The importance of cash flow
Profits do not pay for the running of a business, but cash does. Profits is of course important in the long run, but initially, cash is need to run the business successfully
Cash flow: the sum of cash payments to a business (inflows) minus the sum of
cash payments (outflows)
Liquidation: when a firm ceases trading and its assets are sold for cash to pay
suppliers and other trade creditors.
Insolvent: when a business cannot meet its short term debts
Cash flow planning is vital for new entrepreneurs because:
- New business start-ups are often offered much less time to pay suppliers than larger, well established firms, they are given a shorter credit period - Banks and other lenders may not believe the promises of a new
businesses owner, as they have no trading record
- Finance is often very tight at start-up, so not planning accurately is of even more significance for a business.
Cash inflows: payments in cash received by a business such as those from
customers (debtors) or from the bank, here are some examples:
- Customers cash purchases- these will be difficult to forecast as they depend on sales, so a sales forecast will be necessary
- Debtors’ payments- these are difficult to forecast as these depend on two unknowns. Firstly what is the likely level of sales credit and secondly when will the debtors actually pay
Cash outflows: payments in cash made by a business, such as those to
suppliers and workers, here are some examples:
- Bank loan payments- this will be easy to forecast as this is under direct control.
- Lease for premises- easy to forecast as this will be in the details of property.
How to forecast cash flow?
Forecasting cash means trying to estimate future cash inflows and outflows, usually on a monthly basis. Businesses have to plan this so that they always have a certain amount of money in the business at a certain time, because if not, the business will have no “working capital”
Debtor: customers who have bought products on credit and will pay at am
agreed date in the future.
The structure of cash-flow forecasting
All cash flow forecasts have three basic sections:
Cash inflows: this section records the cash payments into the business,
including cash sale, payments for credit sales and capital inflows.
Cash outflows: this section records the cash payments by the business
including wages and materials
Net monthly cash flow and opening and closing balance: this shows the
net cash flow for the period and the cash balances as the start and end of the period.
Uses of financial planning
- By showing periods of negative cash flow, plans can be put in place to provide additional finance
- If negative cash flow appears to be too great, then plans can be made for reducing theses.
- A new business proposal will never progress beyond the initial planning stage unless investors and bankers have access to cash-flow forecast and the assumptions that lie behind it.
Limitations of financial planning
- Mistakes can be made in preparing the revenue and cost forecast or they may be drawn up by inexperienced entrepreneurs or staff
- Unexpected cost increases may lead to major inaccuracies in forecasts. - Wrong assumptions can be made in estimating the sales of the business,
perhaps based on poor market research.
Causes of cash flow problems
- Lack of planning: cash flow forecasts help greatly in predicting future
to predict potential cash-flow problems so that business managers can take action to overcome them.
- Poor credit control: the credit control department of business keeps a
check on all customers’ accounts, who’s paid and who hasn’t. 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.
- Allowing customers too long to pay debts: in many trading situations
business will have to offer trade credit to customers in order to be
competitive; however allowing customers too long to pay means reducing short term cash inflows, which could lead to cash-flow problems.
- Expanding too quickly: when a business expands rapidly, it has to pay
for the expansion for increased wages and material months before it receives cash from additional sales. This overtrading can lead to serious cash-flow shortages.
- Unexpected events: a cash flow forecast can never be guaranteed to be
100% accurate. Unforeseen increase in costs.
Way to improve cash flow
Managing working capital
Ways to increase cash inflows and their possible drawbacks
Method How it works Possible drawbacks
Overdraft Flexible loans on which the business can draw as necessary up to an
agreed limit
- Interest rates can be high
- Overdrafts can be withdrawn by the bank and often
cause insolvency Short term loan A fixed amount can be
borrowed
- The interests costs have to be paid - The loan must be
repaid by the date Sale of assets Cash receipts can be
obtained from selling off redundant assets
- Selling assets quickly can result in a low price - The assets could
have been used as collateral for future loans
Sale and leaseback Assets can be sold to finance the company
- The leasing costs add to annual overheads
- The assets could have been used as collateral for future loans
Debt factoring Debt factoring companies can buy the customer’s bill from a business and offer immediate cash.
- Only about 90-95% of the debt will now be paid by the debt factoring company
Ways to reduce cash outflows and their possible drawbacks
Method How it works Possible drawbacks Delay payments to
suppliers
Cash outflows will fall in the short term if bills aren’t paid
- Suppliers may reduce any discount offered with the purchase - Suppliers can either demand cash on delivery or refuse to
supply at all Delay on spending
capital
By not buying
equipment, etc. cash will not have to be paid to suppliers - The efficiency of the business may fall if outdate - Expansion becomes very difficult Cut overhead
spending that does not directly affect output
These costs will not reduce production capacity and cash payments - Future demand may be reduced by failing to promote the products effectively
Chapter 28- Costs
Introductions – Who needs cost data?Management decisions can cover a wide range of issues and they require much information before effective strategies can be adopted. These business decisions include location of the operations, which method of production to use, which products to continue to make and whether to buy in components or make them within the business. Major uses of cost data include:
- Profit and loss cannot be calculated without accurate cost data. Location might be based on profits and losses.
- Marketing needs accurate cost data in order to inform their pricing decisions. - Costs records might also help to make comparisons with the past.
- Past costs data can help for future budgets and pricing. - Resource use might be based on costs.
- Business performance is influenced by the cost as the manager decides what is best for the business.
Calculating costs for each product is complex; therefore there are many different classifications. It is important to comprehend cost classification. The most
important ones are: - Direct costs - Indirect costs - Fixed costs - Variable costs - Marginal costs Direct costs
Cost of the meat in a hamburger.
