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1 Cash Management How and Why Businesses Need to Manage their Cash AS & A2 Business Studies PowerPoint Presentations 2005

2 Importance of Cash (1) A business can exist for a while without making profits but A business cannot exist without cash

3 Importance of Cash (2) Profit is a matter of opinion but Cash is a matter of fact

4 Cash versus Profit Cash and profit are not the same thing: A business may sell goods at a profit to a customer but until the customer pays there is no increase in cash Production and operating costs are not reflected in cash until they have been paid for Profit reflects adjustment for things like depreciation (the reduction in the value of fixed assets) that do not involve cash at all Cash may increase due to new investment by shareholders (e.g. issuing new shares) or by raising finance from the bank neither of which affects the operating profit of the business

5 The Cash Management Trade Off To manage its cash successfully, a business faces a trade off between: The cost of holding cash The costs of running out of cash Costs of holding cash The opportunity cost of what else could be done with the money Cash is often an idle asset earning a low return (e.g. bank interest) If cash were put to work elsewhere in the business (i.e. invested ) it could generate profits Costs of running out of cash (examples) Loss of supplier goodwill (may refuse further credit; withdraw discounts etc) Poor industrial relations if wage payments are delayed Ultimately creditors may seek to put the business into receivership in order to recover the amounts owed to them

6 Influences on Cash Balances Four main motives for a business to hold cash (1) Transactions motive To meet current, day to day obligations (e.g. payroll; purchase of raw materials) (2) Finance motive To cover major items such as repayment of bank loans and purchase of fixed assets (3) Precautionary motive Provides a cushion or safety net against unplanned expenditure (4) Investment motive Hold cash so that a business can quickly take advantage of investment opportunities

7 Causes of Cash Flow Problems Making losses If a business keeps making losses eventually it will have cash flow problems Remember that cash is different from profit. For example, losses may be due to a large depreciation charge so cash flow might still be positive Growth As a business grows, it needs to finance higher capacity (e.g. more fixed assets, new locations, more staff) Working capital also tends to grow (e.g. stocks and trade debtors rise) Seasonal changes Many industries have seasonal sales patterns which create cash flow problems at certain times of the year (e.g. sales may be seasonally low, but stocks have to be built up and paid for ahead of a busier sales season) One off items E.g. a repayment of a bank loan; a purchase of a high value fixed asset; the settlement of an annual tax liability

8 Ways to Deal with a Cash Shortage Postpone capital expenditure Often investment projects can be delayed without serious problems for a business (running out of cash is much more serious) Advantage is that this can often generate large cash flow savings Encourage debtors to pay quicker Sometimes it is enough to simply insist that trade debtors pay on time Risk that customer goodwill may be lost Consider offering early payment or settlement discounts Sell fixed assets, investments or other surplus assets Are there any assets that are surplus to requirements? May have to accept a lower than expected value if a quick sale is needed Negotiate reductions in payments Ask trade creditors for extended credit (risk that suppliers will refuse) Negotiate rescheduling of finance payments (e.g. bank interest, repayments) Reduce or stop dividend payments (needs agreement of shareholders)

9 Aims of Good Cash Management The main aim of cash management is to have: The right amount of cash available At the right time What is involved in good cash management Accurate cash flow budgeting and forecasting Obtaining short term borrowing when required Investing cash surpluses when they arise

10 Main Components of Cash Flow The main inflow of cash is usually the cash from sales If a business sells on credit, cash inflow is delayed until customers actually pay up. Effective credit control is essential A business which purchases on credit and is paid in cash (e.g. a supermarket retailer) is at an advantage in terms of cash flow The main outflow of cash is on operating costs, tax and fixed assets Payroll costs are often the largest and most inflexible cost Other major costs might include stock, raw materials and any capital expenditure Many businesses have to fund large amounts of work in progress VAT and tax are regular cash outflows that tend to be paid out in large amounts every 3 6 months Many businesses buy their fixed assets outright. However, there is often an option to finance fixed assets via leasing or hire purchase which helps smooth monthly cash flow

11 Purpose of a Cash Flow Budget Identify when cash outflows might exceed cash inflows Plan when and how to finance significant items of expenditure Ensure that cash balances are available to meet budgeted payments Highlight when cash balances are expected to be positive so that surplus cash can be invested appropriately Create information for key stakeholders so that they can understand and assess the future cash flows of the business (e.g. shareholders; banks)

12 Creating a Cash Flow Budget Start by Creating the Trading Budget Sales Production Materials Labour Other Costs Budget sales volume x price = sales revenue Work out what stock levels are required Opening stock + production closing stock = sales Material purchases are determined by production (above) Again determined by the production budget What labour hours are required to deliver budgeted output? Cost = labour hours * pay rates Budget for variable costs (e.g. distribution costs; sales commission) & fixed costs (e.g. overheads)

13 Turning the Trading Budget into a Cash Flow Budget Sales What proportion of sales are made by offering customers credit? How long will credit customers take to pay up? What discounts need to be offered to customers? What will the level of bad debts be? Purchases What proportion of purchases are obtained from suppliers who supply on credit What period of credit can be taken before suppliers need to be paid What are the major items of capital expenditure? When do they arise in the year and how are they to be financed? What is the timing of other key cash flows? Payment of taxation Payments to providers of finance (e.g. dividends, bank interest; loan repayments)

14 Cash Flow Budget Example Jan Feb Mar Apr May Jun Total '000 '000 '000 '000 '000 '000 '000 RECEIPTS (A) Cash Sales Cash from Trade Debtors Sales of Assets Total Cash Receipts PAYMENTS (B) Cash purchases (materials) Payments to Trade Creditors Wages and Salaries Other Overheads Payment for Fixed Assets Bank Loan Repayments VAT and Other Taxation Total Cash Payments Net Cash Flow (A B) Opening Cash Balance Closing Cash Balance

15 Example Cash Flow Budget Comments Overall the business generates a positive cash flow over the six months Total cash receipts ( 3,115,000) are 175,000 more than total cash payments ( 2,940,000) The bulk of cash receipts come in April June A cash outflow is expected in each of the first three months The maximum cash outflow is in March ( 285,000) due to the large payment to trade creditors and a quarterly VAT payment Budgeted fixed asset payments of 90,000 in February contribute to another large cash outflow Funding the cash flow The business needs short term financing of at least 355,000 (budgeted cash shortfall at the end of March The obvious way to finance this would be to arrange an overdraft facility

16 Short term Funding There are several ways in which a business can raise short term funding to cover expected cash shortages Bank overdrafts A common form of short term borrowing Ideally used to fund fluctuations in working capital Technically repayable on demand to the bank so not risk free Banks charge a fee for agreeing the facility and interest on the balance actually used ( drawn down ) Short term bank loans More commonly arranged to finance specific projects Business may have to provide some security to the bank (e.g. a charge over the trade debtors and stocks of the business) Debt factoring and invoice discounting Involves bringing forward the receipt of cash from trade debtors Expensive

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