CASH FLOW

Cash is often described as the lifeblood of a business because every organization needs
cash to keep functioning. Cash is needed to pay for daily costs such as wages and
electricity. Failure to pay suppliers and trade creditors may eventually result in a business
being declared bankrupt. Cash is a current asset. It is the money that a business actually
receives from the sale of goods and services. It can be either held 'in hand' (actual cash in
the business) or 'at bank' (cash held in a bank account).

Profit in its simplest form is the positive difference between a firm's total sales revenue and
its total costs of production for a given time period.

Profit = Total revenue - Total cost

Profit is not the same as cash.

Working capital (sometimes referred to as net current assets or circulating capital) refers to
cash or other liquid assets available to an organization for its daily operations. Working capital is
essential to pay for raw materials, utility bills, and staff wages and salaries.

Working capital = Current assets – Current liabilities

Current assets are the short-term assets (belongings) of an organization that can be relatively
easy to convert into cash. Typical examples include:
●​ Cash
●​ stocks (inventory)
●​ debtors

Current liabilities are the short-term debts of a business, which need to be repaid within twelve
months of the balance sheet date.
Typical examples include:
●​ bank overdrafts
●​ trade creditors
●​ short-term loans from financiers.

Luxury goods stores have a longer working capital chain.

Liquidity means the extent to which an organization is able to convert its assets (items of
monetary value owned by the business) into cash. Liquid assets are those that can be converted
into cash quickly and without negatively impacting its market value. Examples of liquid assets
include:

●​ Cash (including deposits at a commercial bank)

●​ Debtors
●​ Stock (inventory).

By contrast, illiquid assets are items of monetary value owned by a business that cannot be
converted into cash as easily or quickly. Examples of illiquid assets include:
 ●​ Property
●​ Plant (production facilities)
●​ Equipment.

The liquidity position of an organization indicates the extent to which it 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. A
business in a poor liquidity position may struggle to cover its current liabilities. If the business is
not able to improve its liquidity position, this can eventually lead to bankruptcy.

The liquidity position of a business is important as it shows its ability to repay short-term liabilities
without having to rely on external sources of finance, which could dilute ownership and control
and/or incur debt interest payments. The main method of measuring a firm's liquidity position is
liquidity ratio analysis.​

cash flow forecast is a financial tool used to show the expected movement of cash into and out of
a business, for a given period of time. It is based on three key elements.

Cash inflows are simply the money going into a business from earnings and other sources of
finance. Examples of cash inflows include:

●​ Bank loans
●​ Bank overdrafts
●​ Business angels
●​ Capital injections from the owners of the business
●​ Cash injection from sponsor
●​ Cash payments from customers
●​ Interest received on savings in a business bank account
●​ Crowdfunding sources
●​ Government grants and/or subsidies
●​ Payments made to the business from its debtors
●​ Tax refunds from the government

Cash outflows are simply the money going out of a business to pay for its spending. Examples
of cash outflows include payments for:

●​ Advertising costs
●​ Cost of sales
●​ Delivery charges
●​ Financial perks (benefits)
●​ Heating and lighting costs
●​ Insurance premiums
●​ Packaging costs
●​ Purchasing of stock (inventory)
●​ Rent of buildings and premises
 ●​ Staff wages and salaries
●​ Telecommunications, including Internet charges
●​ Utility bills, e.g. gas, water, electricity, and telephone

Net cash flow (NCF) is the numerical difference between an organization’s total cash inflows
and its total cash outflows, per time period.

Net Cash Flow = Cash inflows – Cash outflows

Reasons for cash flow forecasts :

●​ Banks and other lenders require a cash flow forecast to help ~ them assess the financial
health of the business seeking iI external sources of finance (see Chapter 15).
●​ They can help managers to anticipate and identify periods of potential liquidity problems,
i.e. times of cash deficiency. Managers can then plan accordingly, perhaps by arranging
bank overdrafts or adjusting the timing of cash inflows and cash outflows to avoid liquidity
problems.
●​ They facilitate business planning. Good financial control is not only socially responsible
but can help a business to better achieve its organizational objectives (see Chapter 3).
Forecasts can be compared with actual cash flows in order to improve future predictions
(cash flow forecasts) and planning.

