FINANCIAL PERFORMANCE – CASH FLOWAQA Business

5 DECISION MAKING TO IMPROVE FINANCIAL PERFORMANCE

Do you agree with these quotes?

“Sales for vanity, profit for sanity but cash is king”

“Profitable businesses can still go under if they run out of cash at a critical moment. Forecasting is the most focused method of avoiding that obstacle.”

Peter Jones

5.2.2 FINANCIAL PERFORMANCE – CASH FLOW

In this topic you will learn about

Analysing financial performance

How to construct and analyse cash flow forecasts

How to analyse timings of cash inflows and outflows

The use of data for financial decision making and planning

Making financial decisions

Methods of improving cash flow

Difficulties improving cash flow

THE NATURE OF CASH FLOW

Cash flows into AND out of a business

Cash salesPayments from debtorsOwners’ capital investedSale of assetsBank loan

Purchasing stockPaying wagesPaying debts – bank loans, creditorsPurchasing assets

Cash flow is interested in the balance between these cash inflows and cash outflows in terms if their relative size and timings.

THE NATURE OF CASH FLOW

Cash flow is important to a business as it needs to ensure a positive cash balance in order to be able to meet day to day expenses

A cash flow forecast is a forward looking statement that tries to predict cash inflows and outflows in the future

Cash flow forecasts are an important part of a business plan A cash flow statement is a backward looking statement that

shows what happened to cash inflows and outflows Cash flow statements are normally presented as a part of a

business’ accounts A potentially profitable business may fail because it has

cash flow problems

Before looking at this link try to list up to 11 common reasons why small businesses fail. At which number are you going to put running out of cash?

HOW TO CONSTRUCT A CASH FLOW FORECAST

Forecast cash inflows Owner’s investment or other source of finance

Cash sales estimated from sales forecast may be over or under estimated

to some extent depends upon the scale of research

More difficult for new businesses What is expertise of entrepreneur?

How have estimates been calculated?

Is it a new product or service?

How might competitors react?

Debtor payments estimated from sales forecast Determined by credit terms offered to customers

Will debts be paid on time?

How good is firm’s credit control?

HOW TO CONSTRUCT A CASH FLOW FORECAST

Forecast cash outflows Payment of fixed costs

These should be easy to estimate on a month by month basis Time delay between estimates and signing contracts can cause

inaccuracies Payment of variable costs

If sales are difficult to forecast so are the costs associated with meeting demand

Made more difficult if suppliers are free to change the prices charged

Unforeseen expenses One off payments that were not expected or expenses that have

not been planned for Payment terms

What if a supplier changes terms and wants payment sooner or a lender demands their money back

Unforeseen expenses can have a major impact on cash flow!

HOW TO CONSTRUCT A CASH FLOW FORECAST

Cash inflows shows: cash in from sales

cash sales appear in the month of sale credit sales (receivables)appear in month of cash receipt

cash from other sources e.g. loan, investment Cash outflows shows:

cash out for purchases and payments Cash payments appear in month of purchase Credit payments (payables) appear in month of cash

outflow E.g. phone usage – line rental paid each month, call

charges every 3 months

Write a definition of receivables and payables.

HOW TO CONSTRUCT A CASH FLOW FORECAST

Net cash flow The net result of cash inflows and cash outflows each month Net cash flow = cash inflows – cash outflows

Opening balance How much the business has at the start of each month For a new business in month 1 this will be 0 The closing balance for one month becomes the opening

balance for the next

Closing balance How much the business has at the end of each month Calculated as:

Opening balance + net cash flow

HOW TO CONSTRUCT A CASH FLOW FORECAST

Jan Feb Mar Apr

Cash inflows

Owner’s capital 5000 0 0 0

Cash sales1600 2000 2500 2500

Credit sales 0 400 500 500

Total inflows 6600 2400 3000 3000

Cash outflows

Van lease 700 700 700 700

Materials 2800 800 1000 800

Wages 1000 1000 1000 1000

Other expenses 450 450 450 450

Total outflows 4950 2950 3150 2950

Net cash flow 1650 (550) (150) 50

Opening balance 0 1650 1100 950

Closing balance 1650 1100 950 1000

THE USE OF CASH FLOW FORECASTS FOR FINANCIAL

DECISION MAKING AND PLANNING

To identify the timing and significance of any potential shortfalls

To identify possible corrective action

To help secure finance from potential investors or the bank

To give confidence about short term survival

To provide a guide against which to measure actual cash flow

FACTORS AFFECTING CASH FLOW

Transaction types Sales

cash v. credit Purchases

cash v. credit Payment terms

Timings of cash flows Seasonal sales

e.g. strawberry farm Timings of payments in and out

e.g. package holiday company

Nature of business Start-up capital and costs Time taken from input to output Stock holdings

TIMINGS OF CASH INFLOWS AND OUTFLOWS

Cash inflows

If cash inflows are slow this may cause cash flow problems

A firm may try to speed up cash inflows

This may include offering a discount for early payment or penalties for late payments

Businesses may need to chase customers for payment i.e. credit control

When a business is owed money from customers these are referred to as receivables The business is still to receive the payment

Why might a business be willing to offer a customer long payment terms?

TIMINGS OF CASH INFLOWS AND OUTFLOWS

Cash outflows

If cash outflows are too quick this may cause cash flow problems

A firm may try to slow down cash outflows

This may include negotiating longer payment terms from suppliers

When a business owes money to suppliers these are referred to as payables The business is still to make the payment

What are the potential disadvantages to a business of asking for a longer period to pay?

