Chapter 30.
Forecasting and managing
cash flows
Cash flow forecasts: meaning and purpose
For any business to survive, having enough cash to pay
suppliers, banks, and employees is the most important
financial requirement. A company may have high sales
and low costs, but if it does not manage its cash properly,
it can still run out of money. When cash flow is negative,
the business cannot pay its bills and may become
insolvent or bankrupt, even if the business idea is good.
Planning cash flow is especially important for new businesses
because:
➢ Start-ups usually get less time to pay their suppliers compared
to large, established companies.
➢ Banks and lenders often ask for a cash flow forecast before
they give any loans.
➢ New businesses usually have limited money, so careful
planning is very important.
Cash flow forecasting means estimating how much money will
come in (cash inflows) and go out (cash outflows) in the future,
usually month by month.
Practical example:
For example, Ali is starting a car valeting service. He
plans to clean cars for individual customers and for
businesses such as taxi companies. To succeed, he must
forecast his cash inflows and outflows to make sure he
always has enough money to run his business.
Net cash flow = Total cash inflows - Total cash outflows
Opening balance of a month = Closing balance of the previous month
Closing balance = Opening balance + Net cash flow
Figures in brackets ( ) mean negative cash.
Cash Inflows (money coming into the business)
Owner’s capital (own money invested) - Easy to predict because Ali decides how
much money he will put into the business.
Bank loans - Easy to forecast if the loan is already agreed with the bank, including
the amount and payment dates.
Cash sales from customers - Hard to predict because they depend on how many
customers buy the service. Ali must estimate sales, but forecasts are not always
accurate.
Payments from trade receivables (customers who buy on credit) - Difficult to
forecast because:
- Not all sales are cash; some customers pay later
- Customers may pay late
- Even if one month’s credit is agreed, payment is not guaranteed
Cash Outflows (money going out of the business)
- Lease payment for premises - Easy to predict because the amount is fixed in
the rental agreement.
- Annual rent - Usually fixed for a certain period, so it is easy to forecast, but
the landlord may increase it later.
- Utility bills (electricity, gas, water, telephone) - Hard to forecast because
they change depending on customer numbers, weather, and energy prices.
- Wages - Depend on how many workers are needed and their hourly pay. If
demand changes, wage costs may change each week.
- Materials and supplier payments - Depend on how much the business sells.
More sales mean more materials are needed. If suppliers give longer credit
periods, the business needs less cash at the beginning.
April cash flow:
1 Draw up Ali’s revised cash flow forecast for April,
assuming:
- cash sales are forecast to be $1 000 higher
- payments to trade payables are forecast to be $500 higher
- other costs are forecast to be $1 000 higher.
Recalculate the closing cash balance for April.
Benefits of cash flow forecasting
Preparing a cash flow forecast has several important benefits:
- Shows cash shortages early: If the closing cash balance is negative, the
business knows it may not have enough money to pay its bills. It can then
arrange extra finance, such as a bank overdraft or more money from the
owner.
- Identifies problem periods: The forecast shows months when cash outflows
are much higher than inflows. The business can plan ahead to improve cash
flow, for example by reducing costs, delaying payments, or increasing sales.
- Helps attract finance: Cash flow forecasts are an important part of any
business plan. Banks and investors usually will not provide money unless they see
a clear forecast and understand the assumptions behind it.
Limitations of cash flow forecasting
Many factors, either internal to the business or in the external environment, can
change and therefore affect the accuracy of a cash flow forecast. This means
that cash flow forecasts must be used with caution and the ways in which the
cash flows have been estimated should be understood. Here are the most
common limitations of forecasts:
➢ Mistakes can be made in preparing the revenue and cost forecasts, or they
may be drawn up by inexperienced entrepreneurs or staff.
➢ Unexpected cost increases lead to major inaccuracies in forecasts.
➢ Incorrect assumptions can be made in estimating the sales of the business,
perhaps based on poor market research. This will make the cash inflow
forecasts inaccurate.
Causes of cash flow problems:
Causes of Cash Flow Problems
Most businesses experience cash flow problems at some point. Before learning how to
improve cash flow, it is important to understand why these problems happen:
Lack of planning
Cash flow forecasts help businesses predict future cash shortages. Good financial
planning allows managers to prepare solutions in advance. Without proper planning,
businesses may suddenly run out of cash.
Poor credit control
The credit control team checks customer accounts and monitors who has paid and who
has not. If this system is poorly managed, late payments are not followed up and bad
debts may increase. This reduces cash coming into the business.
Causes of cash flow problems:
Allowing customers too long to pay
Businesses often give customers trade credit to stay competitive. For example, if one
supplier demands immediate payment and another offers two months’ credit, customers
usually choose the credit option. However, longer credit periods delay cash inflows and
can cause cash shortages.
Expanding too quickly
Rapid growth can create problems. The business must pay for new staff, materials, and
equipment before receiving money from extra sales. This situation, called overtrading,
can lead to serious cash shortages even if the business is profitable.
Unexpected events
Unexpected costs can damage cash flow. For example, a vehicle breakdown, rising costs,
or a competitor lowering prices can increase expenses or reduce sales. These events make
the original cash flow forecast inaccurate.
Methods of improving cash flow
There are two ways to improve net cash flow:
✓ increase cash inflows
✓ reduce cash outflows
Methods of increasing cash inflows
Improving Cash Flow by Managing Trade Receivables
Businesses can improve cash flow by managing how quickly customers pay their debts.
1. Reduce or limit credit to customers
The business can refuse to give credit or ask customers to pay faster.
Evaluation:
Many customers expect credit. If credit is not offered, they may buy from competitors
instead. This could reduce sales. The marketing department may want longer credit to
attract customers, while the finance department may want shorter credit to improve cash
flow.
2. Sell debts to debt factors
The business can sell its trade receivables to specialist financial institutions called debt
factors. These companies pay cash immediately and then collect the money from customers
themselves.
Evaluation:
This improves cash flow quickly, but it is expensive. Debt factors do not pay the full value
of the debts because they need to make a profit.
Methods to reduce cash outflows and their possible drawbacks
Improving Cash Flow by Managing Trade Payables
Businesses can also improve cash flow by managing how and when they pay their suppliers
(trade payables).
1. Buy more goods on credit instead of cash
The business can ask suppliers to allow payment later rather than paying immediately.
Evaluation:
This helps keep cash in the business for longer. However, the business may lose discounts for
quick payment, and some suppliers may refuse to offer credit, especially if the business has a
weak credit history.
2. Take longer to pay suppliers
The business can delay payments and use the full credit period offered by suppliers. Larger
businesses often have more power to negotiate longer payment terms.
Evaluation:
This improves cash flow, but it may harm relationships with suppliers. Small suppliers may
struggle with late payments and might refuse to supply goods or provide poor service in the
future.