Survival in business depends on the ability to generate cash. Cash flow information directs attention towards this critical issue. Cash flow is a more comprehensive concept than 'profit' which is dependent on accounting conventions and concepts. The cash budget is an extremely important mechanism for monitoring cash flows. Various complications about timing of cash flows or lack of particular figures may be included in cash budget exam questions.
At the heart of this chapter is the method for
systematically preparing a cash budget. You must be able to set out a budget clearly, supported by appropriate workings.
Section 6 looks at why cash flow problems arise and methods for easing cash shortages.
Section 7 concentrates on float. Float is the time difference between when a payment is first initiated and when the funds become available for use.
1 Cash flows and profit
1.1 Types of cash transaction
Introduction
There are many types of cash transaction. They can be distinguished by their purpose (ie what they are for), their form (how they are implemented), and their frequency.
Sometimes the following distinctions are made. (a) Capital and revenue items
(i) Capital items relate to the long-term functioning of the business, such as raising money from shareholders, or acquiring non-current assets.
(ii) Revenue items relate to day-to-day operations, as in the operating cycle, including other matters such as overdraft interest.
(b) Exceptional and unexceptional items
(i) Exceptional items are unusual. An example would be the costs of closing down part of a business.
(ii) Unexceptional items include everything else. You have to be careful using this distinction, as the phrase 'exceptional item' has a precise meaning in the preparation of a company's financial statements.
(c) Regular and irregular items
(i) Regular items occur at predictable intervals. Such intervals might be frequent such as the payment of wages every week or month, or relatively infrequent, such as the disbursement of interim and final dividends twice a year. A capital item might be the regular repayment of principal and interest on leased property. Annual disbursements are sums of money paid at yearly intervals.
(ii) Irregular items do not occur at regular intervals.
1.2 Cash flows and profit
Trading profits and cash flows are different. A company can make losses but still have a net cash income from trading. A company can also make profits but have a net cash deficit on its trading operations. (a) Cash may be obtained from a transaction which has nothing to do with profit or loss. For example,
an issue of shares or loan stock for cash has no immediate effect on profit but is obviously a source of cash. Similarly, an increase in bank overdraft provides a source of cash for payments, but it is not reported in the income statement.
(b) Cash may be paid for the purchase of non-current assets, but the charge in the income statement is depreciation, which is only a part of an asset's cost.
(c) When a non-current asset is sold there is a profit or loss on sale equal to the difference between the sale proceeds and the 'net book value' of the asset in the statement of financial position at the time it is sold.
(d) Cash flows also differ from trading profits due to changes in the amount of the company's inventories, receivables and payables.
(i) Profit is sales minus the cost of sales.
(iii) Cash received differs from sales because of changes in the amount of receivables. $ Customers owing money at the start of the year X
Sales during the year X
Total money due from customers X
Less customers owing money at the end of the year (X) Cash receipts from customers during the year X
(iv) Cash paid differs from the cost of sales because of changes in the amount of inventories and payables.
$
Closing inventories at the end of the year X
Add cost of sales during the year X
X Less opening inventories at the start of the year (X)
Equals purchases Y
$ Payments owing to suppliers at the start of the year X
Add purchases Y
X Less payments still owing to suppliers at the end of the year (X) Equals cash payments to suppliers during the year X (v) Operational cash flow therefore differs from profit because of changes in the amount of
receivables, inventories and payables between the start and end of a period.
Learning outcome E1(c)
Assume that Beta achieved sales revenue in a particular year of $200,000 and the cost of sales was $170,000. Inventories were $12,000, payables $11,000 and receivables $15,000 at the start of the year. At the end of the year, inventories were $21,000, payables were $14,000 and receivables $24,000.
Required
Calculate the profits and the operational cash flow resulting from the year's trading.
The difference between profit and cash flow has important implications.
