Chapter 30 –

Forecasting
and managing
cash flows
Put yourself in the place of a manager of a business and
consider the saying “Turnover is vanity, profit is sanity,
but cash is king for business”. What does this mean?
The phrase “cash is king” is true for many businesses that
enjoy growing sales but watch their cash flow get worse.
Why is business turnover just vanity?
Businesses often chase turnover (sales) on the basis that
the more sales they make, the “better” the business
performance will be, or at least appear to be.
However, to decide whether the increase in turnover is
worthwhile, how the increase was achieved needs to be
considered. Did management have to reduce the selling
price, or increase costs at all? If so, what was the impact on
net profit and has there been a net benefit from the
increase in sales.
You are currently selling 10,000 units with a $5 margin (the
difference between selling price and cost of production)
which gives a gross profit of $50,000
You could increase sales to 15,000 by reducing margin to $3
… what is the result?
You are currently selling 10,000 units with a $5 margin (the
difference between selling price and cost of production)
which gives a gross profit of $50,000
You could increase sales to 15,000 by reducing the margin
to $3 … but gross profit will fall from $50,000 to $45,000.
Sales have increased by 50% but this has damaged your
profit, which has fallen by $5,000.

Sales = 10,000 units Sales = 15,000 units

Margin = $5 Margin = $3
Gross profit = $50,000 Gross profit = $45,000

Profit has fallen from $50,000 to $45,000 = ($5,000)

If you could increase sales to 15,000 by cutting the
margin to $4, then the gross profit would be $60,000
but did you need to take on a new part-time employee
to achieve these sales?

So long as this cost is less than $10,000 then you are ok,
but if this cost (part time employee) is higher then your
profit will be less than it was ($50,000).
Time to look at profit, cash and the impact on cash flow

Services sold - $100,000

Cost of sales - $75,000
Profit - $25,000.

Customers have been given 30 days credit, but the $75,000

costs must be paid immediately.

The result is a cash shortfall of $75,000 even though a profit

of $25,000 has been made.

This is a problem because other payments, like rent, utilities

etc. have to be made.
What happens if sales remain static?
In this case, the situation doesn’t get worse because next month
you will receive the original $100,000 income at the same time
that you need to pay out the next $75,000 for this month’s costs.
At the end of month 2 you have made :
$200,000 from sales, for which you have received $100,000 cash,
another $100,000 to come in 30 days, and paid out $150,000
costs (you had to pay out $75,000 for month 2).
Sales = $200,000 ($100,000 now paid, $100,000 due in 30 days)
Paid out (overdraft?) = $75,000 + $75,000 = $150,000
Profit = $200,000 - $150,000 = $50,000
Cash = $100,000 - $150,000 = ($50,000)
You have a profit of $50,000 and negative cash flow of $50,000.
If sales continue to grow each month, then it is possible
that cash flow will continue to get worse.
How can a cash shortfall in a business be overcome?
Essentially managers need to make sure that there is
enough liquidity to cover the business, either as cash or the
ability to draw on some sort of facility to pay the bills. Debt
factoring could work here. (Remember - the Debt Factor
company buys the value of a firm’s debts (invoices) less a %
so that the business does not have to wait for the money to
come in, in 30 days.)

Liquidity refers to a company's ability to pay off its short-

terms debts obligations.
There is also a service called Invoice Financing - the
Invoice Finance company lends the business the
outstanding value of a large part of its invoices
(typically 80%) when they are issued. The balance is
received when the invoices are paid and the lender is
then repaid from the invoice payment, plus interest.

https://www.alternativebusinessfunding.co.uk/knowled
ge/surviving-a-recession/turnover-is-vanity-profit-is-san
ity-but-cash-is-king-for-your-business/
Alternatively, the firm could negotiate quicker payment
from customers and / or longer credit from suppliers. But
what are the consequences of this?
The need for CASH remains critical.
Purchasing a vehicle for the business using cash is not
always the best option even if cash is currently available. It
might be worth considering a loan or hire purchase to help
make the purchase and keeping some cash to avoid running
short (a liquidity crisis).
In the short term, cash is more important than profit. The
business will always need to pay bills as they fall due,
because that’s the reality of day-to-day trading.
Remember - profit and cash are not the same thing.