Cost of mechanic in a garage.
Salary of a teacher in a school.
The most common costs in manufacturing are the costs of materials and labour. Indirect costs
Cost of tractor in a farm
Promotional expenditure in a supermarket
Rent to the garage
The cost of cleaning a school
How are costs affected by the level of output?
Not all costs will vary directly in line with production increases and decreases. Costs may be classified by:
Fixed costs: Costs that do not vary with the output in the short run.
Variable costs: Costs that vary with output, for example, materials used in making a washing machine or the electricity used to cook a fast-food meal. Marginal costs: The extra cost of producing one more unit of output.
Problems in classifying costs
For example; Labour costs: These will be variable or fixed costs depending on the employment contract made. For example, if the worker of a company that makes the machines, is made hourly, that will be a variable costs as it fully depends on
the worker his wage, and the wage given to him, but on the other side, a TV presenter will be given a salary that will be a fixed cost, even though he works more that he needs to.
Break-even analysis
Break-even point of production: the level of output at which total cost equal total revenue – neither a profit nor a loss is made.
Break-even analysis can be undertaken in two ways: Graphical method
• Equation method •
The graphical method – the break-even chart. Usually drawn using three pieces of information:
Fixed costs: will not vary in a short term the level of output which must be paid whether the firm produces anything or not.j
Total costs: addition of a fixed and variable costs; variable cost vary in proportional to the output
Sales revenue: obtained by multiplying selling price by output level.
Fixed-cost line is horizontal, showing cost are constant in all output levels. Sales revenue starts at the origin (0), no sales made = no revenue.
Variable-cost line starts at the origin (0), no good produced = no variable cost. (not necessary to interpret the chart, often omitted)
Total cost-line starts at the level of fixed costs, difference between are total and fixed cost being accounted for by variable costs.
Margin of Safety
Margin of safety – the amount by which the sales level exceeds the break-even level of output.
This is a useful indication of how much sales could fall without the firm falling into loss.
The break-even equation
BREAK-EVEN LEVEL OF OUTPUT = FIXED COSTS
CONTRIBUTION PER UNIT
Break-even analysis – further uses
Charts can be redrawn showing potential new situation and this can then be compared with the existing position of the business. Care must be taken in making these comparisons, as forecasts and predictions are usually necessary. Examples of further uses of the break-even technique:
1. A marketing decision – the impact of a price increase
2. An operations-management decision – the purchase of new equipment with lower variable costs.
3. Choosing between two locations for a new factory.
The usefulness of break-even analysis can be summarised as follows: Charts are relatively easy to construct and interpret
Analysis provides useful guidelines to management on break-even points, safety margins and profit/loss levels at different rates of output
Comparisons can be made between different options by constructing new charts to show
Break-even point of production: the level of output at which total cost equal total revenue – neither a profit nor a loss is made.
Break-even analysis can be undertaken in two ways: Graphical method
Equation method
The graphical method – the break-even chart. Usually drawn using three pieces of information:
Fixed costs: will not vary in a short term the level of output which must be paid whether the firm produces anything or not.
Total costs: addition of a fixed and variable costs; variable cost vary in proportional to the output
Sales revenue: obtained by multiplying selling price by output level.
Fixed-cost line is horizontal, showing cost are constant in all output levels. Sales revenue starts at the origin (0), no sales made = no revenue.
Variable-cost line starts at the origin (0), no good produced = no variable cost. (not
necessary to interpret the chart, often omitted)
Total cost-line starts at the level of fixed costs, difference between are total and fixed cost being accounted for by variable costs.
The point at which the total-cost and sales-revenue lines cross (BE) is the break- even point. At productions levels below the break-even point, the business is making a loss; at production levels above the break-even point the business is making a profit.
Evaluation of break-even analysis This analysis also has limitations:
- The assumption that cost and revenues are always represented by straight lines in unrealistic. Not all variable costs change directly or smoothly with “output”.
- Not all costs can be conveniently classified into fixed and variable costs. The introduction
of semi variable costs will make this technique much more complicated - Semi variable cost is an expense which contains both a fixed costs component and a variable cost component
- There is an allowance made for inventory levels on the break-even chart. It is assumed that all units produced are sold. This is unlikely to always be the case in practice
- it is also unlikely that fixed costs will remain unchanged at different output levels up to maximum capacity
Evaluation of the costing approaches Full costing:
Full costing can be useful for single-product firms and as quick guideline to the costs of products. However, it does have serious flaws for multi-product business because the approach does not apportion overheads on a real basis. The final costing figure may, in fact, be inaccurate or misleading. Full-costing data could be used to make comparisons of costs calculated on the same basis over time, but it should not be widely used for decision making.
Marginal or Contribution Costing:
Marginal or contribution costing is now the most widely used method for decision making, because it accepts that fixed overhead costs must be paid during a particular time period, regardless of the level of production. Marginal costing does have one potential drawback. If overheads are set aside for costing
purposes, there is a danger that they could be overlooked altogether. This could mean that contribution is confused with profit, and pricing decisions for products could ignore the fixed-cost element.
Final Evaluation of costs in operations management:
Operations-management decisions often require accurate and up-to-date cost data. Manager need to be aware of the different types and classifications of costs in making their decisions. The importance of cost and profit centres cannot be over-emphasised.
The need to consider more than one method of costing in making crucial decisions is also vital-to depend solely on fixed costing would lead to poor decisions in many instances. Costs are significant but the successful operations manager will also consider other data from a wide range of sources before making decisions on issues such as location, “make or buy”, and purchasing of new capital equipment.