Unit 3: Finance and Accounts
3.6 - Cash Flow
Understanding Cash Management, Working Capital, and Liquidity
1. What is Cash Flow?
Cash flow is the movement of money in and out of a business over a specific period. It tracks the actual receipt and payment of cash, not just sales and expenses on paper.
Key principle: "Cash is king" - A business can be profitable on paper but fail if it runs out of cash to pay bills.
Cash Inflows vs. Cash Outflows
Cash Inflows (Money Coming In)
- Cash sales: Immediate payment from customers
- Payments from debtors: Customers paying credit invoices
- Loans received: Bank loans, overdrafts
- Capital invested: Owner's funds, share issues
- Interest received: From savings or investments
- Sale of assets: Selling equipment, property
- Grants and subsidies: Government support
Cash Outflows (Money Going Out)
- Payments to suppliers: Purchasing inventory, raw materials
- Wages and salaries: Employee payments
- Rent and utilities: Premises costs
- Loan repayments: Principal and interest
- Purchase of fixed assets: Machinery, vehicles, equipment
- Tax payments: Corporate tax
- Dividends paid: To shareholders
- Marketing expenses: Advertising costs
Net Cash Flow
Formula
\[ \text{Net Cash Flow} = \text{Cash Inflows} - \text{Cash Outflows} \]Possible outcomes:
- Positive net cash flow: More money coming in than going out (healthy)
- Negative net cash flow: More money going out than coming in (problem if prolonged)
- Zero net cash flow: Inflows equal outflows (breaking even on cash)
Opening Balance, Net Cash Flow, and Closing Balance
Key relationship:
\[ \text{Closing Balance} = \text{Opening Balance} + \text{Net Cash Flow} \]Where:
- Opening Balance: Cash at start of period
- Net Cash Flow: Inflows minus outflows during period
- Closing Balance: Cash at end of period (becomes next period's opening balance)
2. Cash Flow Forecast
Cash flow forecast is a financial planning tool that predicts future cash inflows and outflows over a specific period (usually monthly for 6-12 months).
Purpose:
- Anticipate cash shortages in advance
- Plan when to arrange financing
- Identify best times for major purchases
- Manage seasonal fluctuations
- Support loan applications
Structure of Cash Flow Forecast
ABC Company - Cash Flow Forecast
January - March 2025
| January | February | March | |
| CASH INFLOWS | |||
| Cash Sales | $50,000 | $55,000 | $60,000 |
| Debtors Payments | $30,000 | $35,000 | $40,000 |
| Loan Received | $100,000 | $0 | $0 |
| Total Inflows (A) | $180,000 | $90,000 | $100,000 |
| CASH OUTFLOWS | |||
| Payments to Suppliers | $40,000 | $45,000 | $50,000 |
| Wages | $25,000 | $25,000 | $25,000 |
| Rent | $10,000 | $10,000 | $10,000 |
| Utilities | $3,000 | $3,000 | $3,000 |
| Purchase Equipment | $80,000 | $0 | $0 |
| Loan Repayment | $2,000 | $2,000 | $2,000 |
| Total Outflows (B) | $160,000 | $85,000 | $90,000 |
| Net Cash Flow (A-B) | $20,000 | $5,000 | $10,000 |
| Opening Balance | $15,000 | $35,000 | $40,000 |
| Closing Balance | $35,000 | $40,000 | $50,000 |
Benefits of Cash Flow Forecasting
- Anticipate problems: Identify cash shortages before they occur
- Arrange finance: Time to secure overdraft or loan if needed
- Plan investments: Identify surplus cash for investment
- Support decisions: When to purchase assets, hire staff
- Seasonal planning: Manage fluctuations in cash flow
- Credibility: Shows banks and investors you plan ahead
Limitations of Cash Flow Forecasts
- Based on estimates: Predictions may be inaccurate
- Unexpected events: Cannot predict economic downturns, accidents
- Customer behavior: Debtors may pay late or not at all
- Requires updating: Must be revised regularly to remain useful
- Time-consuming: Requires careful data collection and analysis
3. Cash Flow vs. Profit
Critical distinction: Profit and cash flow are NOT the same thing. A business can be profitable but have negative cash flow, or vice versa.
