Chapter 23: Cash Flow Forecasting and Working Capital

Why Cash Is Important to a Business?

Cash is a liquid asset, meaning it is immediately available for spending on

goods and services.

If a business has too little cash or runs out completely, it can face major
problems such as:

 Inability to pay workers, suppliers, or the landlord

 Production halts: workers won't work without pay, and suppliers will
stop supplying goods.

 Liquidation: the business may be forced to sell assets to pay debts.

What Is Meant by Cash Flows?

 Cash Inflows: These are ways cash can enter a business.

o Sale of products for cash

o Payments from debtors (customers who owe money)

o Borrowing from external sources

o Sale of assets (e.g., unwanted property)

o Investment from shareholders

 Cash Outflows: These are ways cash can leave a business.

o Purchasing goods/materials for cash

o Paying wages and other expenses

o Purchasing non-current assets

o Repaying loans

o Paying creditors (suppliers)

Example: Cash Inflows or Outflows?

Cash Cash
Transaction
Inflow Outflow

Purchase of new computer for ✓

 Cash Cash
Transaction
Inflow Outflow

cash

Sale of goods to customers (no

✓
credit)

Interest paid on bank loan ✓

Wages paid to employees ✓

Debtors pay their bills ✓

Additional shares sold to

✓
shareholders

Creditors/suppliers paid ✓

Bank overdraft paid off ✓

The Cash Flow Cycle

The cash flow cycle shows the link between inflows and outflows and
explains why cash paid out isn't returned immediately to the business.

1. Cash needed to pay for materials and production costs.

2. Time required to produce goods.

3. Sales to customers (often on credit).

4. Customers pay cash for goods.

5. Cash used again to pay for more materials, and the cycle continues.

What Cash Flow Is Not!

Cash flow is not the same as profit.

Example:

 Gross profit: Revenue – Cost of Goods Sold

 Cash flow: Cash inflows – Cash outflows

Even if a business is profitable, it can run out of cash due to factors such
as:

 Giving customers too long a credit period

  Purchasing too many assets too quickly (overtrading)

 Expanding too fast and holding too much inventory

Importance of Cash Flow Forecasts

A cash flow forecast helps businesses:

 Understand how much cash will be available to pay bills, repay

loans, and buy assets.

 Determine whether they need additional loans to avoid insolvency.

 Ensure that cash is used efficiently, rather than sitting idle.

Uses of Cash Flow Forecasts

 Starting a Business: Helps estimate how much cash will be needed

in the early months when expenses are high.

 Running an Existing Business: Useful for managing cash flow,

especially in situations like a sudden drop in sales or the purchase of
expensive assets.

 Keeping the Bank Manager Informed: Banks require cash flow

forecasts to assess lending risk and determine loan terms.

Managing an Existing Business

Businesses can run into cash flow problems if:

 A business has to borrow money unexpectedly.

 Non-current (fixed) assets are bought all at once.

 Sales drop suddenly.

Proper planning allows businesses to manage cash flow and avoid high
interest rates or overdraft issues with banks.

How a Short-Term Cash Flow Problem Might Be Overcome

A short-term cash flow issue can be managed using several methods.

Below is a breakdown of how these methods work, along with their
limitations:
Method How it Works Limitations

Bank loans provide an Interest payments reduce

Increasing Bank
immediate cash injection profits. Loans must be repaid,
Loans
to the business. creating future cash outflows.

Suppliers might refuse to

Delaying Reduces short-term cash
continue supplying goods or
Payments to outflows by postponing
services, or offer fewer
Suppliers payments.
discounts.

Increases short-term cash

Customers may go elsewhere
Asking Debtors inflows by speeding up
for goods/services with more
to Pay Quickly payments from
favorable credit terms.
customers.

Delaying Capital Reduces short-term Can reduce the business's

Equipment outflows by postponing efficiency in the long term,
Purchases purchases of equipment. possibly affecting productivity.

In the Long Term: For sustainable solutions to cash flow issues, businesses
may need to:

 Attract new investors (e.g., by issuing more shares), but this could
affect ownership and control.

 Cut costs and increase efficiency, though this might lead to

employee dissatisfaction or reduced product quality.

