A potentially profitable business can fail because of poor management of cash flow. Equally, an unprofitable business can enjoy a period in which is has plenty of cash before the bills arrive!
Cash flow and profits are two very different concepts:
– A business makes a profit if, over a given period of time, its rebenue is greater than its expenditure. A Business can survive without making a profit for a short period of time, but it is essential that it earns profits in the long run.
– Cash Flow relates to the timing of payments and receipts. Cash flow is important in the short term as a business must pay people and organizations to whatever it owes money.
Without a business manages the timing of its payments and receipts carefully, it may find itself in a position where it is operating profitability but is running out of cash regularity. This could be because it is forced to wait for several months before receiving payment from customers. In the meantime, it has to settle its own debts.
Why do businesses forecast cash flows?
Businesses undertake cash flow forecasting for a variety of reasons:
1) To make sure that they do not suffer from periods when they are short of cash and are unable to pay their debts by forecasting cash flows, a business can identify times at which they may not have sufficient cash available. This allows them to make the necessary arrangements to overcome this problem.
2) To support applications for loans businesses often require loans when they are first established and when growing. Banks and other financial institutions are far more likely to lend money to a business that has evidence of financial planning.
Constructing cash flow forecasts
Although cash flow forecasts differ from one another, they usually have three sections and are normally calculated monthly. An essential part of cash flow forecasting is that inflows and outflows of cash should be included in the plan at the time they take place.
1) Cash in – The first section forecasts the cash inflows into the business, usually on a monthly basis. This section included receipts from cash sales and credit sales. Credit sales occurs when the customer is given time to pay: Typically sixty or ninety days.
2) Cash out – The cash out (expenditure) section will state the expected expenditure on the goods and services. Thus, a typical section may include forecasts of expenditure on rent, rates, insurance, wages and salaries, fuel and so on. The net monthly cash flow is calculated by subtracting the total outflow of cash from the total inflow.
3) Net monthly cash flow – The final section of the forecast has the opening balance and the closing balance. The opening balance is the businesses cash position at the start of each month. This will, of course, be the same figure as at the end of the previous month. The net monthly cash slow is added to the opening balance figure. The resulting figure is the closing cash balance for the month. It is also the opening balance for the following month.