Chapter – 32

Cash Flow
Definitions
1. Cash flow forecast – the prediction of all expected receipts and expenses of a
business over a future time period which shows the expected cash balance at
the end of each month.
2. Cash inflows – the flow of money into a business.
3. Cash outflow – the flow of out of a business.
4. Net cash flow – the difference between the cash flowing in and the cash
flowing out of a business in a given time period.
5. Solvency – the degree to which a business is able to meet its debts when
they fall due.
CASH FLOW FORECASTS
Without cash a business cannot trade. Experts suggest that about 20 per cent of
business failures are due to poor cash flow. Even when trading conditions are good,
businesses can fail. A business must ensure that it has enough cash to pay staff
wages and bills when they are due. One way for a business to help control its cash
flow is to plan ahead by producing accurate cash flow forecasts. Such forecasts
also form an important part of business plans.
INTERPRETING CASH FLOW FORECASTS
A cash flow forecast lists all the likely receipts (cash inflows) and payments (cash
outflows) over a future period of time. All the entries in the forecast are estimated
because they have not occurred yet. The forecast shows the planned cash flow of
the business month by month. It also shows three key figures at the bottom of the
forecast:
Net cash flow: This is the difference between cash inflows and cash outflows for
the month. The equation to calculate net cash flow is given by:
Net cash flow = Total cash inflows - Total cash outflows
If this value is negative it means that more cash has flowed out of the business than
has flowed in.
Opening balance: This is the amount of cash that the business has at the beginning
of each month. For the first month in the forecast it will be the amount of cash the
business has left over from the previous trading period. For the rest of the forecast
the opening balance will always be the same as the closing balance from the
previous month.
Closing balance: This is the amount of cash that the business expects to have at the
end of each month. It takes into account the opening balance and the net cash flow
for the trading month. It may be positive or negative. The equation to calculate the
closing balance is given by: Closing balance = Net cash flow + Opening balance
CONSTRUCTING A CASH FLOW FORECAST
Constructing a cash flow forecast is a straightforward process. It can be done
manually but is easier using a spreadsheet.
The first column is used to describe the entries in the forecast and the remainder
shows financial values for each month in a future trading period - 6 months or 12
months perhaps. The cash flow forecast is constructed by entering financial values
in the three sections described below.
Cash inflows: Once the structure of the document has been prepared (dividing the
paper into columns), the values for expected cash inflows for each month can be
entered. This is the top section in the forecast. Examples of cash inflows are cash
from cash sales, cash from credit sales, interest received from banks, fresh capital
(introduced by the owners perhaps), cash from loans and cash from the sale of
business assets such as an unwanted vehicle. Most of these values have to be
estimated (forecast) by the business.
Once these values have been entered for each month in the forecast the total cash
inflows can be calculated.
Cash outflows: The middle section of the cash flow forecast is constructed by
entering all the expected payments that the business plans to make each month.
These payments represent cash outflows. This is likely to be the largest section and
examples of monthly entries might include payments to suppliers for raw materials
or goods for resale; payments for utilities such as gas, water and electricity; wages;
payments to the tax authorities; loan repayments to banks and other expenses such
as advertising, insurance, cleaning, rent, interest and motor expenses. Most of these
payments will have to be estimated but some may be known in advance.
Once these values have been entered for each month in the forecast the total cash
outflows can be calculated. This is done by adding the values in each column for
each month.
Closing balance: The bottom section of the forecast is used to calculate the
expected closing balance. This is the cash that the business expects to have at the
end of each month. It is calculated by adding together the net cash flow and the
opening balance and may be positive or negative.
THE USE OF CASH FLOW FORECASTS
Businesses draw up cash flow forecast statements to help control and monitor cash
flow in the business. There are certain advantages in using forecasts to control cash
flow.
Identifying the timing of cash shortages and surpluses: A forecast can help to
identify in advance when a business might wish to borrow cash. At the bottom of
the statement the monthly closing balances are shown clearly. This will help the
reader to identify when a bank overdraft will be needed. A business should try to
avoid being overdrawn at the bank because interest is charged. If certain payments
can be delayed until cash is available, this will avoid unnecessary borrowing.
Cash flow forecasts are particularly helpful for businesses that have seasonal
demand. This is because cash inflows will be irregular, i.e. high during peak season
and low at off-peak times. It will be important to delay some payments during
periods where cash inflows are expected to be low.
Supporting applications for finance: When trying to raise finance, lenders often
insist that businesses support their applications with documents showing business
performance, outlook and solvency. A cash flow forecast will help to indicate the
future outlook for the business. It is also common practice to produce a cash flow
forecast statement in the planning stages of setting up a business. It is unlikely that
any potential investor or lender will finance a business without a thorough business
plan supported by a cash flow forecast.
Enhancing the planning process: Careful planning in business is crucial. It helps to
clarify aims and improve performance. Producing a cash flow forecast is a key part
of the planning process because it is a document concerned with the future. If
business owners try to run a business without any forward planning, mistakes are
more likely to be made and it is difficult to identify problems in advance. A lack of
planning is likely to result in poor business performance.
Monitoring cash flow: During and at the end of the financial year, a business
should make comparisons between the predicted figures in the cash flow forecast
and those that actually occurred. This will help identify where problems have
arisen. The business can then try to identify possible reasons for any significant
differences between the two sets of figures.
THE LIMITATIONS OF CASH FLOW FORECASTS
Although cash flow forecasts are extremely useful in helping to manage a business,
it is important to recognise their limitations.
 Some of the financial information used in forecasts will be based on
estimates.
 Business activity is subject to external forces that are beyond the control of
owners and managers. Changes in factors such as interest rates, the state of
the economy, government legislation, exchange rates, competition and
consumer tastes can have an impact on business costs and revenues. As a
result, there will be an impact on a cash flow forecast.
 A business uses resources in preparing a cash flow forecast. A business
owner or employee will spend time gathering the information and
assembling the forecast. It will also have to be regularly updated so that the
monitoring process is meaningful. There might be a danger, for instance, that
an owner spends too much time focusing on the cash flow forecast at the
expense of meeting customer needs.
 A cash flow forecast only focuses on one important business variable - cash.
Other variables are also important, such as profit, profit margins and
productivity. The cash flow forecast cannot be used on its own to evaluate
the performance of a business.