Operational
Profit cash flow
$ $
Sales 200,000 200,000
Opening receivables (∴ received in year) 15,000
Closing receivables (outstanding at year end) (24,000)
Cash in 191,000
Cost of sales 170,000 170,000
Closing inventory (purchased, but not used, in year) 21,000
Opening inventory (used, but not purchased, in year) (12,000)
Purchases in year 179,000
Opening payables (∴ paid in year) 11,000
Closing payables (outstanding at year end) (14,000)
Cash out 176,000
Profit/operational cash flow 30,000 15,000
Profit 30,000
(Increase)/Decrease in inventories Opening 12,000
Closing (21,000)
(9,000) (Increase)/Decrease in receivables Opening 15,000
Closing (24,000)
(9,000)
Increase/(Decrease) in payables Closing 14,000
Opening (11,000)
3,000
Operational cash flow 15,000
In practice, a business will make many other adjustments. The profit figure includes items which do not involve the movement of cash, such as the annual depreciation charge, which will have to be added back to arrive at a figure for cash.
Both 'receipts and payments' forecasts and forecasts based on financial statements could be used
alongside each other. The cash management section and the financial controller's section should reconcile differences between forecasts on a continuing basis, so that the forecast can be made more accurate as time goes on.
All cash forecasts can now be prepared quickly and easily on spreadsheets. This enables revised figures to be calculated whenever assumptions are changed.
Section summary
A cash flow forecast can be prepared by projecting the movement in the statement of financial position or income statement.
6 The need for cash management
6.1 Cash flow problems
Introduction
This section looks at why cash flow problems arise and methods of easing shortages.
We have already used the concept of the operating cycle, which connects investment in working capital with cash flows. Cash flow problems can arise in several ways.
CASH FLOW PROBLEMS
Making losses Continual losses will eventually mean problems, whose timing depends on the size of losses and whether depreciation is significant; if it is, problems arise on replacement of assets
Inflation Ever-increasing cash flows required just to replace used-up and worn out assets
Growth Growth means business needs to support more receivables and inventory Seasonal business Cash flow difficulties may occur at certain times when cash inflows are low
and outflows high, as inventories are being built up One-off items of
expenditure
Large items such as a loan repayment or the purchase of expensive non- current asset such as freehold land
Poor credit control procedures
A long average time for credit customers to pay may cause problems
6.2 Methods of easing cash shortages
6.2.1 Improving the business
Cash deficits can arise out of basic trading factors underlying the business such as falling sales or increasing costs. Clearly, the way to deal with these items is to take normal business measures, rectifying the fall in sales by marketing activities or, if this cannot be achieved, by cutting costs.
6.2.2 Controlling the operating cycle: short-term deficiencies
Cash deficits can also arise out of the business's management of the operating cycle and from timing differences. The following are possibilities.
(a) Borrowing from the bank. This is only a short-term measure. It is possible that a bank will convert an overdraft into a long-term loan, or perhaps new overdraft limits can be set up.
(b) Raising capital. This is likely to be expensive and should be generally used for long-term investment, not short term cash management.
(c) Different sources of finance (such as leasing) might be used.
When a company cannot obtain resources from any other source such as a loan or an increased overdraft, it can take the following steps.
(a) Postponing capital expenditure
(i) It might be imprudent to postpone expenditure on non-current assets which are needed for the development and growth of the business.
(ii) On the other hand, some capital expenditures might be postponable without serious consequences. The routine replacement of motor vehicles is an example. If a company's policy is to replace company cars every two years, it may decide, if cash is short, to replace cars every three years.
(b) Accelerating cash inflows which would otherwise be expected in a later period
The most obvious way of bringing forward cash inflows would be to press receivables for earlier payment (leading and lagging receivables).
(c) Reversing past investment decisions by selling assets previously acquired
Some assets are less crucial to a business than others and so if cash flow problems are severe, the option of selling short-term investments or even property might have to be considered.
(d) Negotiating a reduction in cash outflows, so as to postpone or even reduce payments There are several ways in which this could be done.
(i) Longer credit might be taken from suppliers (leading and lagging payables). (ii) Loan repayments could be rescheduled by agreement with a bank.
(iii) A deferral of the payment of tax could be agreed with the taxation authorities.
(iv) Dividend payments could be reduced. Dividend payments are discretionary cash outflows, although a company's directors might be constrained by shareholders' expectations. (v) Inventory levels could decrease to reduce the amount of money tied up in their production
cost.
Assume that Gilbert Gosayne sells Nullas. Each Nulla costs $50 to make and is sold for $100. The bank has refused an overdraft to Gilbert Gosayne. Suppliers are normally paid at the end of Month 1; the Nullas are sold on the 15th of Month 2. Payment is received on the first day of Month 3.
(a) Under this system we have the following forecast.
Inflows Outflows Balance
$ $ $
Month 1 (end) – 50 (50)
Month 2 – – (50)
Month 3 (beginning) 100 – 50
In other words the cash cycle means that the firm is in deficit for all of Month 2. As the bank has refused an overdraft, the suppliers will not be paid.
(b) If, however, Gilbert Gosayne persuades its suppliers to wait for two weeks until the 15th of Month 2 and offers a settlement discount of $5 to customers to induce them to pay on the 15th of Month 2, the situation is transformed.
Inflows Outflows Balance
$ $ $
Month 1 – – –
Month 2 95 50 45
Month 3 – – 45
In practice, it is not that simple.
(a) Suppliers can object to their customers taking extra credit and it can also harm their businesses, thus jeopardising their ability to make future supplies. The customer also loses the possibility of taking advantage of trade discounts.
(b) Customers might refuse to pay early, despite the inducement of a discount. In fact, a firm's customers and suppliers might be 'leading and lagging' themselves.
A firm might be in a position to choose which of its suppliers should be paid now rather than later. Certain suppliers have to be paid early, if they are powerful. The bank is a powerful supplier: it is worth keeping the bank happy even if the firm loses out on a few trade discounts in the process.
Shortening the operating cycle is helpful in dealing with short-term deficiencies and saving interest costs, but it is not necessarily a long term solution to the business's funding problems. This is because a shorter operating cycle time will reduce the amount of cash that a company needs to invest in its operating activities.