Business (9609) | Forecasting and managing cash flows

Finance and Accounting (AS Level): Forecasting and Managing Cash Flows (5.3)

Welcome to one of the most vital topics in business finance! This chapter is all about cash flow—the lifeblood of any business. You might think that being profitable means a business is safe, but history is full of companies that made huge profits and still went bankrupt because they ran out of cash!

We will learn how to forecast (predict) future cash movements and, crucially, how managers can take steps to prevent cash shortages. Don't worry if numbers seem tricky; we will break down the calculations step-by-step.

Key Concept: Cash vs. Profit

Before diving into forecasts, we must clarify the fundamental difference between cash and profit. This is a very common point of confusion for students!

Cash Flow (Liquidity)

Cash flow is simply the movement of actual money (physical currency or bank deposits) into and out of the business over a specific period.
Cash is about timing: When money comes in and when it goes out.
Analogy: Cash is the air a business breathes. Without it, the business dies, even if it has millions in assets.

Profit (Profitability)

Profit is the result of revenue (money earned from sales) minus costs (expenses incurred) over a specific period.
Profit is about value: It includes items that aren't cash yet, such as credit sales (money owed to the business by customers).

Why can a profitable business run out of cash?
Imagine a furniture company sells a huge order for $100,000 (meaning high profit). However, they allowed the customer 90 days to pay. They had to pay their suppliers immediately for materials and their workers this month. They have a profit on paper, but zero cash in the bank right now to pay next month's rent! This is a cash flow problem.

1. Cash Flow Forecasts: Meaning and Purpose (5.3.1)

What is a Cash Flow Forecast?

A Cash Flow Forecast is a future-looking document (usually prepared monthly) that estimates the expected cash inflows (receipts) and cash outflows (payments) over a defined time period (e.g., the next 6 months or 1 year).

The Purpose of Forecasting Cash Flows

Forecasting cash flow is essential for effective financial planning and decision-making. Its main purposes include:

• Identify Potential Shortfalls (Deficits): It highlights when the business expects to run out of cash. This warning allows management to arrange for short-term borrowing (like an overdraft) *before* the crisis hits.
• Plan for Surplus: If large cash surpluses are predicted, managers can plan to invest the excess cash to earn interest, rather than leaving it sitting idle in the bank.
• Support Loan Applications: Banks and investors require a forecast to determine if the business can generate enough cash to repay a loan. A well-constructed forecast increases confidence.
• Monitor and Control: The forecast acts as a budget. Actual results can be compared against the predicted amounts to identify why cash movements were different from expectations.
• Manage Working Capital: It helps managers determine how much Working Capital (money needed for day-to-day operations) they need.

2. The Structure of a Simple Cash Flow Forecast

A simple cash flow forecast has three main components: Receipts (Inflows), Payments (Outflows), and Balances.

Cash Inflows (Receipts)

These are all the ways money is expected to come into the business.

• Cash Sales: Money received instantly for goods or services.
• Credit Sales/Trade Receivables: Money collected from customers who bought goods previously on credit.
• Owner’s Capital: Money injected by the owner.
• Bank Loans/Overdrafts: Money borrowed from financial institutions.
• Sale of Assets: Cash received from selling old non-current assets (e.g., old machinery).

Cash Outflows (Payments)

These are all the ways money is expected to leave the business.

• Purchases of Inventory: Paying suppliers for raw materials or stock.
• Wages and Salaries: Paying employees.
• Rent, Utilities, and Administration Costs: Day-to-day running costs.
• Purchases of Non-Current Assets: Buying machinery or vehicles (Capital Expenditure).
• Repaying Loans: Making loan repayments or paying interest.
• Trade Payables: Paying suppliers who previously allowed the business credit.

3. Calculating Opening and Closing Balances (Step-by-Step)

The most important element of the forecast is tracking the cash balances, which tells us exactly how much cash the business expects to have in the bank at the start and end of each month.

