Chapter 27-Forecasting Cash flows.
The importance of cash flow
Profits do not pay for the running of a business, but cash does. Profits is of course important in the long
run, but initially, cash is need to run the business successfully
Cash flow: the sum of cash payments to a business (inflows) minus the sum of cash payments (outflows)
Liquidation: when a firm ceases trading and its assets are sold for cash to pay suppliers and other trade
Insolvent: when a business cannot meet its short term debts
Cash flow planning is vital for new entrepreneurs because:
- New business start-ups are often offered much less time to pay suppliers than larger, well
established firms, they are given a shorter credit period
- Banks and other lenders may not believe the promises of a new businesses owner, as they have
no trading record
- Finance is often very tight at start-up, so not planning accurately is of even more significance for
Cash inflows: payments in cash received by a business such as those from customers (debtors) or from
the bank, here are some examples:
- Customers cash purchases- these will be difficult to forecast as they depend on sales, so a sales
forecast will be necessary
- Debtors’ payments- these are difficult to forecast as these depend on two unknowns. Firstly
what is the likely level of sales credit and secondly when will the debtors actually pay
Cash outflows: payments in cash made by a business, such as those to suppliers and workers, here are
- Bank loan payments- this will be easy to forecast as this is under direct control.
- Lease for premises- easy to forecast as this will be in the details of property.
How to forecast cash flow?
Forecasting cash means trying to estimate future cash inflows and outflows, usually on a monthly basis.
Businesses have to plan this so that they always have a certain amount of money in the business at a
certain time, because if not, the business will have no “working capital” Debtor: customers who have bought products on credit and will pay at am agreed date in the future.
The structure of cash-flow forecasting
All cash flow forecasts have three basic sections:
Cash inflows: this section records the cash payments into the business, including cash sale, payments for
credit sales and capital inflows.
Cash outflows: this section records the cash payments by the business including wages and materials
Net monthly cash flow and opening and closing balance: this shows the net cash flow for the period and
the cash balances as the start and end of the period.
Uses of financial planning
- By showing periods of negative cash flow, plans can be put in place to provide additional finance
- If negative cash flow appears to be too great, then plans can be made for reducing theses.
- A new business proposal will never progress beyond the initial planning stage unless investors
and bankers have access to cash-flow forecast and the assumptions that lie behind it.
Limitations of financial planning
- Mistakes can be made in preparing the revenue and cost forecast or they may be drawn up by
inexperienced entrepreneurs or staff
- Unexpected cost increases may lead to major inaccuracies in forecasts.
- Wrong assumptions can be made in estimating the sales of the business, perhaps based on poor
Causes of cash flow problems
- Lack of planning: cash flow forecasts help greatly in predicting future cash problems in the
business. This form of financial planning can be used to predict potential cash-flow problems so
that business managers can take action to overcome them.
- Poor credit control: the credit control department of business keeps a check on all customers’
accounts, who’s paid and who hasn’t. If this credit control is inefficient and badly managed, then
debtors will not be chased up for payment and potential bad debts will not be identified.
- Allowing customers too long to pay debts: in many trading situations business will have to offer
trade credit to customers in order to be competitive; however allowing customers too long to
pay means reducing short term cash inflows, which could lead to cash-flow problems. - Expanding too quickly: when a business expands rapidly, it has to pay for the expansion for
increased wages and material months before it receives cash from addition