Key Differences
| Aspect | Profit | Cash Flow |
|---|---|---|
| Definition | Revenue minus all expenses | Actual movement of cash in and out |
| Timing | Recorded when sale made (accrual basis) | Recorded when cash received/paid |
| Includes | Credit sales (not yet paid), depreciation | Only actual cash transactions |
| Formula | Revenue - Expenses | Cash Inflows - Cash Outflows |
| Statement | Profit and Loss Account | Cash Flow Statement/Forecast |
| Can be manipulated? | More easily (through accounting choices) | Harder (actual money movement) |
Example: Why Profit ≠ Cash Flow
Scenario: Company makes $100,000 sale in December
Profit Impact (Immediate):
- Sale recorded as revenue in December
- Increases profit by $100,000 (minus costs)
- Appears on December Profit & Loss Account
Cash Flow Impact (Delayed):
- If sale on 60-day credit terms, cash received in February
- No cash inflow in December despite sale
- Can show profit but negative cash flow
Result: Company is profitable on paper but may struggle to pay December bills if waiting for cash
Reasons Profitable Business May Have Cash Flow Problems
- Credit sales: Sales recorded as revenue but cash not yet received
- Overtrading: Growing too fast without adequate cash
- Large capital purchases: Buying expensive equipment uses cash immediately
- Inventory buildup: Cash tied up in unsold stock
- Slow-paying customers: Debtors taking longer than expected to pay
- Seasonal variations: Uneven sales throughout year
- Loan repayments: Principal repayments not shown as expense but reduce cash
4. Working Capital
Working capital is the money available for day-to-day operations. It represents the difference between current assets and current liabilities.
Formula
\[ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} \]Where:
- Current Assets: Cash, inventory, accounts receivable (debtors)
- Current Liabilities: Accounts payable (creditors), short-term loans, overdrafts
Working Capital Calculation
Company E Balance Sheet Extract:
- Current Assets:
- • Cash: $30,000
- • Inventory: $80,000
- • Debtors: $50,000
- • Total Current Assets = $160,000
- Current Liabilities:
- • Creditors: $40,000
- • Short-term loan: $20,000
- • Total Current Liabilities = $60,000
Working Capital:
\[ \text{Working Capital} = \$160,000 - \$60,000 = \$100,000 \]Interpretation: Company has $100,000 available to fund operations after paying short-term debts
Importance of Working Capital
- Operational necessity: Need cash to operate daily
- Pay bills on time: Avoid penalties and damaged relationships
- Take opportunities: Bulk purchase discounts, new deals
- Handle emergencies: Buffer for unexpected expenses
- Creditworthiness: Shows financial stability to lenders
Working Capital Cycle
The working capital cycle (also called cash conversion cycle) is the time between paying suppliers and receiving cash from customers.
Steps:
- Purchase inventory (cash out to suppliers)
- Hold inventory (cash tied up)
- Sell goods (possibly on credit)
- Wait for customer payment (cash tied up in debtors)
- Receive cash from customers (cash back in)
Goal: Shorten this cycle to improve cash flow
Ways to Improve Working Capital
1. Increase Current Assets:
- Improve debt collection (chase late payers)
- Reduce inventory levels (just-in-time)
- Increase cash sales vs. credit sales
- Offer early payment discounts
2. Decrease Current Liabilities:
- Negotiate longer payment terms with suppliers
- Pay off short-term debts
- Convert short-term debt to long-term
3. Operational Improvements:
- Better inventory management
- Faster production and sales processes
- Improved credit control procedures
5. Liquidity Position
Liquidity refers to how easily a business can convert assets into cash to meet short-term obligations. It's about having enough cash or near-cash assets to pay bills on time.