A business that does not have enough cash

to pay its day-to-day expenses (e.g. what it
owes to its suppliers etc) is said to be
insolvent and may be forced into liquidation.

Cash flow refers to the sum of cash

payments into a business (cash inflows)
less the sum of cash payments out of the
business (cash outflows).
An insolvent business is one which cannot
pay its debts.

Liquidation occurs when a firm stops

trading and its assets are sold for cash in
order to pay its debts – suppliers and other
creditors.
Cash flow is important for all businesses but
especially so for new (start-up) businesses
and cash flow planning is a vital part of
successfully running any business.
This is because :
• Start-ups have not yet been able to build
up a relationship with their suppliers and
consequently may be given shorter credit
terms, or no credit at all.
• With no trading record, banks and other
lenders may be unwilling to loan money to
the business.
• New business owners may not fully
appreciate how much it costs to start a
business (new premises, new machinery,
no sales until products have been
produced, wages and salaries etc) and
cash-flow planning is vital to keeping
ahead of how much cash is actually
needed.
Tip
When you have the opportunity, emphasis
the importance of having enough cash in
the short-term.
Profit can be earned in the long-term but
cash payments have to be made all the
time.
Forecasting cash flow
A cash flow forecast is a budget or estimate
which identifies the expected cash inflows
and cash outflows and when they are likely to
take place, usually on a month by month
basis.
A forecast is a prediction for the future and is
uncertain. Never refer to forecasts as actual
accounts. Forecasts are financial planning
estimates that deal with the future.
Cash inflows
Remember that cash inflow means all
the sources from which cash comes
into the business over a period of
time.
3 likely cash
payments that
could be received
by a firm (cash
inflows)?
Cash inflow can result from :
• Cash sales (need to be forecast –
need a sales forecast as well)
• Payment received from debtors
(again, some question about when
people will pay)
• Investment by the owners
• Loans and overdrafts
Cash outflows
Also remember that cash outflows
means all the sources to which cash
goes out of the business over a period
of time.
3 likely cash
payments that a firm
might make (cash
outflows)?
Cash outflow can result from :
• Cash purchases (need to be forecast, will
depend on production levels)
• Payment of wages and salaries to staff
(wages may vary with production)
• Purchase of fixed assets (will be planned)
• Payments to creditors
• Repaying loans
• Miscellaneous expenses
The structure of cash-flow forecasts

A cash flow forecast is an estimate of a

firm’s future cash inflows and outflows.

All businesses need cash flow forecasts to

enable them to identify potential cash-flow
problems ahead of time.
All cash-flow forecasts consist of :
• A cash inflow section
• A cash outflow section
• A net cash flow section which
shows opening and closing cash
balances for the period (usually
monthly)
 $000 Jan Feb Mar Apr
Cash inflows Owner’s capital 6 0 0 0
Cash sales 3 4 6 6
Payment by trade receivables 0 2 2 3
TOTAL CASH INFLOW 9 6 8 9

Cash outflows Lease (deposit) and rent 9 1 1 1

Payment for trade payables 0.5 1 3 2
Labour 1 2 3 3
Other costs 0.5 1 0.5 1.5
TOTAL CASH OUTFLOW 11 5 7.5 7.5

NET CASH FLOW NET MONTHLY CASH FLOW (2) 1 0.5 1.5
OPENING CASH BALANCE 0 (2) (1) (0.5)
CLOSING CASH BALANCE (2) (1) (0.5) 1
Opening cash balance is the cash held by
the business at the start of the month.

Closing cash balance is the cash held by the

business at the end of the month. This
amount becomes the next month’s
opening cash balance.
Net cash flow refers to the estimated
difference between cash inflows and cash
outflows.

By April the closing cash balance is positive

and the net monthly cash flow shows an
increasing trend.
All figures in $000 Jan Feb Mar Apr
The net cash
Net monthly flow is negative
cash flow (2) 1 only
0.5 in 1.5
the
first
Openingmonth of the forecast.
cash balance 0 (2) (1) (0.5)
Closing cash balance (2) (1) (0.5) 1
However, these are only forecasts and
will depend on how accurately the
manager has been able to predict cash
inflows and outflows.
The figures can be altered – for example
the manager may be able to negotiate to
pay the rental deposit over six months
rather than a single payment in the first
month of operations.
 $000 Jan Feb Mar Apr
Cash inflows Owner’s capital 6 0 0 0
Cash sales 3 4 6 6
Payment by trade receivables 0 2 2 3
TOTAL CASH INFLOW 9 6 8 9

