Cash flow
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About 70% of all business failures occur because the business runs out of money. Therefore a business must make sure that it has enough cash to pay its bills otherwise it will go bankrupt. It is therefore important that businesses try and predict what money they will receive and what money they will need to pay out. Businesses should produce a cash flow forecast which shows the inflows and outflows of money. This will hopefully show any periods where the business may run out of cash. If the business knows of problems in advance it can arrange a short-term loan or overdraft.
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Cash and the Business
Cash is constantly flowing in and out if the business. The diagram below shows how cash is used to buy raw materials which are then used to make goods and services. These goods and services are then sold to customers for cash and the cycle begins again.
Cash Flow Forecast
Cash flow forecasts are used to show the inflows and outflows of money to and from the business. Examples of cash inflows and outflows are as follows:
• inflows - sales revenue, loans from banks and grants from government;
• outflows - payments for raw materials, wages, rent, interest on loans, telephone, new machinery and taxes.
The cash flow forecast will show the business if there are any periods where it may run out of cash. If a business knows in advance that it is going to run out of cash it can try and make arrangements to avoid the problem, for example, by arranging a short-term loan or overdraft.
As the cash flow forecast shows what may happen in the future it can help a business to make decisions. For example the business could use a cash flow forecast to help make the following decisions about the following ideas:
• start to produce a new good or service;
• invest in a new factory, shop or office;
• expand or reduce existing activities.
If the cash flow forecast shows that the business will run out of money it is unlikely to go ahead with the idea.
Banks will normally ask to see a cash flow forecast before they agree to lend the business any money. The bank will want to make sure that the business is able to pay back any money lent to it.
Many cash flow forecasts are now produced using a spreadsheet such as Microsoft Excel. It is possible to put formulae into spreadsheets that will automatically calculate the values for you. This is particularly useful if you want to change the inflows or outflows to see the effect on the closing balance as it saves a lot of time and effort. Below is an example of a cash flow forecast for a record shop produced in Excel.
Cash inflows are equal to the value of sales each month, this is also known as the business’s revenue. Any loans from the bank or grants from government would also be shown as a cash inflow.
Cash outflows are equal to the money that goes out of the business. In this case the outflows are wages, stock (records), rent and other costs. The other costs could be interest on loans, utility bills, telephone, new machinery and taxes.
The other totals are calculated as follows:
Net cash flow = Cash Inflows – Cash Outflows
£1,100 = £10,000 – £8,900 (for January)
Opening balance = Closing balance from the previous month
Closing balance = Opening balance + Net cash flow
£1,100 = £0 + £1,100 (for January)
If the purpose of this cash flow was to see how Steve’s Record Shop would do in the future, it would appear that the business will not run out of cash as the closing balance gets larger each month. It is important to note that the starting balance is £0 in this example, however in reality there would be large start up costs. These start up costs could be shown as a negative opening balance, for example, if it cost £15,000 to get the shop ready for opening the opening balance would be -£15,000. Negative figures are either shown in brackets or written in red. You may have heard the expression that a business which is losing money is in the “red”.
Identifying Problems Using a Cash Flow Forecast
As we have previously mentioned the cash flow forecast can be used to identify future problems. The following cash flow forecast shows a business that has a negative net cash flow every month. This leads to the closing balance becoming a larger negative figure every month, in other words the business falls further and further into debt. It should be obvious that this business should not open as it is only a matter of time before it becomes bankrupt.
The following cash flow forecast shows a very large net cash flow every month. Whilst this is not a huge problem in itself, it is wasteful having large amounts of money doing nothing. The money could be put to better use by purchasing more stock, expanding the size of the business or giving it to the owners.
In this final case we see the business has to pay an extra bill of £5,000 in March to refurbish the shop. The other costs increase from £900 to £5,900 for March. This has the effect of giving the business a negative closing balance in March and April. If the business is to survive these months it will have to find a way to borrow money. The business could take a short term loan or an overdraft to ensure that it had enough money to pay its outflows for March and April.
Links
Below link shows why cash flow statements don't show profit and the differences between cash flow statements and profit and loss accounts http://www.bized.ac.uk/learn/business/accounting/cashflow/trail/cashflow5.htm