What are the costs and benefits to Tesco of delaying payments to suppliers?

What is the likely consequence of this to their suppliers?

CASH FLOW PROBLEMS

Businesses need to have sufficient cash to meet day to day finances Buying stock Paying wages Utility bills

Insufficient liquid cash funds may mean an inability to meet short term debts Bank overdraft Payables (trade creditors)

Limited cash may result in missed opportunities A key consideration should be whether the cash flow problem

is short term or long term A firm may be able to survive short term cash flow problems Long term cash flow problems may be insurmountable

CAUSES OF CASH FLOW PROBLEMS

Credit sales Long payment terms Poor credit control

Overtrading Additional overhead and day to day expenses Increased capital expenditure

Internal management Stock control Relationship with suppliers Poor or inaccurate planning

Seasonality Unexpected events

What were the causes of the

cash flow problems at Newport?

Could Newport have done anything to avoid these problems?

IMPROVING CASH FLOW

Increasing the volume of the inflow of cash

Speeding up the timing of the inflow of cash

Inflows Capital invested

Loans

Cash sales

Debtor payments

Reducing the volume of the outflow of cash

Slowing down the timing of the outflow of cash

Outflows Loan repayments

Day to day running expenses

Interest payments

IMPROVING CASH FLOW - INFLOWS

Using financial institutions i.e. banks Overdraft – an arrangement with the bank allowing the

business to withdraw money above the amount available Provides some financial peace of mind Backed by a cash flow forecast to show ability to repay Allows flexibility Incurs interest and possible arrangement fee Can be ordered to repay immediately

Short-term loan – an arrangement with a bank to lend money for a set period of time Pre agreed repayment terms Incorporated into budget and cash flow Interest rate may be lower than an overdraft Interest is paid on the total value of the loan May need to be backed by collateral

IMPROVING CASH FLOW - INFLOWS

Factoring

Debt factoring – the process of selling a business’ debts i.e. the money owed to it, to a factor house at a reduced amount in order to receive immediate payment Immediate payment of debt

Reduced risk of non payment (bad debt)

Factor house takes a % as their profit

May alter customer’s image of business

Factoring is a service offered by banks. Read what RBS says about factoring.

IMPROVING CASH FLOW - INFLOWS

Sale of assets

Sale of assets – turning an obsolete asset into cash Potentially quick cash injection

Asset must be no longer needed

Loss of future use or value of asset

Possible low value received

One off action

Sale and leaseback – turning an asset into cash whilst still being able to use it through a lease agreement Quick cash inflow in the short term

Reduced value of business’ assets

Larger cash outflow in the long term

Assets are items owned by a business e.g. vehicles and machinery.

IMPROVING CASH FLOW - INFLOWS

Cash payments from customers Reducing credit terms – credit terms refers to the amount of time a

customer is given to pay for their goods and services Some businesses offer customers a discount for immediate or quick

payment Quick cash inflow Reduced risk of bad debt May need to offer a discount May lose customers

Credit control – the process of chasing payments from debtors (people who have bought from you on credit) Brings cash into the business Full amount received May alienate customers Administratively demanding

Should businesses

enrol the help of experts in

credit control?

IMPROVING CASH FLOW - OUTFLOWS

Delaying payment to suppliers Negotiating longer payment terms May incur penalties Need to maintain positive relationship

Stock management Reducing money tied up in stock Need reliable stock deliveries

Reduce overhead spending Cut unnecessary expenditure Should not have negative impact on productivity Consider any knock on effect on sales

ACTIVITY – DAVE’S DIRECT DELIVERIES

Dave started his courier business 3D Ltd 5 years ago. It currently operates with a fleet of 8 trucks and 2 bikes. Over the past year however things have got tough; rising fuel prices, increased road tax and falling customer numbers have meant he has had to reduce his drivers from 8 to 5, all of whom are paid on a weekly basis.

Dave already has a bank loan for £50 000, the repayment on which has also gone up recently due to a rise in interest rates. Last month two of his regular customers cancelled their contracts, one of whom still owes him £6 000. Both explained that they were moving to cheaper competitors who offered 45 day payment terms compared to Dave’s 30 days. Dave’s wife Doris helps out on a part time basis in the office where she answers the phone, sends invoices and keeps the financial records of payments and expenditure.

Dave is worried, his bank balance is nearly zero and if things don’t improve in the next 3 months he is anxious he will have serious cash flow problems and not be able to meet his day to day running costs.

1) Identify the possible steps Dave could take to help solve his cash flow problem.2) For each step identify an argument for and against taking that step.3) Recommend 3 proposals to Dave. You should prioritise and justify your proposed solutions.

DIFFICULTIES IMPROVING CASH FLOW

Damage to the firm’s reputation

Potential loss of customers if payment terms affect competiveness

Administrative costs and time

Loss of discounts or need to offer discounts

May affect profitability e.g. only receive part of debt or more expensive to lease assets in the longer run

IN PAIRS

Method of improving cash flow Potential difficulties of improving cash flow

Overdraft

Short term bank loan

Factoring

Sale of assets

Sale and leaseback

Cash payments from customers

Credit control

Delay payment to suppliers

Stock management

Reduce overhead spending

1.1 UNDERSTANDING THE NATURE AND PURPOSE OF BUSINESS

In this topic you have learnt about

Analysing financial performance

How to construct and analyse cash flow forecasts

How to analyse timings of cash inflows and outflows

The use of data for financial decision making and planning

Making financial decisions

Methods of improving cash flow

Difficulties improving cash flow