Chapter 5.

30 - Forecasting and managing cash flows

30.1 Cash flow forecasts: meaning and purpose

For any business to survive, having sufficient cash to pay suppliers, banks and employees is the single most important
financial factor. A business could have high revenue and low expenses, but if it does not manage cash effectively, it
could still have negative cash flow. Without positive cash flow, any company – no matter how promising its business
model – will become insolvent and bankrupt.

Importance of cash-flow planning:

• New business start-ups are often offered much shorter credit to pay suppliers than larger, well- established firms.
• Banks and other lenders will need to see evidence of a cash flow forecast before making any finance available.
• Finance is often very tight at start-up, so accurate planning is much more significant for new businesses.

Forecasting cash flow means trying to estimate future cash inflows and cash outflows, usually on a month-by-month
basis.
Cash inflows
• Owner’s own capital injection
• Bank loan payments
• Customers’ cash purchases
• Trade receivables payments
Cash outflows
• Lease payment for premises
• Annual rent payment
• Electricity, gas, water and telephone bills
• Wage payments
• Cost of materials and payments to suppliers

The structure of cash flow forecasts

A cash flow forecast is typically constructed monthly, often for the next 12 months, but it can cover a shorter time
period. A cash flow forecasts have three basic sections:
• Cash inflows: This section records the cash payments to the business, including cash sales, payments for credit
sales, and capital inflows.
• Cash outflows: This section records the cash payments made by the business, including wages, materials, rent and
other costs.
• Net cash flow and opening and closing balance: This shows the net cash flow for the period and
the cash balances at the start and end of the period (the opening cash balance and the closing cash
balance).
If the closing balance is negative (shown by a figure in brackets), then a bank overdraft will almost certainly be
necessary to finance this.

Benefits of cash flow forecasting

• They show negative closing cash flows. This means that plans can be made to source additional finance, such as a
bank overdraft or the injection of more capital from the owner.
• They indicate periods of time when negative net cash flows are excessive. The business can plan to reduce these by
taking measures to improve cash flow.
• They are essential to all business plans. A business start-up will never gain finance unless investors and bankers
have access to a cash flow forecast and 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.
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
1. Lack of planning
Cash flow forecasts help greatly in predicting future cash problems for a business. Financial planning can be used to
predict potential cash flow problems so that business managers can take action to overcome them in plenty of time.
2. Poor credit control
The credit control department of a business keeps a check on all customers’ accounts. They record who has paid, who
is paying on time and which customers are not paying on time.
3. Allowing customers too long to pay debts
Many businesses have to offer trade credit to customers in order to be competitive. Allowing customers too long to pay
means reducing short-term cash inflows, which leads to cash flow problems.
4. Expanding too rapidly
When a business expands rapidly, it has to pay for the expansion and for increased wages and materials months before
it receives cash from additional sales.
5. Unexpected events
Unforeseen increases in costs could lead to negative net cash flows not being indicated on the original cash flow forecast.
Factors such as the breakdown of a delivery truck that must be replaced or a competitor lowering prices unexpectedly
will make the original cash flow forecast inaccurate.

Methods of improving cash flow

There are two ways to improve net cash flow:
1. Increase cash inflows

2. Reduce cash outflows

a) Improving cash flow by managing trade receivables
• Not extending credit to customers or asking customers to pay more quickly
• Selling claims on trade receivables to specialist financial institutions called debt factors.
• Finding out whether new customers are creditworthy
• Offering a discount to customers who pay promptly
Improving cash flow by managing trade payables
• Purchasing more supplies on credit and not cash. Evaluation of this approach: Discounts from suppliers for quick
cash payment might be stopped. Some suppliers might refuse to offer credit terms.
• Extend the period of time taken to pay. Evaluation of this approach: Slow payment by larger businesses is often a
great burden for the small businesses that supply them. Suppliers may be reluctant to supply products or to offer a
good service if they consider that a business is a late payer.