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5.2 Cash-Flow Forecasting and Working Capital

Nearly everyone will be aware of the importance of a business  making a profit and have a basic idea of how it’s calculated. However, cash-flow can be just as crucial for business success, as cash is the life blood of the business. Without enough cash the business will not survive.  So it is essential as business students that we get to grips with cash flow.

Cash-flow questions can be simple calculations to find the value of X and Y in a cash flow forecast or longer questions where students must look at the case study data and recommend ways of improving cash flow.

JanFebMarchApril
Cash Inflow50120150220
Cash Outflow280270170140
Net Cash Flow(230)(150)Y80
Opening Balance0(230)(80)(400)
Closing BalanceX(380)(400)(320)
Past Paper Question Example 

Paper 1 Calculate values for: [2]

X: 

Y: 

5.2.1 The Importance of Cash and of Cash Flow Forecasting

Why cash important to a business

What is cash? It is money we can use right away to pay business bills or debts. It may not be physical cash, most transactions are online these days, but it has to be in a business bank account and available if needed. 

For more on the difference between profit and cash go to 5.3 Income Statement

  Link  5.3 Income Statements

Day to day a business will have cash coming in and going out. 

Cash inflow is cash coming into the business, like when a business receives payment from sales, or receives money from a bank loan.

Cash InFlowsCash OutFlows
Payments Received from customersPayments to suppliers, rent, workers’ salaries
Money from bank loan or overdraftRepayments to bank 

Cash outflow is cash going out of the business and occurs when a business has to pay bills like suppliers, rent, workers’ salaries or bank loan repayments.

If the cash outflows all happen before the cash inflows the business will have cash flow problems.

If the business can’t pay it’s workers they will stop working or if they can’t pay their suppliers production will stop. This will eventually force the business to stop operating and it will close. This is often referred to as bankruptcy or insolvency.

To avoid this catastrophe the business has to ensure there is enough cash at all times so they can pay their bills. 

Liquidity is the term used to describe cash flow. If a business is liquid it can pay it’s short term debts.

To help manage cash flow businesses use a cash flow forecast. Managers can look into the future and see if they will have enough cash to pay all their short term debts. 

⭐⭐⭐Top Tip ⭐⭐⭐
Learn all the different cash inflows and cash outflows in a business 

This will really help when understanding the cash flow forecast. A common mistake is when students confuse cash inflows and outflows.

What is a cash-flow forecast?

A Cash flow forecast estimate of future cash inflows and outflows 

Cash flow forecast can look complicated, there are a lot of numbers and columns, but once you understand how it works it is straightforward and logical.

Amend or complete a simple cash-flow forecast

Cash flow forecast for X&Y ($)

JuneJulyAug
Cash Inflow200300100
Cash Outflow
Raw Materials50150200
Shop rent and other costs100100100
Total Cash Outflows150250300
Net Cash Flow5050(200)
Opening Balance100150200
Closing Balance1502000

June Cash Flow Forecast Calculation

Above we can see the cash flow forecast model that is used in Cambridge IGCSE exams.  At the top we’ve got the cash inflow, usually from sales, in this case $200.

Then we have to calculate the cash outflow, we do this by adding up all the cash outflows, in this case raw materials and shop rent. This gives us a total of $150. 

We then subtract the cash outflows from the inflows and this gives us the net cash flow $50.

Net Cash Flow = Cash inflows – Cash outflows

The final step is to add the net cash flow to the cash that was already in the business or opening balance. This then gives us the closing balance of $150.

The closing balance for one month becomes the opening balance in the next. So the closing balance of $150 in June becomes the opening balance for July. The closing balance that we get for July becomes the opening balance for August and so on.

So let’s now work through the July and August cash flow forecast using the same calculations.

July Cash Flow Forecast Calculation

We have to calculate the cash outflow for July, we do this by adding up all the cash outflows, in this case raw materials and shop rent. This gives us a total of $250. 

We then subtract the cash outflows from the inflows and this gives us the net cash flow of $50

The final step is to add the net cash flow to the cash that was already in the business or opening balance. This then gives us the closing balance of $200.

The closing balance for one month becomes the opening balance in the next. So the closing balance of $150 in July becomes the opening balance for August.

August Cash Flow Forecast Calculation

Finally, we can calculate the cash outflow for August, we do this by adding up all the cash outflows, in this case raw materials and shop rent. This gives us a total of $300. 

We then subtract the cash outflows from the inflows and this gives us the net cash flow of -$200, but we show negative sums in brackets ($200).

    ⚠⚠ DANGER!  ⚠⚠
Negative numbers are shown in brackets in financial statements like cash flow forecasts. So if the cash in the business is less than zero, this is shown in brackets. -200 becomes (200)

The final step is to add the net cash flow to the cash that was already in the business or opening balance. This then gives us the closing balance of $0.

How to interpret a simple cash-flow forecast

We can see that X&Y could have a cash shortage in August, the closing balance is $0. This means if there is an unexpected cash outflow, like an emergency repair or additional expense they won’t have enough cash to pay their short term debts.

How can these cash flow problems be overcome? 

How a short-term cash-flow problem might be overcome

Increasing cash inflows or decreasing cash outflows will lead to increased cash flow.

You may be asked a question like this one:

Past Paper Question Example 
Cash Flow Forecast for Low Flo
JanFeb
Cash Inflow100200
Cash Outflow
Raw Materials50150
Shop rent and other costs100100
Total Cash Outflows150250
Net Cash Flow(50)(50)

Paper 1 Outline two ways Low Flow could improve their cash flow in January

Way 1:

Explanation: 

Way 2:

Explanation:  (4)

It’s important to know that every method of increasing cash flow will have a cost or a risk attached.

Your job is to pick the option with the minimum disruption to the business. 

Firstly we can increase the cash coming in to overcome a period  when the business is short of working capital . If the business gets a loan of £100 this will mean they don’t run out of cash in January. 

However, loans will be payable with interest, and it depends on whether a bank will lend Low Flo the money

Secondly, Low Flo may have the option of asking for money from sales early. In some cases businesses may have to wait for payment from sales. Therefore, if Low Flo asks for payment a month early it can improve the cash flow. 

However, this may not be possible if Low Flo have already received payment  straight away when it makes a sale. Also, they may lose customers who are unwilling to pay immediately, and go to another business instead.

Low Flo can also reduce the cash outflows. One way of doing this is delaying payment to suppliers. If Low Flo pays for the raw materials in February it means they can avoid having a negative cash flow in January.  

However, suppliers may be unwilling to wait for payment, so delaying payment may not be possible. 


5.2.2 The Concept and Importance of Working Capital

Working capital: capital available to a business day to day to pay short term debts. Working capital is calculated by subtracting current liabilities from current assets.

Working Capital  = Current Assets – Current Liabilities

As we have seen with the importance of cash flow, working capital is essential for the survival and effective operation of a business.

Working capital also shows the financial strength of a business. Investors and banks will check to ensure a business has sufficient working capital before considering offering to finance a business.

  Link  5.5.2 Liquidity Ratios 

Working capital and cash flow is analysed further with the use of liquidity ratios in 5.5.2

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