Cash outflows Lease (deposit) and rent 9 1 1 1

Payment for trade payables 0.5 1 3 2
Labour 1 2 3 3
Other costs 0.5 1 0.5 1.5
TOTAL CASH OUTFLOW 11 5 7.5 7.5

NET CASH FLOW NET MONTHLY CASH FLOW (2) 1 0.5 1.5
OPENING CASH BALANCE 0 (2) (1) (0.5)
CLOSING CASH BALANCE (2) (1) (0.5) 1
Activity 30.1
April cash flow
Draw up a 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.
 $000 Jan Feb Mar Apr
Cash inflows Owner’s capital 6 0 0 0
Cash sales 3 4 6 7
Payment by trade receivables 0 2 2 3
TOTAL CASH INFLOW 9 6 8 10

Cash outflows Lease (deposit) and rent 9 1 1 1

Payment for trade payables 0.5 1 3 2.5
Labour 1 2 3 3
Other costs 0.5 1 0.5 2.5
TOTAL CASH OUTFLOW 11 5 7.5 9

NET CASH FLOW NET MONTHLY CASH FLOW (2) 1 0.5 1

OPENING CASH BALANCE 0 (2) (1) (0.5)
CLOSING CASH BALANCE (2) (1) (0.5) 0.5
Benefits of cash flow forecasting :
A business uses a cash flow forecast to :
• Identify potential shortfalls in cash
balances – for example, if the forecast
shows a negative cash balance then the
business needs to organise a bank
overdraft facility, or it might reschedule
some of its outflows if it can, or rethink
the credit terms it offers customers.
• establish that the trading performance
of the business (revenues, costs and
profits) turns into cash.
• analyse whether the business is
achieving the financial objectives set
out in the business plan (which will
almost certainly include some kind of
cash flow budget).
• present to the bank when applying for
an overdraft facility.
Limitations of cash flow forecasts

Cash flow forecasts do not anticipate

internal or external changes e.g.
marketplace shifts, changing customer
demands.

To remain useful, the forecast must be

adjusted to reflect any changes which
occur.
Limitations of cash flow forecasts
• A cash flow forecast is only a rough
estimate and mistakes can be made when
preparing the forecast.
• Unexpected cost increases will lead to
major forecast inaccuracies unless the
forecast is reworked to take these into
account.
• Wrong assumptions can be used in laying
out the forecast (e.g. regarding sales)
which will make the forecast inaccurate.
The causes of cash flow problems
A cash flow problem occurs when a business
does not have enough cash to be able to pay its
liabilities.
The main causes of cash flow problems are:
• Lack of planning
• Allowing customers too much credit
• Poor credit control
• Overtrading (expanding too rapidly)
• Unexpected changes
• Seasonal demand
Lack of planning
If forecasts are not used then the
business has little chance of
anticipating future cash flow problems
and taking the necessary action to
cope with them.
Allowing customers too much credit
Customers who buy on credit are called
"trade debtors".
Offering credit may be a good way of
building sales.
However allowing customers too long to
pay will lead to a short-term reduction is
cash inflows and possible cash flow
problems.
Poor credit control
The credit control department records
which customers have paid what they
owe and which have not.
It is important to manage these debts to
avoid a situation developing where some
customers do not pay what they owe
and the debts have to be reclassified as
bad debts.
Expanding too rapidly, or overtrading
This occurs where a business expands
too quickly, putting pressure on short-
term finance to pay for additional
materials and wages before it receives
cash from additional sales.
Overtrading refers to the rapid
expansion of a business without
obtaining all the necessary finance
so that a cash-flow shortage
develops.
Unexpected changes
This refers to unforeseen events that are not
included in the cash flow forecast.
Examples might include :
• Internal change (e.g. machinery breakdown,
loss of key staff)
• External change (e.g. economic downturn,
accidents, change in legislation that requires
a business to invest in new facilities)
Seasonal demand
Seasonal demand changes lead to
predictable changes in demand and cash
flow.
Production or purchasing is usually in
advance of seasonal peaks in demand which
leads to cash outflows before cash inflows.
However this can be managed by building
the expected outflows and inflows into the
cash flow forecast.
Activity 31.5 (page 470): Taxi firm’s cash flow

Increase in oil prices – lead to fuel price increase for

taxis and increase cash outflows.

