Cash flow Notes

Cash flow refers to the movement of a business organization’s cash inflows (cash received from
the sale of goods and/or services) and cash outflows (used to pay for the costs of running the
business).
Cash flow forecasting and cash flow statements are often used to measure the financial health of
a business. This is because the comparison of cash inflows and cash outflows enables
managers to determine whether the organization is able to pay its costs in order to maintain its
business operations.
Cash flow refers to the movement of an organization’s cash inflows (cash received from the sale
of goods and services) and cash outflows (used to pay for the costs of running the business).
Cash flow is often used to measure the financial health of a business - and is an indicator of the
financial health of the economy as a whole. This is because the comparison of cash inflows and
cash outflows enables managers to see whether the business is able to pay its costs in order to
maintain its operations.

Sales revenue = Price × Quantity

Sales revenue is the value of goods and/or services sold to customers. Profit is the value of
sales revenue after all costs have been accounted for. This is the money that the business earns.
Hence, profit is the positive difference between a firm’s sales revenue and its total costs of
production.

Profit = Sales revenue – Total costs

Cash flow refers to the movement of money in and out of an organization. Cash flow
forecasting is a quantitative technique used by business managers to predict how cash is likely
to flow into and out of the organization for a particular period of time, such as for the next twelve
months.
Cash flow forecasting is a management tool used to monitor an organization’s cash flows in
order to avoid liquidity problems. Knowing in advance when the business is likely to face a period
of cash shortages (or a liquidity problem) can help it to plan accordingly so that it can continue to
operate.
Cash inflows are simply the money going into a business from earnings and other sources of
finance. Examples of cash inflows include:

 Bank loans

 Bank overdrafts

 Business angels

 Capital injections from the owners of the business

 Cash injection from sponsor

 Cash used by customers to pay for the sale of goods and services*

 Interest received on savings in a business bank account

 Crowdfunding sources
  Government grants and/or subsidies

 Payments made to the business from its debtors

 Tax refunds from the government*

Net cash flow (NCF) is the numerical difference between an organization’s total cash
inflows and its total cash outflows, per time period.

Net Cash Flow = Cash inflows – Cash outflows

A positive net cash flow exists if the total cash inflows are greater than the total cash outflows for
a given period of time, such as a month or per quarter. A negative net cash flow exists if the total
outflows exceed the total inflows for particular time period.
A liquidity problem occurs when there is a lack of cash in the organization because its cash
inflow is less than its cash outflow, i.e., it experiences negative net cash flow.
Being able to predict cash flow helps a business with its financial management and decision-
making.
To calculate cash flows for each time period, the following items are needed:

 Opening balance
 Net cash flow
 Closing balance
The opening balance in a cash flow forecast refers to the value of cash held by a business at
the start of a trading period (usually the beginning of the month).
Net cash flow is the numerical difference between an organization’s total cash inflows and its
total cash outflows, per time period.
The closing balance in a cash flow forecast refers to the value of cash held by a business at
the end of a trading period (usually the final day of the month), which therefore becomes the
opening balance for the next time period.
Closing balance = Opening balance + Net cash flow

Cash flow forecasting formulae

Net cash flow = Total cash inflow – Total cash outflow
Closing balance = Opening balance + Net cash flow
Opening balance = Closing balance in previous month
Note: Remember that a cash flow forecast (CFF) is different from a cash flow
statement (CFS).
A CFF is a prediction of the cash flows in and out of a business over the foreseeable future. The
CFS shows the actual cash inflows and outflows for a specified time period.
Cash flow is not the same as profit because a profitable business can still face liquidity
problems. This is because profit is declared if sales revenues exceed total costs of production,
whereas cash flow refers to the actual movement of money in and out of the organization. The
timing of these cash flows depends of the product’s working capital cycle, so whilst it might be
profitable, the firm can still experience cash flow issues.

Cash flow problems arise when an organization has insufficient funds to run its business, i.e.
when net cash flow is negative. Such problems can arise due to internal reasons (such as poor
cash flow management) and external factors (such as changes in consumer preferences and
tastes).

Examples of causes of cash flow problems include:

 A lack of financial planning resulting in sales revenue being lower than expected
 Poor credit control, which can lead to bad debts (debtors who are unable to pay for
their purchases that have been bought on trade credit)
 Poor cost control, resulting in costs of production being higher than budgeted
 Poor inventory control, resulting in overstocking of products (which have cost money to
purchase but have yet to be sold to customers)
 Overtrading, i.e. the firm expanding too fast, which increases cash outflows, but not
necessarily with the cash inflows
 Seasonal fluctuations in demand for the firm’s goods and/or services
 Unexpected events, such as a crisis or unforeseen costs that arise rapidly.

Strategies to reduce cash outflows

Possible strategies to reduce cash outflows include:

 Negotiate with creditors and suppliers to improve trade credit terms. Securing a longer
credit period helps to delay cash outflows.
 Pay for purchases of goods and services on trade credit, rather than using cash.
 Opt for leasing capital equipment instead of purchasing such assets. Although this
reduces the organization’s net assets on its balance sheet, it can provide much needed
liquidity for the firm.
 Reducing stock levels (inventories), as this can reduce cash outflows needed to pay for
purchasing stocks. This is particularly important for organizations with a long working
capital cycle.
Strategies to increase cash inflows
Possible strategies to increase cash inflows include:

 Raising prices of the products the business sells that have few substitutes or a high
degree of brand loyalty. Loyal customers are not overly sensitive to higher prices, so this
earns a greater profit margin for the business.
 Reduce prices of the products the business sells that have a high degree of competition.
This can help to attract customers from rival firms.
 Reducing the credit period helps to improve the cash flow cycle, because customers
buying on credit pay within a shorten time period. However, some customers may be
 unhappy about having to pay earlier, so may seek alternative providers that offer better
credit terms.
 Encourage debtors to pay their invoices early by offering discounts. This shortens the
working capital cycle.
 Improved marketing strategies to attract customers, raise brand awareness, boost sales
and develop customer loyalty.
 Use a debt factoring service to chase up outstanding debtors.
Strategies to seek additional sources of finance
Possible strategies to seek additional sources of finance include:

 Businesses will often rely on bank overdrafts or bank loans as additional finance when
faced with a liquidity problem. These external sources of finance can help the business
during times of negative net cash flow, or when it experiences a negative closing
balance. However, external finance incurs interest repayments, which can harm cash
outflows.
 Secure finance from sponsorships, donations or financial gifts. This can help to boost
cash inflows, thereby improving the cash flow position. However, these sources of
finance are not easily accessible to most businesses.
 Selling shares in a limited liability company in order to raise additional sources of
finance. Whilst this could bring in additional cash, it can be an expensive operation, and
such option is not available to sole traders and partnerships.
 In the worst-case scenario, an organization could sell its fixed assets to raise additional
finance. For example, the business could sell off its underused or out-dated assets. In
June 2020, British Airways decided to sell some of its multi-million-dollar art collection
in order to raise cash to help it get through the crisis caused by the coronavirus
pandemic.