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Cash is the most liquid of all the assets of a business -it represents the bank balance and the cash that the business has available on the premises (otherwise known as 'petty cash').
Cash flow refers to the difference between the cash flowing into the business (e.g. through sales revenue) and the cash flowing out of the business (e.g. bills and wages).
Having a positive cash flow is vital for the survival of a business, since without the ability to pay workers and suppliers then the business will soon have to cease trading.
This potential problem is compounded by the fact that businesses often have to pay many expenses several weeks or even months before any cash actually flows into the business.
For example, wages and salaries will have to be paid to employees, suppliers will have to be paid for any raw materials, and the rent or mortgage payments will have to be paid before the products can be manufactured and sold to customers.
Further to this point, if the products are sold on credit to customers, then the time delay between the cash outflows and the cash inflows will be even longer and will sometimes require a business factor using capital funding services to increase cash flow quickly.
The major causes of cash flow crises for a business are:
- Overtrading -where the business attempts to expand too rapidly, without a sufficient financial base.
- Having too much money invested in stocks.
- Allowing too much credit to their customers.
- Unexpected changes in demand for their products.
- Overborrowing -therefore having large monthly loan repayments, which have to be met.
There are many actions that a business can take when it is experiencing a liquidity crisis:
- Offering price discounts to boost sales and sales revenue.
- Selling off fixed assets.
- A 'sale and lease back' arrangement.
- Chasing debtors for the monies owed to the business.
- Selling off stocks.
Whatever action is decided upon, the business must ensure that it is implemented quickly and that a careful eye is kept on the liquidity (cash flow) position in the future.
A cash flow statement is a Financial Accounting document, which shows the cash inflows and the cash outflows for a business over the past 12 months.
It indicates those months in which the business suffered a cash flow crisis (where cash outflows were greater than cash inflows) and it will also highlight those months in which the business was cash-rich (i.e. more cash inflows than cash outflows).
It allows a business to prepare a cash flow forecast for the forthcoming year, by basing the estimated cash inflows and outflows on the results from the previous year.
A cash flow forecast is a Management Accounting document, which outlines the forecasted future cash inflows (from sales) and the outflows (raw materials, wages, etc) per month for a business over an accounting period.
|Total cash inflows||3500||1100||1050||850||500|
|Total cash outflows||3400||700||950||1200||550|
|Net monthly cash flow||100||400||100||(350)||(50)|
The business forecasts that in January it will experience cash inflows of £1,100 and cash outflows of £700, leaving a positive net monthly cash flow of £400.
This is added to the £200 bank balance which existed at the end of December, to give a forecasted bank balance at the end of January of £600.
In February, the forecasted cash inflows are only £100 more than the forecasted outflows, leaving a bank balance of £700.
However, in the months of March and April, the business is forecast to experience negative net monthly cash flows (i.e. its cash outflows are forecast to be greater than its cash inflows).
This gradually reduces the bank balance to just £300 by the end of April.
It is important for a business to produce a cash flow forecast, so that it can prepare for those months in which it is forecast to experience a cash flow crisis (i.e. the business needs to arrange extra borrowing or overdraft facilities to provide extra cash).
Alternatively, in the months where the business is forecast to be cash-rich, it can use this money profitably elsewhere within the business (e.g. new product development).