Increased unemployment – lead to reduced demand for

taxi services. This will reduce cash inflows and some
cash outflows, e.g. fuel purchases.

Lower train fares – could lead to increased demand for

taxis as train passengers use taxis to complete journeys.
Increased cash inflows and outflows.
Ways to improve cash flow
The most important part of improving
cash flow is having a reliable and up-
to-date cash flow forecast. This can be
achieved by keeping the forecast up-
to-date so that it reflects the main
cash flow issues as accurately as
possible.
Note that improving sales revenues and profit
might lead to a long-term improvement in the
cash flow position but possibly a short-term
deterioration in cash flows.
For example advertising more to increase
sales must be paid for before sales are likely
to improve.
Make sure that you understand the
difference between sales revenues and cash
flows.
Management can take certain actions
to improve cash flow, which include :

Increase Reduce cash

cash inflows outflows
Increasing cash inflows :
• Arrange overdraft facilities with the
bank – this is a flexible source of cash
but interest will have to be paid and the
bank can withdraw this facility at any
time.
• Obtain a short-term loan – again,
interest will have to be paid and the
loan must be repaid by a certain date.
Increasing cash inflows :
• Sell unused or redundant assets – this
will boost cash flow but the assets may
have to be sold for less than their value
if the money is needed quickly. In
addition, the assets might be needed at
a later date or could be used as
collateral for a future loan.
Increasing cash inflows :
• Sale and leaseback – which allows the
asset to be sold while the firm still has
its use. However lease costs will add to
overheads and the assets is no longer
available for use as collateral.
Increasing cash inflows :
• Reduce or cancel credit terms to customers
– which will bring cash in sooner but
customers may not be happy with this
arrangement and could decide to purchase
products from competitors who offer more
generous credit terms.
The business may need to offer a financial
incentive, such as a prompt-payment discount
which of course will reduce cash inflows as
well as the profit margins.
Increasing cash inflows :
• Debt factoring – this refers to a firm
selling its debts to a debt factoring
business for less than the full value of
those debt.
This means that the cash comes in
immediately rather than having to wait
for debtors to pay but less than the full
amount is received because the debt
factor business also has to make a profit.
Managing debtors or trade receivables
A business can adjust the credit terms it
offers to customers, or sell its debts off, in
order to increase cash inflows.
It also needs to be careful who it makes
credit available to by checking on the
credit worthiness of prospective customers
(possibly by asking for references or using
the services of a credit enquiry agency).
Decreasing cash outflows :
• Cut overhead costs which do not
directly affect output – this may be
the most important method of
improving cash flow. Every business
can identify savings in non-essential
costs if it looks hard enough.
Decreasing cash outflows :
• Delay payments to suppliers - by
taking longer to pay bills owed, a
business can reduce cash outflows
but it risks losing out on discounts
and damaging relationships with
suppliers.
Decreasing cash outflows :
• Delay payments to suppliers - by
taking longer to pay bills owed, a
business can reduce cash outflows
but it risks losing out on discounts
and damaging relationships with
suppliers.
Decreasing cash outflows :
• Cut back or delay expansion plans - many
of the biggest cash outflows occur when a
business is expanding (e.g. opening new
offices or shops, adding a production line
or factory).
By delaying this expansion, cash can be
conserved in the short-term. However the
efficiency of the firm might be reduced by
using outdated or inefficient equipment.
Decreasing cash outflows :
• Using leased capital equipment –
which means the firm can use updated
assets without having to make large
payments for them.
However leasing costs have to be paid
and the asset is not owned by the
business and is therefore not available
as collateral.
Managing creditors or trade payables
Creditors are suppliers who have agreed to
supply products on credit and who have not
been paid yet.
By increasing credit purchases the firm can
delay cash outflows. However, if the firm is
late making its payments the firm may lose
out on discounts for prompt payments and
the supplier may refuse to supply further
goods, which could cause delays to
production.
Managing creditors or trade payables
A larger firm usually has more leeway with
suppliers to extend its credit terms.
However, slow payments by larger
businesses to smaller businesses is a
problem for the smaller business.
In addition suppliers may be reluctant to
supply to a firm which is known to be a late
payer.