Cash-flow forecasting and working capital
Cash refers to the physical money and funds immediately available in the bank. It is distinct from profit. A business can be profitable (making more revenue than expenses) but still fail if it runs out of cash.
Cash is critical for two main reasons:
- Solvency: The business must have enough cash to pay its short-term debts (e.g., wages, rent, supplier payments) as they fall due. If a business cannot pay its debts, it is insolvent and may be forced into liquidation.
- Liquidity: Cash provides the flexibility to seize opportunities (like buying stock at a discount) or handle emergencies without needing expensive external financing.
It calculates the net cash flow for each period:
\text{Net Cash Flow} = \text{Total Inflows} - \text{Total Outflows}
And the closing balance:
\text{Closing Balance} = \text{Opening Balance} + \text{Net Cash Flow}
To construct a forecast, you must identify when cash actually moves, not just when sales or purchases are made.
Key Components:
- Cash Inflows:
- Cash sales (money received immediately).
- Receipts from trade receivables (credit customers paying their bills later).
- Bank loans or overdrafts received.
- Sale of non-current assets (e.g., selling old machinery).
- Cash Outflows:
- Cash purchases (paying for stock immediately).
- Payments to trade payables (paying suppliers later).
- Wages and salaries.
- Rent, rates, and utilities.
- Interest payments on loans.
Why is it important?
- Identifying Shortfalls: It predicts months where the closing balance might go negative (a cash deficit), allowing the business to arrange finance (like an overdraft) in advance.
- Planning: It helps management decide when they have surplus cash to invest or pay off debts.
- Credibility: Banks require forecasts to assess if a business can repay a loan.
The Correction:
- If a business sells goods on credit, no cash comes in immediately. The cash inflow only occurs when the customer pays (receipt from trade receivables).
- If a business buys stock on credit, no cash goes out immediately. The cash outflow only occurs when the supplier is paid (payment to trade payables).
Examiner Note: Always check if the question specifies 'cash sales' or 'credit sales'. Only actual money moving in/out counts in a cash-flow forecast.
The Phrase: 'A negative closing balance indicates a cash deficit or liquidity problem, meaning the business does not have enough liquid funds to meet its immediate obligations.'
Why this works: Examiners look for the term 'deficit' or 'negative balance'. Simply saying 'the business loses money' is incorrect because it confuses cash flow with profit. You must specify that it is a liquidity issue, not necessarily a profitability issue.
- Rapid growth/Overtrading: The business expands quickly, requiring large upfront payments for stock and wages before customers pay their credit terms.
- Poor debt collection: Allowing trade receivables too long to pay means cash is tied up in unpaid invoices, reducing available liquidity.
If a business faces a temporary cash deficit, it can use several short-term solutions:
Bank Overdraft:
- Mechanism: The bank allows the business to withdraw more money than is in its account, up to an agreed limit.
- Pros: Flexible; interest is only paid on the amount used.
- Cons: Interest rates are usually high; it is a short-term solution only.
Delaying Payments to Suppliers (Trade Payables):
- Mechanism: The business asks suppliers for extended credit terms (e.g., from 30 days to 60 days).
- Pros: Keeps cash in the business longer without paying interest.
- Cons: May damage supplier relationships or result in loss of early-payment discounts.
Factoring (Selling Receivables):
- Mechanism: The business sells its trade receivables (invoices) to a third party called a factor at a discount. The factor pays the business immediately (minus a fee), and the factor collects the money from the customers later.
- Pros: Provides immediate cash; transfers the risk of bad debts to the factor.
- Cons: Expensive due to fees/discounts; may damage customer relationships if the factor is aggressive in collection.
Other Solutions:
- Chasing Debtors: Offering discounts for early payment or insisting on cash sales.
- Selling Non-Current Assets: Selling unused machinery or land to raise quick cash (though this reduces long-term capacity).
- Reducing Inventory: Selling off slow-moving stock at a discount to convert inventory into cash.
The Phrase: 'Using an overdraft would be appropriate because it provides immediate liquidity without the long-term commitment of a loan, which is suitable for temporary seasonal cash flow gaps.'
Why this works: Examiners award marks for application. You must link the solution to the context. For example, if the problem is 'seasonal,' an overdraft is good because it's flexible. If the problem is 'long-term expansion,' an overdraft is bad because it's short-term and expensive.
Working Capital is the capital available to a business for its day-to-day operations. It represents the funds used to pay short-term debts and expenses.
It is calculated as:
\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}
- Current Assets: Cash, inventory (stock), and trade receivables (money owed by customers) that will be converted to cash within one year.
- Current Liabilities: Trade payables (money owed to suppliers) and short-term loans due within one year.
Why is it important?
- Paying Day-to-Day Expenses: It ensures the business can pay wages, rent, and utilities without interruption.
- Maintaining Liquidity: Adequate working capital prevents cash-flow crises. If working capital is negative (Current Liabilities > Current Assets), the business is in a liquidity crisis.
- Supporting Growth: A business needs sufficient working capital to finance the gap between paying for stock/labor and receiving payment from customers.
- Credibility with Banks: A healthy level of working capital shows banks that the business is financially stable and capable of repaying loans.
The Correction: Working capital is the funds available to pay those costs, not the costs themselves. It is a stock of financial resources (Current Assets minus Current Liabilities), not an expense.
Examiner Note: Do not say 'Working capital is wages and rent.' Say 'Working capital is used to pay wages and rent.'
\text{Working Capital} = 100,000 - 40,000 = 60,000</span></p> <p><strong>Explanation:</strong><br>This positive working capital of60,000 is important because it provides a buffer for day-to-day expenses. It ensures the business can meet its short-term debts (like paying suppliers) and reduces the risk of insolvency. It also allows the business to handle unexpected costs without needing immediate external finance.
The Phrase: 'Although the business is profitable, it may have insufficient working capital because its funds are tied up in inventory and trade receivables. Profit is an accounting measure, whereas working capital measures liquidity.'
Why this works: This directly addresses the core distinction between profitability (income statement) and liquidity (balance sheet/cash flow). Examiners reward students who recognize that profit does not guarantee cash availability.