1. Calculate Total Cash Inflows (Receipts): Sum up all the expected receipts for the month.
2. Calculate Total Cash Outflows (Payments): Sum up all the expected payments for the month.
3. Calculate Net Cash Flow: This shows the net movement of cash for that specific month. $$ \text{Net Cash Flow} = \text{Total Cash Inflows} - \text{Total Cash Outflows} $$
4. Determine the Opening Balance: This is the cash the business already had in the bank at the start of the month.
   Important: The Opening Balance for the current month is always equal to the Closing Balance of the previous month. (For the first month in the forecast, this is the current bank balance).
5. Calculate the Closing Balance: This is the final cash amount predicted to be in the bank at the end of the month. $$ \text{Closing Balance} = \text{Opening Balance} + \text{Net Cash Flow} $$

4. Methods of Improving Cash Flow (5.3.1)

When a cash flow forecast predicts a deficit (a negative closing balance), managers must take urgent action. These actions generally focus on two strategies: increasing cash inflows or decreasing cash outflows.

A. Boosting Cash Inflows (Get money in faster)

• Reduce Trade Receivables (Debtors): Encourage customers who bought on credit to pay quicker.
  Methods: Offer a discount for early payment (e.g., 2% off if paid within 10 days) or introduce stricter credit control procedures (chasing outstanding debts more aggressively).
• Increase Cash Sales: Focus marketing efforts on promotions that require immediate cash payment, rather than credit sales.
• Sale of Unwanted Assets: Sell off any non-current assets (old vehicles, unused machinery) that are no longer needed to bring in immediate cash.
• Debt Factoring: Sell the trade receivables (invoices) to a specialist finance company (a factor). The factor pays the business immediately (minus a fee/commission) and takes on the risk and responsibility of collecting the debt later. This is fast cash, but costly.

B. Reducing Cash Outflows (Pay money out slower or less often)

• Increase Trade Payables (Creditors): Delay paying suppliers. If a supplier offers 30 days credit, pay on day 30 instead of day 15.
  Warning: This must be managed carefully! Paying too late can damage relationships with suppliers, who might then refuse credit or charge higher prices in the future.
• Reduce Inventory (Stock): Lower the amount of raw materials or finished goods kept in storage. Less inventory means less cash is tied up in stock that isn't being used yet. (This links strongly to Just-in-Time inventory management).
• Delay Capital Expenditure: Postpone large purchases of non-current assets (e.g., waiting six months to buy that new delivery van).
• Leasing Instead of Buying: Rather than using a huge lump sum of cash to purchase an asset, lease it. This spreads the cost out through monthly rental payments.

C. Short-Term Finance

If the cash deficit is inevitable and urgent, the business must seek short-term funding:

• Bank Overdraft: The bank allows the business to temporarily withdraw more money than is currently in the account, up to an agreed limit. This is often the quickest and most flexible short-term solution for managing unexpected deficits.
• Short-Term Loan: A small loan repaid over a short period (usually under a year).

Common Mistake to Avoid

Students often suggest "increasing sales" to fix a cash flow problem. While higher sales *should* lead to more cash, if those sales are all done on credit (and customers take a long time to pay), then increased sales will *worsen* the short-term cash flow crisis because the business needs to pay for the materials and labour right now! The focus must be on increasing *cash receipts* and speeding up payment from customers.

Example of a Simple Cash Flow Forecast Calculation

Let's look at how the balances move across three months for a small café. The business starts January with an Opening Balance of \( \$500 \).

Interpretation:

• In January, the café had a negative Net Cash Flow of \(\$-300\). This meant cash went down. However, because they started with \(\$500\), they ended the month positively with a Closing Balance of \(\$200\).
• This Closing Balance of \(\$200\) automatically becomes the Opening Balance for February.
• In February, they took out a loan, resulting in a large positive Net Cash Flow (\(\$800\)), dramatically increasing their closing balance to \(\$1,000\).

This simple forecast shows that without the loan in February, the business might have needed to dip into an overdraft in January or February had their outflows been slightly higher. It is a vital tool for making proactive decisions.