27Forecasting cash flows 27Activity 27.1 open-ended question.

27Forecasting cash flows 27Activity 27.1 open-ended question. Activity 27.2 (page 497): April cash flow 1 Draw up a revised cash-flow forecast for April assuming: cash sales are forecast to be $1,000 higher materials are forecast to be $500 higher other costs were forecast to be $1,000 higher. [8] April Revised April Cash inflows all figures in 000 Owner s capital injection 0 0 Cash sales 6 7 Payments by debtors 3 3 Total cash in 9 10 Cash outflows Lease 0 0 Rent 1 1 Materials 2 2.5 Labour 3 3 Other costs 1.5 2.5 Total cash out 7.5 9 Net cash flow 1.5 1 Opening balance 0.5 0.5 Closing balance 1 0.5 Activity 27.3 answer provided on Student s CD-ROM. Activity 27.4 (page 500) Using your knowledge of finance from Chapter 26, what sources of finance could a small business with ambitious expansion plans use to prevent cash-flow problems arising? [6] Sources of finance include: Bank loans to finance capital equipment bank loans have the advantage of providing set repayments and this aids financial planning. 1

Trade credit for purchase of stock this is only a short-term source of finance. Owner s capital this will help avoid over-dependence on debt financing. Activity 27.5 (page 500): Taxi firm s cash flow How would the following events be likely to affect the cash flow of a taxi-operating company: increase in oil prices increased unemployment lower train fares? [8] Event Increase in oil prices Increased unemployment Lower train fares Effect on cash flow This will lead to an increase in the price of fuel for the taxis. This will lead to an increase in cash outflows. This could lead to a reduction in demand for taxi services as customers travel less. This in turn reduces cash inflows. Less demand will also reduce some of the cash outflows such as fuel purchases. This could lead to an increase in demand for taxis as train passengers use taxis to complete their journeys. There will, therefore, be an increase in cash inflows from customers as well as outflows associated with fuel purchases. Activity 27.6 (page 503): Cash flow drying up for Indian small firms 1 Explain the term working capital. [3] Working capital may be defined as current assets less current liabilities. Working capital is necessary to fund the day-to-day running of the business. 2 Explain why Mr Gupta is finding it so difficult to control his working capital. [9] Mr Gupta is finding it difficult to control his working capital because of the pressures being placed on cash inflows and outflows including: Customers are demanding credit terms for purchases, thus delaying cash inflows. Customers are expecting discounts, thus reducing cash inflows relative to cash outflows. The global recession has caused a drop in demand for machines for which his business has already outlaid cash. Falling demand has resulted in a lack of cash inflows. 3 Evaluate three ways in which Mr Gupta could try to reduce the finance tied up in working capital. [12] 2

Method Reduce stock Commentary This may be difficult to achieve in the short term due to the recession having reduced sales. Mr Gupta might be forced to reduce prices considerably in order to shift machines, but this could result in losses being made on sales. In the longer term, the firm should consider just-in-time (JIT) stock control, but whether this is feasible depends on the food and chemical plants expectations of lead time for delivery of equipment. Negotiate better credit terms with suppliers Controlling costs Mr Gupta could put pressure on his suppliers to offer extended credit terms. This will allow more time for the receipt of income from customers. As suppliers also face cash-flow problems, they will be reluctant to extend credit terms; however, due to falling sales they may be forced to accept what Mr Gupta wants. This could be achieved by reducing administrative and production costs. It may be necessary to reduce worker hours or negotiate a pay reduction for employees. It may be possible to replace labour with machinery this has an impact on short-term capital availability, but will reduce the working capital requirements over the longer term. This may be an unsuitable strategy as Mr Gupta faces a short-term crisis and needs to reduce working capital requirements immediately; therefore, negotiating wage reductions with staff would be preferable. Revision case study 1 (page 504): Gita Fashions Ltd 1 Prepare a three-month cash-flow forecast for Gita s business starting in July. [6] ($000) July August September Cash inflows Cash sales 6 6 3 Payments by debtors 8 6 6 Total cash in 14 12 12 Cash outflows Materials 8 6 6 Labour 3 3 3 Overheads 6 6 6 Total cash out 17 15 15 Net cash flow 3 3 6 Opening balance 15 18 21 Closing balance 18 21 27 3