Constructing cash flow forecasts

Consider the following numerical example which shows a • simplified six-month cash flow
forecast for Rachel Proffitt Trading Co. Assume that the firm receives $4,000 of rental income in
November. It is common to show negative numbers in a cash flow forecast by using brackets. In
addition to the three key components in a cash flow forecast outlined above, there are two other
important parts:

The opening balance is the amount of cash at the beginning of a trading period. Notice that the
opening balance is the same value as the preceding month's closing balance. For example, at
the close of business on 31st July, the cash balance was $3,000 so it is logical that the opening
balance on 1st August is the same value, i.e. $3,000.

The closing balance is the amount of cash at the end of a trading period. It is calculated by using
the formula: Closing balance = Opening balance + Net cash flow. For example, although the net
cash flow (the difference between cash inflows and cash outflows) is negative $2,000 in July, the
closing balance is positive $3,000 due to the opening balance of $5,000 in July.
Investment expenditure helps the business to produce and supply goods or services that
generate future cash flows and generate profits for the business. An example of the relationship
between investment, profit and cash flow is when a business purchases an asset (investment) it
experiences a fall in its cash flow position, although this can improve its profits in the future. The
opposite happens when a business sells an asset (divestment), which improves its cash flow
position but usually happens due to falling profits.

deal worth 32 times larger than Skype's operating profits at the time. However, the software giant
simply relied on its strong cash flow position from its broad product portfolio of over 100 other
companies it had already acquired. Another cash-rich company is Facebook (Meta), which
bought Instagram for $1 billion in 2012, Oculus for $2 billion in 2018 and WhatsApp for a
staggering $19.3 billion in 2014.

Good cash flow management is vital for investment opportunities because poor cash flow results
in missed opportunities for capital expenditure that can help the business to be more competitive
and profitable in the future. The pharmaceutical industry is an example - it can quite easily take
around 17 years to commercialize a drug to the mass market. Effective cash flow management
and product portfolio management (see Chapter 27) are therefore necessary prerequisites before
a business can turn an investment into profit for its owners.
Examples of causes of cash flow problems include:

●​ 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.
Possible strategies to reduce cash outflows include:

●​ 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.

Possible strategies to increase cash inflows include:

●​ Raising prices of the products the business sells that have few substitutes or a high
degree of brand loyalty. Loyal customers are not overly sensitive to higher prices, so this
earns a greater profit margin for the business.
●​ 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. However, some customers may be
unhappy about having to pay earlier, so may seek alternative providers that offer better
credit terms.
●​ 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.
●​ Use a debt factoring service to chase up outstanding debtors.

Possible strategies to seek additional sources of finance include:

●​ Businesses will often rely on bank overdrafts or bank loans as additional finance when
faced with a liquidity problem. These external sources of finance can help the business
during times of negative net cash flow, or when it experiences a negative closing
balance. However, external finance incurs interest repayments, which can harm cash
outflows.
●​ Secure finance from sponsorships, donations or financial gifts. This can help to boost
cash inflows, thereby improving the cash flow position. However, these sources of
finance are not easily accessible to most businesses.
●​ 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. For example, the business could sell off its underused or out-dated assets. In
June 2020, British Airways decided to sell some of its multi-million-dollar art collection
in order to raise cash to help it get through the crisis caused by the coronavirus
pandemic.
Investment appraisal

Investment refers to the purchase of an asset with the potential to yield future financial
benefits.
Investment appraisal is the general term referring to the quantitative techniques used to
calculate the financial costs and benefits (i.e. the potential net gains) of an investment
decision.
The three main methods of investment appraisal are:
●​ the payback period
●​ the average rate of return and
●​ the net present value (HL only).
The actual method or methods used will depend on the circumstances facing the
business.