(a) If a company is profitable but short of cash, one reason could be an increase in the other elements of working capital. Instead of seeking credit from a bank to finance the growth in working capital, management may consider whether operational cash flows could be improved by squeezing working capital, and:
(i) Reducing receivables (ii) Reducing inventories
(iii) Taking more trade credit from suppliers
Better control over working capital could remove the need to borrow.
(b) If a company is making losses, it could try to maintain a positive operational cash flow by taking more credit (ie by increasing its payables and so reducing working capital). (Supplier companies would then consider whether to give the extra credit required, or whether to refuse because the risk would be too great.)
Learning outcome E1(c)
Write brief notes on why the reported profit figure of a business for a period does not normally represent the amount of cash generated in that period.
1.3 Benefits of holding cash
(a) Transactions motive. Cash is needed for every-day expenses such as wages and payments to suppliers.
(b) Precautionary motive. This is cash held ‘just in case’ to cover unexpected expenditure. (c) Investment motive. This is cash held to take advantage of any unforeseen profit-making
opportunities.
Obviously when a business is holding cash, it is not getting as high returns as it might if it invested the cash instead.
Section summary
Trading profits and cash flows are different. A company can make losses but still have a net cash income from trading. A company can also make profits but have a net cash deficit on its trading operations.
2 The purpose of cash forecasts
Introduction
Cash forecasting ensures that sufficient funds will be available when they are needed to sustain the activities of an enterprise. Efficient financial planning also minimises interest payments and maximises the return from any spare cash. Interest rates will differ according to whether money is being lent to, or borrowed from, the bank. The time value of money is another important factor. The bank will charge a higher rate of interest on a long-term loan than on a short term loan and will pay a higher rate of interest on an account subject to a longer notice of withdrawal than on an account that requires only 24 hours notice.
All of these factors must be considered when forecasting cash requirements.
Banks have increasingly insisted that customers provide cash forecasts (or a business plan that includes a cash forecast) as a precondition of lending. A newly established company wishing to open a bank account will also normally be asked to supply a business plan. The cash and sales forecasts will also allow the bank to monitor the progress of the new company, and control its lending more effectively.
2.1 Deficiencies
Any forecast deficiency of cash will have to be funded.
(a) If borrowing arrangements are not already secured, a source of funds will have to be found. If a company cannot fund its cash deficits it could be wound up.
(b) The firm can make arrangements to sell any short-term financial investments to raise cash.
(c) The firm can delay payments to suppliers, or pull in payments from customers. This is sometimes known as leading and lagging.
Because cash forecasts cannot be entirely accurate, companies should have contingency funding, available from a surplus cash balance and liquid investments, or from a bank facility.
Forecasting gives management time to arrange its funding. Planning in advance, instead of a panic measure to avert a cash crisis, gives a business more choice on when to borrow, and will probably mean obtaining a lower interest rate.
2.2 Forecasting a cash surplus
If a cash surplus is forecast, having an idea of both its size and how long it will exist could help decide how best to invest it.
In some cases, the amount of interest earned from surplus cash could be significant for the company's earnings. The company might then need a forecast of its interest earnings in order to indicate its prospective earnings per share to stock market analysts and institutional investors.
2.3 Types of forecast
A CASH BUDGET is a detailed budget of estimated cash inflows and outflows, incorporating both revenue
and capital items. (CIMA Official Terminology)
In companies that use cash flow reporting for control purposes, there will probably be: • A cash budget divided into monthly or quarterly periods
• A statement comparing actual cash flows against the monthly or quarterly budget • A revised cash forecast
• A statement comparing actual cash flows against a revised forecast
Revised forecasts should be prepared to keep forecasts relevant and up-to-date. Examples would be a revised three-month forecast every month for the next three-month period, or a revised forecast each month or each quarter up to the end of the annual budget period.
A rolling forecast is a forecast that is continually updated. When actual results are reported for a given time period (say for one month's results within an annual forecast period) a further forecast period is added and forecasts for intermediate time periods are updated. A rolling forecast can therefore be a 12- month forecast which is updated at the end of every month, with a further month added to the end of the forecast period and with figures for the intervening 11 months revised if necessary.