2 Would you advise the bank manager to increase the overdraft limit? Explain your answer. [4] No Gita s business is haemorrhaging cash. The forecast shows a deterioration in its cash position of $12,000 between the start of July and the end of September. The bank would be exposing itself to greater potential losses by extending the overdraft. Yes If the bank does not extend the overdraft, it is possible that the supplier which is owed money will seek to have Gita Fashions Ltd declared bankrupt so that they are able to recover some of their debt. If that happens, then the bank may not recover all of the money that it is owed. Extending the overdraft would provide Gita a breathing space to sort out cash-flow problems and put her business on a secure financial footing; this would enable the bank to recover all of its debts in the longer term. 3 What additional information would help you to advise the bank manager? [4] A cash-flow forecast over a longer time period would be helpful to assess whether the monthly cash flows will continue to be negative. Sales, and therefore cash flow, may be highly seasonal. Projected trading and profit and loss accounts for the business would help identify its ability to repay any borrowing. A balance sheet would give a clear indication of the ability of Gita Fashions Ltd to repay debt. A business plan would show how Gita intends to turn the business around. 4 Explain to Gita how a cash-flow forecast might have helped her business avoid the problem it now faces. [6] A cash-flow forecast may have identified the cash-flow problems the business is currently facing. This would have enabled Gita to be proactive in implementing measures to avoid cash shortages. Gita may have been able to: negotiate with suppliers to extend credit periods reduce cash outflows by analysing overheads and identifying where savings could be made increase cash inflows through more careful control of credit terms offered. Revision case study 2 (page 504): Setting up in business 1 Explain two ways in which the increase in interest rates could have an impact on the cash-flow forecast. [6] An increase in interest rates represents an increase in the cost of borrowing. As such, it will affect Asif s building business in two main ways: Increase cash outflow Asif intends to finance his business using both a start-up loan and an overdraft facility. An increase in interest rates will increase interest payments on Asif s borrowing. This will increase the overheads of the business. 4

Reduce cash inflow as Asif is starting a building business, demand for its services is likely to be affected by the rate of interest. An increase in interest rates may put off some customers from having extensions built as the repayments they make from any borrowing will rise. Thus, there will be a drop in demand for house extensions and a reduction in cash inflows for Asif s business. 2 If inflation did rise, how would this be likely to affect the cash flow of the business? [4] As the text comments, inflation relates to the rate at which prices were rising. Thus, an increase in inflation would put upward pressure on the costs of Asif s building business. Material costs, labour costs and overheads would be likely to increase. As a consequence, cash outflows from the business would rise. It is possible that Asif would be able to pass on some of these increased costs to customers, but much would depend on the extent to which customers are sensitive to price increases. It is also possible that an increase in inflation may undermine consumer confidence and consumers would, therefore, be less likely to proceed with major expenditures such as house extensions. Top tip There is no one definitive answer to this question. The overall impact will depend on many factors such as the extent to which there is a rise in inflation and the reaction of the monetary authorities. The examiner is looking for reasoned argument. In this case, given the low number of marks, a detailed response is not required; rather an appreciation of how inflation might affect cash inflow and outflow. 3 Discuss the usefulness to Asif of constructing the cash-flow forecast as part of the business plan. [6] Constructing a cash-flow forecast as part of a business plan will benefit Asif in the following ways: It will help secure finance. Asif s forecast indicates that his business will be short of finance in its first six months of trading. However, it provides clear evidence that the cash position of the business is improving by the end of the period, with July and August showing net cash inflows of $2,000 and $4,000 respectively. Thus, if the bank is convinced by the assumptions underlying the forecast, it may look favourably on Asif s application for finance. It will help avoid cash-flow problems. By identifying times during which his business has scarce cash resources, Asif would be able to plan how to deal with that problem. For example, he will ensure that he is able to meet the $23,000 shortage of cash in June. Many businesses fail due to being unable to meet their short-term debts. By preparing a cash-flow forecast and taking action in the light of any cashflow problems identified, Asif is more likely to avoid insolvency. This may be particularly important in the building trade as money is often tied up in stock and work-in-progress. Thus, there may be a significant time gap between cash outflows for supplies and labour and cash inflows for completed work. 5

