Cash flow forecasts

Firms usually exist to make a profit. However, it is also important for firms to monitor their cash flow position, otherwise they may not be able to pay their bills, supplier costs or wages. If they do not pay these they may be faced with closure.

It is vital, therefore for managers to track their cash flow position.

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A cash flow forecast

A cash flow forecast is an estimate of the timing and amounts of cash inflows and outflows into an organisation over a specific period, usually one year.

A cash forecast contains three main elements:

Cash inflows may arise from cash sales, debtors paying what they owe, interest received, bank loans, rent payments and disposal of assets.
Cash outflows occur when the organisation pays its creditors, makes cash purchases, buys assets, pays taxes, wages and rent and any other cash outgoing for business expenses. Not all of these pass through the profit and loss account.
Net cash flow is the difference between cash inflows and cash outflows. Ideally this should be positive, although organisations can survive negative cash flows if it can find cash from other sources, such as an additional bank overdraft.

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A positive cash flow is not profit and a negative cash flow is not a loss. Do not use these terms interchangeably.

A profitable business may run out of cash - this is called insolvency. This could be the result of selling output with too long a credit period or tying up funds in new assets. According to the UK Department of Trade and Industry more business failures result from lack of cash than any other reason. This is particularly true for new businesses. Too little cash can result in the following problems:

Non payment of suppliers
Discounts lost for late payment of bills
Wages and salaries may not be paid on time, causing poor motivation, high labour turnover, absenteeism and industrial unrest
New capital assets cannot be afforded
Tax cannot be paid.

Managing cash flow.

To manage cash, a firm will need to assess:

The size and timing of cash flows into the business
The size and timings of cash flows out of the business
Whether there are other sources of finance to cover short term need for cash

Cash-flow forecast.

A cash-flow forecast is an attempt by management to plan ahead and prevent future liquidity problems. Each month a firm estimates the amount of cash entering and leaving the business and whether this will result in a cash deficit (overdraft) or surplus. If an overdraft is predicted, the managers will have to consider potential solutions. These could include:

Arranging an overdraft with a bank
Arranging a longer term loan
Rescheduling payments or considering alternative purchase solutions, e.g. hire purchase, or possible leasing arrangements
Selling assets or postponing purchases
Finding cheaper suppliers
Reducing credit terms for customers or lengthening credit terms with suppliers

Some businesses are highly seasonal, e.g. farming, tourism. It is likely that firms in these industries will experience some cash-flow problems. If they make arrangements with banks to cover these periods then problems of insolvency may not arise

Alternatively, a firm may have too much cash during the year. This may result in the loss of interest as longer-term investments carry higher interest rates. Firms could also purchase more productive assets.

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Example 1 - cash-flow forecast

A typical cash-flow is shown below:

New Horizon Holidays

Cash flow forecast year ($000s)

Month	Jan.	Feb.	Mar.	Apr.	May	June	July
Receipts/inflows
Cash sales	100	120	240	280	430	500	540
Payments from debtors	50	100	100	140	200	340	450
Other (loan received)					80
*Total cash inflows*	150	220	340	420	710	840	990

Payments/outflows
Labour	20	40	50	60	100	180	200
Flights	40	75	90	100	180	190	210
Hotel bookings	30	80	120	140	250	260	300
Interest		20			20
Advertising	5	30	30
Electricity	15			15			15
Rent	50			50			50
Salaries	50	50	50	50	50	50	50
Purchase of fixed assets				60
*Total cash payments*	210	295	340	475	600	680	825

Net cash flow	(60)	(75)	(0)	(55)	110	160	165
Opening cash balance	70*	10	(65)	(65)	(120)	(10)	150
Closing cash balance	10	(65)	(65)	(120)	(10)	150	315

* January's opening balance of $70,000 is the closing cash balance from December

Similarly, January's closing balance of $10,000 becomes the opening balance of February.

Figures in brackets are negative, i.e. negative cash flow - an overdraft.

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Examiners like to add complications to cash flows. The most common are:

Delayed payments or receipts. It is common practice for firms to buy and sell products on credit. The examination question may give a table of sales or purchases but then say that the credit term is one month. It is important that you make the cash flow or inflow one month later. Remember this is cash forecast, not a record of other assets. In the following example the goods received in January are not paid for until February:

	Jan	Feb	March	April	May	June	July
Good received ($000)	20	30	30	25	40	50
Payment - cash outflow		20	30	30	25	40	50

Asset purchases made in instalments
Payment such as electricity may be payable every quarter

The important thing is to make sure that the timings of the cash inflows and outflows are accurate.

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Example 2 - Interactive cash flow forecast

Follow the link below to open up an interactive spreadsheet of a cash flow forecast. In this spreadsheet, you can change the values of the various receipts and payments and see the impact on the firms cash balance. Once you have experimented a bit with changing values, reset the spreadsheet (using the 'reset' button) and try the following questions.

Interactive cash flow forecast

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1	Cash flow forecast What will be the final cash balance if the firm's rent increases to $300? If the rent increases to $300, the final closing cash balance will be reduced to $188.

Perils of cash flow forecasting

A firm prepares a forecast, no more. It makes assumptions when preparing the forecast and there is no guarantee that all expectations or assumptions will be met. This means that cash flow forecasting has to be a continuous or ongoing process. The firm needs constantly to check on the cash position and identify problems before they happen, otherwise the firm may find itself in a liquidity crisis.

A liquidity crisis may be caused by a number of factors including:

Overstocking happens if the firm does not match its production or purchasing with final demand patterns and holds too much stock, which ties up liquid funds.
Overborrowing creates significant interest payments. If interest rates rise, these payments may be unsustainable.
Unexpected changes in the external environment may occur, such as seasonal variations and sudden changes in demand patterns.
Poor credit control can cause liquidity issues if the firm allows too much credit some of which may go 'bad' in recessionary times.
Overtrading occurs when a firm expands without securing the necessary long-term finance, which results in the reduction of working capital. If a firm accepts new orders, these may be profitable when sold. However, production ties up liquid funds in assets such as work-in-progress and the storage of stock as well as paying production expenses. The firm will not recover its liquidity until payment is made for the goods, which may not be for a long period, especially if the purchaser takes advantage of a credit period.

Accounts and finance

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