in the following ways:
1 Keeping smaller inventory levels
2 Using computer systems to record sales and, therefore, inventory levels, and ordering as required
3 Efficient inventory control, inventory use and inventory handling as to reduce losses through damage wastage and shrinkage
4 Just-in-time inventory ordering – by reducing inventory holdings using this technique, and by only producing when orders have been received, working capital tied up in inventories will be minimised. Getting goods to customers as quickly as possible will speed up the eventual payment received for these products
Managing working capital: Explain Cash
Cash can be managed by:
1 Use of cash-flow forecasts – these can help the management of cash flows and working capital
2 Wise use of investment of excess cash
3 Planning for periods when there might be too little cash and arranging for overdraft facilities from the bank to avoid a liquidity crisis
