Topic 3.

7 Cash flow
Introduction

In financial accounting, a cash flow statement, also known as statement of cash

flows, is a financial statement that shows how changes in balance sheet accounts
and income affect cash and cash equivalents, and breaks the analysis down to
operating, investing and financing activities.

Cash flow describes movement of cash into (inflows) and out of a business
(outflows) as a business operates. It is dangerous for a business to keep too much
or too little cash and so, it must keep just the right amount of cash.

Why the cash flow forecast is so important

If a business runs out of cash and is not able to obtain new finance, it will become
insolvent. An insolvent business can be forced into liquidation where the firm
ceases trading, and its assets are sold off to pay her creditors. It is no excuse for
management to claim that they didn't see a cash flow crisis coming.

So, in business, "cash is king". Cash flow is the life-blood of all businesses –
particularly start-ups and small enterprises. As a result, it is essential that
management forecast (predict) what is going to happen to cash flow to make sure
the business has enough to survive

On completion of this chapter, you should be able to:

Analyse and apply:

 The difference between profit and cash flow

 The working capital cycle
 Cash flow forecasts and make calculations to amend them
 The relationship between investment, profit and cash flow

Evaluate strategies for dealing with cash flow problems:

  reducing cash outflow
 improving cash inflows
 looking for additional finance

3.7.1 Cash flow and profit

Distinguish between cash flow and profit?

3.7.2 The working capital cycle

 Define and give examples of:

– working capital
- Liquidity
- Current assets
- Current liabilities
 Describe the working capital cycle and its relationship to how much cash a
business needs.

 Why it’s not desirable to have too little or too much working capital

Enough working capital must be present in an organization to allow production

to take place. If a firm has too little working capital, then it will be difficult for
the company to trade with other companies and run into liquidity problems.
See example below.

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coronavirus/index.html

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CEO Secrets: 'I was making money, but had no money' - BBC News
 On the other hand, having too much capital tied up in raw materials or finished
goods with a large amount of cash reserves in the bank account may mean the
firm is missing out on potential profitable opportunities. Holding too much
stock may also create additional costs. Therefore, firms must strive to have
just enough working capital, not too much or too little. How much cash is
needed depends on the working capital cycle.

3.7.3 Cash flow forecasts

Define cash flow forecast

With examples, describe cash inflows

With examples, describe cash outflows

Define, “net cash flow”

What are the reasons businesses conduct cash flow forecasts?

 Identifies potential shortfalls in cash balances in advance – think of the

cash flow forecast as an "early warning system". This is the most important
reason for a cash flow forecast
 Makes sure that the business can afford to pay suppliers and
employees. Suppliers who don't get paid will soon stop supplying the
business; it is even worse if employees are not paid on time
 Spot problems with customer payments – preparing the forecast
encourages the business to look at how quickly customers are paying their
debts. Note – this is not really a problem for businesses (like retailers) that
take most of their sales in cash/credit cards at the point of sale.
 As an important discipline of financial planning – the cash flow forecast is
an important management process, similar to preparing business budgets.
  External stakeholders such as banks may require a regular
forecast. Certainly, if the business has a bank loan, the bank will want to
look at cash flow forecasts at regular intervals

3.7.4 Structure of the cash-flow forecast

Cash flow statement has 3 sections:

Section 1: Cash inflows

Section 2: Cash outflows

Section 3: Net monthly cash flow and opening and closing balance

Describe:

 Opening balance

 Closing balance

Cash flow statement template

Item Jan Feb Mar Apr

Opening balance [A]
Cash inflows
Cash received
Sale of assets
overdrafts

Total inflows [B]

Cash outflows
Rent
Wages
Materials
Interests
Loan repayment
Total outflows [C]
Net flows [D] = [B-C]
Closing balance
[A+D]

Example of a cash flow statement

 Example 2 of cash flow statement

Note that, the closing balance of one period (month) is the opening balance of the
period. For example, the closing balance for December is the opening balance for
January of the following year.
Worked example

Cash inflows Jan Feb March April

 Owner’s capital 3
injections 4
 Cash sales 1
 Payments by debtor 1
 Loan capital

Total cash in 9 6 8 9
Cash outflows
 Lease
 Rent
 Material
 Labour
 Other costs
Total outflows 11 5 7.5 7.5
Net cash flows (inflows- (2) X Y Z
outflows)
Opening balance 0 (2) (1) (0.5)
Closing balance (2) (1) (0.5) 1
(net flow + opening
balance)
NB: The closing balance of one period is the opening balance of the next period.

NOTE: Remember to identify the exact period when cash came in or left the
business. For example, if goods worth $1200 are sold on credit payable 50% in
the second and 3rd month, no cash will flow in in the first month even though
sales took place in this month. $600 will flow in in the 2nd month and another
$600 in the 3rd month.

Analyse the cash-flow for the above business.

What does the above table tell the owner of this business about the prospects for
his business?

The business appears to be struggling for cash in the first 3 months but gets into a
good position at the end of the four months. We think it has a good prospect
because:

One, the closing balance in April is positive, so the bank overdraft has been fully
paid.

Furthermore, there was only one month, the first month of operation, in which
the net cash flow was negative.

Finally, the net cash flow is increasing each month. This shows the business has a
bright future.

3.7.5 Cash flow problems

Explain what is meant by “cash flow problems”

What are the causes of cash flow problems?

Evaluate the following strategies for dealing with cash flow problems:

 reducing cash outflow by doing what?

 improving cash inflows by doing what?

  looking for additional finance. From where?
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Describe the relationship between investment, profit and cash flow

Distinguish between ‘cash flow statement’ and cash ‘flow forecast’

Explain some of the limitations of cash-flow forecasting

Remember that whereas cash flow forecasting does not solve cash flow problems,
they are essential part of financial planning and can help prevent cash-flow
problems from developing.

3.7.6 Cash flow and the CUEGIS concepts

HW
Finished this Homework handwritten

Worked Examples
Answers
Next topic: 3.8 Investment Appraisals