The payback period (PBP) refers to the amount of time needed for an investment project
to earn enough profits to repay the initial cost of the investment. The formula for
calculating the PBP is:
The average rate of return (ARR) calculates the average profit on an investment project
expressed as a percentage of the amount invested. The formula for calculating the ARR is:
●​ The main advantage of the ARR method of investment appraisal is that it enables
easy comparisons (in percentage terms) of the estimated returns on different
investment projects. For example, if two projects are predicted to yield the same
ARR, then the relatively cheaper project might be more desirable given that it carries
less financial risk.
●​ However, a weakness of the ARR method is that it ignores the timings of the net
cash flows and hence is prone to forecasting errors when considering seasonal
factors (see Chapter 25).
●​ In addition, the project's useful life span (which might be a pure guess) is needed
before any meaningful calculations can be made. Finally, as with all time-based
forecasts, errors are more likely the longer the time period under consideration; we
might know what is likely to happen tomorrow, but we are less sure about the events
 in five years from now. No single business back in 2019 could have predicted the
devastating impacts of a global pandemic, for example.
Net present value.
Suppose you had the option of receiving a university scholarship to the value of $30,000 in
either one lump sum today or over a 4-year period. Which would you opt for? Most people
would go for the first option rather than the deferred payment option. The reason is linked to
the saying 'time is money'. Money received today can be invested or simply saved in a bank
to earn compound interest, whereas money received in the future will have lost some of its
value. For example, if you have $100 and decide to place it into a bank account paying 5%
interest, at the end of the year you will have $105. Therefore, $105 received in a year's time
is worth the same as $100 received today. If this was saved for a further year, then the
present value of $100 received in two years' time would be $110.25 (i.e. $105 plus another
5% interest).

Discounting is the reverse of calculating compound interest. A • discount factor is used to

convert the future net cash flow to its present value today. Given that receiving money today
is worth more than it is in the future, the discount factor can represent inflation and/ or
interest rates. Inflation refers to a rise in the general price level over time. In other words,
higher prices in the future will reduce the real value of money received in the future.

As an example, suppose a business expects to receive $100,000 in three years' time whilst
today's interest rate is 5%. What is the present value of the $100,000? From Table 21.2, we
can see that the discount factor for 5% interest over 3 years is 0.8638. Hence, the present
value of the $100,000 received in 3 years' time is $100,000 x 0.8638 = $86,380. This is the
equivalent of receiving $86,380 today and leaving it in the bank to earn compound interest of
5% for 3 years, which would equate to $100,000 received at the end of Year 3.
 The net present value (NPV) is the sum of
all discounted cash flows minus the cost of
the investment project. Money received in
the future is worth less than if it were
received today, so the longer the time
period of the project under consideration,
the lower the present value of that future
amount of money.
The NPV is calculated by using the formula:
NPV = Sum of present values - Cost of
investment.
The original amount invested is often
referred to as the principal or capital outlay.
The NPV will be positive (greater than the
principal) if the value of the discounted
(future) net cash flows are enough to justify
the initial cost of the investment. If the NPV
is negative, then the investment project is
not worth pursuing on financial grounds. In
the following Worked example 21.3, as the
NPV has a positive value of $132,940, the
investment project should go ahead.
However, the business must take care not
to over-rely on the NPV method, as the
value would be reduced if interest rates
were to go up during the next five years.
Other limitations are that NPV calculations
can be complex and that results are only
comparable if the initial investment cost is
the same between competing projects

In summary, when assessing the value of investment projects, it is important to consider how
the value of money changes over time. Cash received in the future is not of the same value
as if it were received today because the money could have been invested to generate
financial returns. Inflation also reduces the value of money in the future. So, it is important to
calculate the present value of money in order to distinguish between the yields of
investments received over different time periods. American poet and philosopher Ralph
Waldo Emerson (1803 1882) made this point in his quote that "Money often costs too much”
BUDGETING
A budget is a financial plan for expected revenue and expenditure for an organisation or a department
within an organisation, for a given period of time. It is an essential part of the way an organisation is
coordinated or managed. Budgets can be stated in terms of financial targets such as planned sales
revenues, costs, cash flow or profits. Good budgets should set challenging and realistic targets.
Budget variance will also be covered in this topic.​

What is a cost centre? A cost centre is a reporting unit of a business that is responsible for costs
incurred.
What is a profit centre? A profit centre is a reporting unit of a business that is responsible for profits
generated.
It is unlikely that there will be a cost centre or a profit centre in a centralised company; since the
company’s control is from a small team at the top. However, in a decentralised company, such as a
chain of retail stores or restaurants, where the power and the responsibility are shared, cost and profit
centres proliferate.

Does a cost centre incur costs? The simple answer is “yes”. But cost centres incur costs to enable
the profit centres to generate profits.

For example, if the marketing department is a cost centre because the company invests heavily in
marketing, and the marketing function enables the sales division to generate profits. Thus, even if the
marketing department incurs costs and does not generate direct profits, it enables the sales division to
create direct profits for the company.

