Why is cash important?

If a firm doesn’t have any cash to pay its workers, suppliers, landlord and government, the business could go into liquidation– selling everything it owns to pay its debts. The business needs to have an adequate amount of cash to be able to pay for all its short-term payments.

Cash Flow

The cash flow of a businesses is its cash inflows and cash outflows over a period of time.

Cash inflows are the sums of money received by the business over a period of time. E.g.:

  • sales revenue from sale of products
  • payment from debtors– debtors are customers who have already purchased goods from the business but didn’t pay for them at that time
  • money borrowed from external sources, like loans
  • the money from the sale of business assets
  • investors putting more money into the business

Cash outflows are the sums of money paid out by the business over a period of time. Eg:

  • purchasing goods and materials for cash
  • paying wages, salaries and other expenses in cash
  • purchasing fixed assets
  • repaying loans (cash is going out of the business)
  • by paying creditors of the business- creditors are suppliers who supplied items to the business but were not paid at the time of supply.

The cash flow cycle:

Cash Flow Diagram

Cash flow is not the same as profit! Profit is the surplus amount after total costs have been deducted from sales. It includes all income and payments incurred in the year, whether already received or paid or to not yet received or paid respectfully. In a cash flow, only those elements paid by cash are considered.

Cash Flow Forecasts

A cash flow forecast is an estimate of future cash inflows and outflows of a business, usually on a month-by-month basis. This then shows the expected cash balance at the end of each month. It can help tell the manager:

  • how much cash is available for paying bills, purchasing fixed assets or repaying loans
  • how much cash the bank will need to lend to the business to avoid insolvency (running out of liquid cash)
  • whether the business has too much cash that can be put to a profitable use in the business

Example of a cash flow forecast for the four months:

Cash flow forecast

The cash inflows are listed first and then the cash outflows. The total inflows and outflows have to be calculated after each section.

The opening cash/bank balance is the amount of cash held by the business at the start of the month

Net Cash Flow = Total Cash Inflow – Total Cash Outflow

The net cash flow is added to opening cash balance to find the closing cash/bank balance– the amount of cash held by the business at the end of the month. Remember, the closing cash/bank balance for one month is the opening cash/bank balance for the next month!

The figures in bracket denote a negative balance, i.e., a net cash outflow (outflows > inflows)

Uses of cash flow forecasts:

  • when setting up the business the manager needs to know how much cash is required to set up the business. The cash flow forecast helps calculate the cash outflows such as rent, purchase of assets, advertising etc.
  • A statement of cash flow forecast is required by bank managers when the business applies for a loan. The bank manager will need to know how much to lend to the business for its operations, when the loan is needed, for how long it is needed and when it can be repaid.
  • Managing cash flow– if the cash flow forecast gives a negative cash flow for a month(s), then the business will need to plan ahead and apply for an overdraft so that the negative balance is avoided (as cash come in and the inflow exceeds the outflow). If there is too much cash, the business may decide to repay loans (so that interest payment in the future will be low) or pay off creditors/suppliers (to maintain healthy relationship with suppliers).


How can cash flow problems be overcome?

When a negative cash flow is forecast (lack of cash) the following methods can be used to correct it:

  • Increase bank loans: bank loans will inject more cash into the business, but the firm will have to pay regular interest payments on the loans and it will eventually have to be repaid, causing future cash outflows
  • Delay payment to suppliers: asking for more time to pay suppliers will help decrease cash outflows in the short-run. However, suppliers could refuse to supply on credit and may reduce discounts for late payment
  • Ask debtors to pay more quickly: if debtors are asked to pay all the debts they have to the firm quicker, the firm’s cash inflows would increase in the short-run. These debtors will include credit customers, who can be asked to make cash sales as opposed to credit sales for purchases (cash will have to be paid on the spot, credit will mean they can pay in the future, thus becoming debtors). However, customers may move to other businesses that still offers them time to pay
  • Delay or cancel purchases of capital equipment: this will greatly help reduce cash outflows in the short-run, but at the cost of the efficiency the firm loses out on not buying new technology and still using old equipment.

In the long-term, to improve cash flow, the business will need to attract more investors, cut costs by increasing efficiency, develop more products to attract customers and increase inflows.

Working Capital

Working capital the capital required by the business to pay its short-term day-to-day expenses. Working capital is all of the liquid assets of the business– the assets that can be quickly converted to cash to pay off the business’ debts. Working capital can be in the form of:

  • cash needed to pay expenses
  • cash due from debtors – debtors/credit customers can be asked to quickly pay off what they owe to the business in order for the business to raise cash
  • cash in the form of inventory –  Inventory of finished goods can be quickly sold off to build cash inflows. Too much inventory results in high costs, too low inventory may cause production to stop.




Notes submitted by Lintha

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5 thoughts on “5.2 – Cash Flow Forecasting and Working Capital

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