4 Suggest to Asif four ways in which he might reduce the negative cash flows of his business in the first six months. [4] Offer less credit on sales. Cash sales in March are particularly low, although debtor payments in April indicate that substantial sales are anticipated in March. Negotiate longer credit terms on purchase of materials. Negotiate phased payments on capital expenditure. Reduce non-essential overheads. Increase capital injection in March. Essays 1 a Explain how a profitable business might run out of cash. [8] A business is profitable if its revenues exceed its costs. However, profit is not the same as cash flow; cash inflows from sales will be delayed where goods are sold on credit and cash outflows may result from capital expenditures which are not recorded in the profit and loss account. For example, investing in new machinery will generate a cash outflow, but, in calculating profit, it is the depreciation of that machinery, spread over a number of years, which is relevant, not the initial cash outflow. Consequently, there is a significant difference between profitability and solvency. Businesses may run out of cash for a number of reasons including: Overtrading this involves expanding a business too fast for the available finance. Holding too much stock stock drains cash from the business as it has to be paid for. Thus, it may lead to cash-flow problems. However, holding large quantities of stock may have only a marginal effect on profitability (increased costs of stock holding). Giving too much credit sales made on credit are recorded as revenue in the profit and loss account and thus contribute to profit. However, there is only a cash inflow when debtors settle their accounts. A cash-flow problem may arise if the firm pays its own debts quickly but allows long credit terms to customers. Seasonal fluctuations this can make cash-flow management very difficult. Revenues may vary seasonally but cash outflows, such as rent, interest on loans and salaries, remain relatively constant. This will drain working capital during the off-season. Thus, even though over the course of a 12-month period the business may be profitable, during the off-season it may run out of cash. b Analyse and evaluate the importance of cash-flow forecasting to a business experiencing rapid expansion. [17] This questions centres on the issue of overtrading. A business needs to manage its working capital carefully, as it expands, to avoid cash-flow problems. If there is insufficient finance in place to fund expansion, then insolvency is possible. The problem typically arises because there may be cash outflows to pay for capital equipment, stock and extra workers as a business expands, but cash inflows are 6

delayed as the business waits for demand to increase and customers to pay for purchases. Cash-flow forecasting, as part of the planning process, will help a business identify, in advance, likely cash-flow problems. The business can then take action to find the necessary finance to fund growth. Although cash-flow forecasting is important, it is only as good as the accuracy of the assumptions on which it is based. If the wrong assumptions are made, then the cash-flow forecast will be inaccurate and it will be of limited use to the business. Further, when a business is experiencing rapid expansion, it will be more difficult to predict cash flows accurately. Top tip Don t wait until the conclusion to answer the question. It is often a good idea to make your judgement in the introduction. 2 a Explain the importance of cash-flow forecasting to a new entrepreneur. [10] Definition of cash-flow forecast: this is a prediction of the cash inflows and cash outflows of a business in a given time period. Many firms that go out of business do so because of cash-flow problems. Firms cannot continue to trade if they are unable to pay their wages and suppliers due to a lack of cash. This is particularly a problem for new businesses, as in the first months of trading there is often a significant pressure on cash flow a new business will typically face set-up costs and running costs which drain cash from the business and it may be some time before sales start to generate cash inflows. Consequently, it very important for a new business to prepare a cash-flow forecast. It will help to predict when there may be a shortage of cash. Thus, the business will be able to advise its bank that it might need to borrow some money to cover the cash shortfall. A forecast can be used as a means of control. If successive monthly cash outflows are identified, then the business can plan how to deal with this problem. A new business will need to attract investors and bankers. A cash-flow forecast based on sound assumptions is usually necessary to persuade banks to back the business venture. b Evaluate three ways in which a building company, operating in a very competitive market, might try to improve its weak cash-flow position. [15] A difficulty faced by building firms is that there is often a significant time delay between cash outflows for purchasing land and materials and paying labourers and receiving cash inflows from the sale of property or payment with respect to building work completed. This delay may be for many months as new housing may take time to sell. Building firms will often have high levels of stock, for example building materials, and work-in-progress. This will cause a large outflow of cash 7