Profit centres have few specific functions:

●​ Generate profits directly: Profit centres help generate direct profits from their activities. For
example, the sales department directly sells products to customers to create profits.
●​ Compute returns on investments: Since the profits centre is responsible for revenues and
costs, calculating returns on investments becomes easy in profit centres.
●​ Help in effective decision making: Since the activities of profit centres are directly
generating revenues and profits, it is easier to make effective decisions. The activities that
generate the most revenues and profits should be increased, and activities that increase the
cost but do not generate profit should be reduced.
●​ Help in budgetary control: Since the profit centre is evaluated based on deducting actual
costs from budgeted costs, profit centers offer more budgetary control. When the actual costs
are compared with the budgeted expenses, profit centres can understand the difference and
apply the lessons in the next set of requirements.
●​ Provides extrinsic motivation: Since the team of the profit centre directly controls the
outcomes (or revenues and profits), their performance is rewarded, which offers them
extrinsic motivation to work harder and generate more profits.

Budgeting
A budget is a detailed, financial plan for a future time period.

Why a budget is important?

If no financial plans are made, an organisation drifts without real direction or purpose. Managers will
not be able to allocate the scarce resources of the business effectively without a plan to work towards.
Employees working in an organisation without plans for future action are likely to feel demotivated, as
they have no targets to work towards - and no objectives to be praised for achieving.

If no targets are set, then an organisation cannot review its progress because it has no set objective
against which actual performance can be compared.

Key terms:

●​ Budget: A detailed financial plan for the future.

●​ Budget holder: Individual responsible for the initial setting and achieving of the budget.
●​ Delegated budgets: Control over budgets is given to less senior management.

Purposes of setting budgets and financial planning

●​ Planning – the budgetary process makes managers consider future plans carefully so that
realistic targets can be set
●​ Effective allocation of resources – budgets can be an effective way of making sure that the
business does not spend more on resources than it has access to
●​ Setting targets to be achieved – most people work better if they have a realisable target at
which to aim
●​ Coordination – different people from different departments will have to work effectively
together to achieve targets
●​ Monitoring and controlling – plans cannot be ignored once in place
●​ Modifying – if evidence suggests an objective cannot be reached and the budget is
unrealistic, then either the plan or the way of working towards it must change
●​ Assessing performance – once the budget period has ended, variance analysis will be used
to compare actual performance with the original budgets

Potential limitations of budgeting

●​ Lack of flexibility. If budgets are set with no flexibility built into them, then sudden and
unexpected changes in the external environment can make them very unrealistic.
●​ Focused on the short-term. Budgets are usually set for the relatively short-term (e.g. the
next 12 months). Managers may be tempted to take short-term decisions to stay within the
budget, may not be in the best long-term interest of the firm (e.g. cutting back on R&D
spending).
●​ Result in unnecessary spending. Typically, if budgets for the year are not spent, the budget
for the following year may well be cut. This provides a perverse incentive for managers to
engage in inefficient spending to ensure continued funding.
 ●​ Training needs must be met. Setting and keeping to budgets is not easy and all managers
with delegated budget responsibilities need extensive training in this role.
●​ Setting budgets for new projects. Setting realistic budgets may be difficult and frequent
budget revisions may be necessary when major, new projects are undertaken (e.g., financing
a new school gymnasium).

Budgetary control is the use of corrective measures taken to ensure that actual outcomes equal the
budgeted outcomes by systematic monitoring of budgets and investigating the reasons for any
variances. A variance exists if there is a difference between the budgeted figure and the actual
outcome. Budgetary control requires managers to investigate the cause(s) of any variance.

Variance= Actual outcome - Budgeted outcome

Budgetary control – variance analysis Importance of variance analysis

Variance analysis: The process of
●​ It measures differences from the
investigating any differences between
the planned performance of each
budgeted figures and actual figures.
department both month by month and

Adverse variance: Exists when the at the end of the year.

difference between the budgeted and actual ●​ It assists in analysing the causes of

figure leads to a lower than expected profit. deviations from budget.

●​ An understanding of the the reasons
Favourable variance: Exists when the
for variations form the original
difference between the budgeted and actual
planned levels can be used to
figure leads to a higher than expected profit.
change future budgets in order to
make them more accurate.
●​ The performance of each
individual budget-holding section
may be appraised in an accurate
and objective way.