Liquid assets (in order of liquidity):
- Cash (most liquid)
- Marketable securities (stocks, bonds)
- Accounts receivable (money owed by customers)
- Inventory (least liquid of current assets)
Why Liquidity Matters
- Survival: Inability to pay bills leads to insolvency
- Creditworthiness: Lenders assess liquidity before lending
- Supplier relationships: Pay on time to maintain good terms
- Employee morale: Must pay wages consistently
- Opportunities: Liquid businesses can seize chances quickly
Insolvency vs. Bankruptcy
Insolvency: Unable to pay debts when they fall due
- Liabilities exceed assets
- Or unable to meet payment obligations
- Legal state that may lead to bankruptcy
Bankruptcy: Legal declaration that business cannot pay debts
- Court process
- May lead to liquidation (closing business, selling assets)
- Or restructuring (reorganizing to continue operating)
Liquidity Ratios (Covered in Detail in Unit 3.5)
1. Current Ratio:
\[ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \]Ideal: 1.5 to 2:1
2. Acid Test Ratio (Quick Ratio):
\[ \text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \]Ideal: 1:1 or slightly higher
Note: Inventory excluded because it's less liquid (takes time to sell)
Causes of Liquidity Problems
- Overtrading: Expanding too quickly without sufficient capital
- Poor cash flow management: Not monitoring inflows/outflows
- Excessive inventory: Cash tied up in unsold stock
- Slow-paying customers: Long credit periods
- Seasonal fluctuations: Uneven sales patterns
- Unexpected expenses: Equipment breakdown, legal issues
- Economic downturn: Reduced sales, customers defaulting
- Poor financial planning: Lack of forecasting
Solutions to Liquidity Problems
Short-term Solutions:
- Arrange overdraft: Temporary credit facility
- Chase debtors: Speed up customer payments
- Delay payments: Negotiate extended terms with suppliers
- Sale and leaseback: Sell asset then lease it back
- Reduce inventory: Sell off excess stock
- Cut costs: Reduce discretionary spending
Long-term Solutions:
- Improve cash flow forecasting: Better planning
- Secure long-term finance: Loans, equity investment
- Renegotiate payment terms: Both with customers and suppliers
- Improve operational efficiency: Faster production, better inventory management
- Increase retained profits: Reduce dividend payments
6. Investment Appraisal and Cash Flow
When businesses consider investing in new projects or assets, they evaluate future cash flows to determine viability.
Key Investment Appraisal Methods
1. Payback Period
Definition: Time taken for initial investment to be recovered from cash inflows
Formula:
\[ \text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}} \](When cash inflows are constant)
Example:
- • Initial investment: $100,000
- • Annual cash inflow: $25,000
- • Payback = $100,000 ÷ $25,000 = 4 years
Interpretation: Shorter payback = Lower risk, faster return
Summary: Key Relationships
- Cash Flow ≠ Profit: Can be profitable with poor cash flow, or vice versa
- Working Capital = Current Assets - Current Liabilities
- Liquidity: Ability to meet short-term obligations
- Good liquidity: Positive working capital + adequate current ratio
- Cash is survival: More businesses fail from cash flow problems than lack of profit
✓ Unit 3.6 Summary: Cash Flow
You should now understand that cash flow tracks actual money movement (inflows minus outflows) and differs critically from profit, which records sales when made rather than when paid. Cash flow forecasts predict future cash positions to anticipate shortages and plan financing needs. The formula Closing Balance = Opening Balance + Net Cash Flow connects periods. Working capital (Current Assets - Current Liabilities) represents funds available for operations, and the working capital cycle describes time from paying suppliers to receiving customer payments. Liquidity measures ability to meet short-term obligations through adequate cash and liquid assets. Businesses can be profitable yet face insolvency if unable to pay bills on time. Managing cash flow through forecasting, controlling the working capital cycle, maintaining adequate liquidity ratios (current ratio 1.5-2:1, acid test 1:1), and distinguishing cash movements from accounting profit is essential for business survival and success.