with little prospect of an early inflow of cash. Building firms may also face seasonal fluctuations in demand leading to seasonal cash inflows. There are a number of solutions to improve the cash-flow position: Improving stock control as stock is a significant factor for building firms, this would appear to be an area to consider carefully. The building company should delay purchase of and payment for stock until the last possible moment. This will require careful planning, e.g. the use of critical path analysis to ensure that stock is on hand at the right time. The downside to this approach is that opportunities for bulk-buying discounts may be lost. If that is the case, then it may affect their ability to set competitive prices when tendering for contracts. Further, any delay in arrival of vital stock could result in workers being left with nothing to do but still requiring payment. Reducing credit periods payment from debtors is another significant issue to a builder. Thus, when entering into contracts for work the builder might ensure that payments are staggered. Some of the money may be paid up front with the remainder at specified points during and following the building work. However, as this is a competitive market, insistence on upfront payments may deter potential customers and lose the firm new contracts. Avoid overtrading in considering new contracts for work the firm should take care to avoid over-extending itself. Taking on too many building jobs will place a strain on the working capital of the business. Factoring this involves selling debt to a specialist debt-collection agency. The building company will receive part of the value of the debt immediately from the debt factor, who will then collect the full amount from the debtor. Factoring will provide around 80% of the value of debts factored. This enables the builder to ease cash flow without giving up any independence. However, it can send out a message that the building firm has problems. Leaseback the building company may well have fixed assets which it can sell and lease back, such as machinery and the premises from which it operates. Although this generates immediate cash inflow, it is at the price of long-term rental expense; thus, profit will ultimately be reduced. Overdraft this is a short-term bank loan. Overdrafts have high interest rates and should, therefore, be used only for short periods wherever possible. As interest is an expense to the business, it reduces profitability. Note on developing context and evaluation: This question concerns a builder in a competitive market, therefore reference might be made to issues such as: stocks of building materials, e.g. bricks capital equipment, e.g. scaffolding and machinery such as diggers employees, e.g. carpenters contractors, e.g. electricians. Evaluation may consider: As the market is competitive, it will be necessary to remain competitive in terms of cost and service. Thus, changes which negatively affect prices and service quality may lead to a reduction in demand, causing problems for the business in the future. Consideration of this issue may lead to evaluation being rewarded. Evaluation may also be rewarded for justifying the most beneficial solution to the business from the three methods identified. 8

Further reading Red Letter Days owes us thousands, say suppliers. Daily Telegraph article on the demise of Red Letter Days, a gift-experience business: http://www.telegraph.co.uk/finance/2919862/red-letter-days-owes-us-thousands-saysuppliers.html Working Lunch cash flow. Working Lunch is a BBC business programme. This article relates to a 2001 broadcast and considers the importance of cash flow to the success of soft-drinks manufacturer Innocent Smoothies: http://news.bbc.co.uk/1/hi/programmes/working_lunch/education/1604537.stm Working Lunch cash flow. This is another case study from the BBC s Working Lunch website. It explains the difficulties that seasonal demand can create for a business: http://news.bbc.co.uk/1/hi/programmes/working_lunch/education/1791212.stm 9