 Develop new products to attract more customers, but this requires

time and upfront cash for research and development.

The Concept and Importance of Working Capital

Working capital refers to the cash and assets that a business can readily
convert into cash to meet short-term obligations. It's calculated as:

Working capital = Current assets – Current liabilities

The importance of working capital lies in its ability to help a business meet
daily operational expenses, take advantage of discounts, and avoid
insolvency. Effective working capital management ensures a business can
pay for materials, wages, and other necessary costs without needing to
take on excessive debt.

 Cash: Helps pay day-to-day costs and purchase inventory.

  Debtors: Relates to sales made on credit; a higher sales volume may
require more credit.

 Inventories: Adequate stock levels are important, but excessive

stock can result in opportunity costs.

International Business Focus: Kodak vs. Kier Group

1. Technological Change for Kodak: The rise of digital photography

impacted Kodak's cash flow by reducing demand for traditional film.
Kodak responded by diversifying its product range and obtaining
loans, which increased cash inflows from new markets.

2. Ending of the Property Boom for Kier Group: The decline in the
property market meant Kier had to wait longer for payments from
customers. To manage cash flow, Kier minimized cash outflows by
holding minimal inventory and relying on just-in-time deliveries.

Both businesses tackled their cash flow problems with different

approaches suited to their industries: Kodak diversified its product
offerings, while Kier optimized its operations to reduce cash tied up in
inventory.

HOMEWROK: Exam-style questions: Short answer and data

response

1. Bruno manages a hotel. Most of the hotel bedrooms are occupied

during the main tourist season, which lasts for seven months. The hotel’s
main cash outflows are the same each month but food costs and some
employee costs increase when there are more tourists. Bruno plans to
have the hotel redecorated but he does not know whether the cost of this
will mean the hotel exceeds its overdraft limit. The hotel’s bank account is
overdrawn for several months of each year.

a. Define ‘cash outflows’.[2]

b. Identify two likely cash outflows for Bruno’s hotel.[2]

c. Outline two effects on Bruno’s hotel if he offers hotel guests credit of

one month following a stay in the hotel.[4]

d. Explain two likely benefits to Bruno of producing a cash flow forecast.[6]

e. Explain the advantages and disadvantages of any two ways in which

Bruno could improve the cash flow position of the hotel. Which way would
you advise him to use? Justify your answer.[6]
2. Abbas Manufacturing produces wheels for cars. It holds high inventory
levels so that one-off orders from major car manufacturers can be
satisfied quickly. The world’s big car manufacturers demand long credit
periods from their suppliers of three months. Abbas Manufacturing has
prepared the following cash flow forecast for the next three months:

a. Define ‘net cash flow’.[2]

b. Identify two reasons why Abbas Manufacturing needs high amounts of

cash or working capital.[2]

c. Calculate the values for x and y in the cash flow forecast. Show your
working.[4]

d. Amend the cash flow forecast for July assuming cash from debtors and
material costs are going to be 10 per cent higher than originally forecast.
Show your working.[6]

e. Using the cash flow forecast above, suggest two ways Abbas
Manufacturing can reduce its bank overdraft (negative closing balance).
Recommend the best one to choose. Justify your advice.[6]

Definitions to learn

 The cash flow of a business is the cash inflows and outflows over a
period of time.

 Cash inflows are the sums of money received by a business during a

period of time.

 Cash outflows are the sums of money paid out by a business during
a period of time.

 A cash flow cycle shows the stages between paying out cash for
labour, materials, and so on, and receiving cash from the sale of
goods.

 Profit is the surplus after total costs have been subtracted from
revenue.

 A cash flow forecast is an estimate of future cash inflows and

outflows of a business, usually on a month-by-month basis. This
then shows the expected cash balance at the end of each month.

 Net cash flow is the difference, each month, between inflows and
outflows.
 Closing cash (or bank) balance is the amount of cash held by the
business at the end of each month. This becomes next month’s
opening cash balance.

 Opening cash (or bank) balance is the amount of cash held by the
business at the start of the month.

 Working capital is the capital available to a business in the short

term to pay for day-to-day expenses.