Cash and cash flow forecasts

Last time

Before we start: last time, in Methods of production, efficiency and lean production, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Cash is not profit

A business can be profitable and still fail, because it runs out of cash to pay its bills. Cash is the money it actually has, now. This lesson covers why cash matters, how to read and complete a cash flow forecast, and how to solve a cash shortage.

Why cash matters

Cash pays wages, suppliers, rent and loan repayments. Without it, workers and suppliers stop working with the business. A business with no cash may be forced to close by its creditors, even if it sells a lot. Cash is also needed to take opportunities, such as a cheap bulk order.

Cash inflows and outflows

Cash inflows are money coming in: cash sales, payments from credit customers, loans, and money from selling assets. Cash outflows are money going out: wages, raw materials, rent, electricity, loan repayments and buying equipment. Net cash flow is inflows minus outflows for the month.

The cash flow forecast

A cash flow forecast is an estimate of the cash inflows and outflows over the next months. Each month: opening balance, plus net cash flow, gives the closing balance. The closing balance becomes next month's opening balance. It warns when cash will be short, so action can be taken early.

A forecast, worked

The business starts January with 1,000 dollars. In January, inflows of 5,000 minus outflows of 4,500 give 500, so it closes at 1,500. February: 4,000 minus 5,500 is minus 1,500, so it closes at zero. March: 6,000 minus 4,800 is 1,200, closing at 1,200.

Reading the forecast

February's closing balance is zero: the business has no cash left, and any surprise cost would leave it unable to pay. The cause is February's outflows being bigger than its inflows. The forecast shows the problem in advance, so the owner can arrange an overdraft or delay a payment.

Causes of cash flow problems

Giving customers too long to pay, while paying suppliers quickly. Holding too much inventory, which ties up cash. Expanding too fast, unexpected costs, or a fall in sales.

Solving short-term problems

Increase inflows: ask customers to pay sooner, or offer discounts for quick payment; sell unused assets. Reduce or delay outflows: ask suppliers for longer credit, delay buying equipment, or lease instead of buying. Arrange an overdraft or short-term loan to cover the gap.

Cash and profit

Profit is revenue minus costs over a period. Cash is the money held at a moment. A business can make a sale on credit, so profit rises, but no cash comes in until the customer pays. That is why profitable businesses can still run out of cash.

Limits of a forecast

A forecast is only as good as its estimates. Sales may be lower than expected, or costs higher. Unexpected events, such as a machine breaking or a price rise, change the figures. So it should be updated regularly.

Mistakes that lose marks

Mistake one: saying cash and profit are the same. Mistake two: in a forecast, forgetting that the closing balance becomes next month's opening balance. Mistake three: suggesting a long-term solution, such as selling shares, for a one-month cash shortage. The fix: careful arithmetic, and a short-term solution that fits.

The full-marks tip

The full-marks tip: in a forecast, work month by month: opening plus inflows minus outflows equals closing. For a solution, say how it raises inflows or cuts outflows, and its drawback.

On one card

So, on one card: cash flow. Keep it for revision.