2. Key issues for this topic
• What is a cash flow
problem?
• Why do cash flow
problems occur?
• How a business can
improve its cash flow to
avoid or address
problems
3. A Reminder from Unit 1
Cash inflows Cash outflows
Cash sales Payments to suppliers
Receipts from trade debtors Wages and salaries
Sale of fixed assets Payments for fixed assets
Interest on bank balances Tax on profits
Grants Interest on loans & overdrafts
Dividends paid to
Loans from bank
shareholders
Share capital invested Repayment of loans
4. Why Businesses Need Cash
Finance is needed for…
Business Set-up
Day-to-day trading (working
capital)
Growth
5. A Typical Cash Flow Cycle
Inflow Stocks
– cas h ordered
custom paid by from
ers
supplier
Customers Production
pay for turns stocks
their into
purchases products
paid to
Outfl ow - cash ees
& employ
suppliers
Stocks held
Products until a
sold to customer is
customers found
6. The cash flow operating cycle
• It is equal to:
– The time that goods are in stock
– plus the time that debtors take to pay
– minus the period of credit received from suppliers
• The working capital cycle can be shortened by
– reducing the level of stock - this lowers the number of days
the stock is held
– speeding up the rate of debtor collection -the faster
business collects from its debtors the better
• The shorter the cycle, the lower the value of working
capital to be financed by other sources
7. What is cash flow problem?
When a business
does not have
enough cash to
be able to pay
its liabilities
8. Main Causes of Cash Flow Problems
• Low profits or (worse) losses
• Over-investment in capacity
• Too much stock
• Allowing customers too much credit
• Overtrading
• Unexpected changes
• Seasonal demand
9. Profit = most important source of cash
• The profit a business makes
from trading is the most
important source of cash
• There is a direct link
between low profits or
losses and cash flow
problems
• Most loss-making businesses
eventually run out of cash
10. Over-investment in capacity
• Spending too much on
fixed assets
• Made worse if short-term
finance is used (e.g. bank
overdraft)
• Fixed assets are hard to
turn back into cash
11. Too much stock?
• Excess stocks tie up cash
• Increased risk that stocks
become obsolete
• But...
• There needs to be enough
stock to meet demand
• Bulk buying may mean
lower purchase prices
12. Allowing Customers Too Much Credit
• Customers who buy on credit are
called “trade debtors”
• Offer credit = good way of
building sales
• But...
• Late payment is a common
problem
• Worse still, the debt may go
“bad”
13. Overtrading (1)
• Where a business expands too quickly,
putting pressure on short-term finance
• Classic example – retail chains
– Keen to open new outlets
– Have to pay rent in advance, pay for shop-fitting,
pay for stocks
– Large outlay before sales begin in new store
• Businesses that rely on long-term
contracts also at high risk of overtrading
14. Overtrading (2)
Cause Business expands its order book at a faster
rate than access to working capital will
sustain
Symptoms Higher trade debtor figure
Cash running out
Withholding payments to suppliers
Actions Reduce business activity – slow growth down
Introduce new share capital to ease the strain
Improve the management of working capital
15. Unexpected changes
• Events that are not
included in the cash flow
forecast
• Internal change
– E.g. Machinery breakdown, loss
of key staff
• External change
– E.g. Economic downturn,
accidents
16. Seasonal demand
• Where there are predictable
changes in demand & cash
flow
• Production or purchasing
usually in advance of seasonal
peak in demand = cash
outflows before inflows
• This can be managed – cash
flow forecast should allow for
seasonal changes
18. How to Handle Cash Flow Problems
• Have a good cash flow forecast
• Manage working capital effectively
• Choose the right sources of finance
– Bank overdraft v bank loan
– Factoring
– Sale and leaseback
19. Importance of Good Cash Flow Forecasts
• The key to cash flow
management is having
good information
• A good cash flow
forecast:
– Updated regularly
– Makes sensible
assumptions
– Allows for unexpected
changes
21. Improving working capital
Amounts owed by
Debtors
customers
Amounts owed to
Creditors
suppliers
Stocks Cash tied up in stocks
22. What is working capital?
• Working capital is the cash needed to pay
for the day to day trading of the business
• Often, suppliers and employees have to
be paid before customer pay for their
goods
23. Why working capital is important
• Working capital “oils the wheels” of
business
• Businesses use cash to finance stocks
through the production process
• It facilitates the smooth flow of
production and the supply of goods to
customers
• In financing debtors, it enables the
business to offer credit to customers
24. Working capital needed depends on
• Planned production volumes
• Forecast cost per unit
• The length of the production cycle
• Credit terms allowed to customers
• Credit terms received from suppliers
25. A lack of working capital means…
• Harder to buy in bulk and benefit from
discounts
• Difficulties in offering credit to customer
with the danger of losing sales
• Loss of reputation with suppliers if there
are difficulties in settling debts
• Harder to respond to opportunities
• Increased danger of overtrading
26. Dealing with working capital shortages
• Discount prices
• Reduce purchases
• Negotiate more credit from suppliers
• Delay the payment of bills (but not for too long)
• Credit control - chase trade debtors (customers
who haven’t paid)
• Negotiate a bank overdraft
• Debt factoring
• Sell assets
• Sale and leaseback
27. Managing debtors better
• Credit control
• Policies on how much credit to give and repayment
terms and conditions
• Measures to control doubtful debtors
• Credit checking
• Selling off debts to debt factors
• Cash discounts for prompt payment
• Improved record keeping – e.g. accurate
and timely invoicing
28. Debt factoring
• The selling of debtors (money owned to
the business) to a third party
• This generates cash
• It guarantees the firm a percentage of
money owed to it
• But will reduce income and profit margin
made on sales
• Cost involved in factoring can be high
29. What is credit control?
• Establishing credit limits for new customers
• Credit checking new and existing customers
• Setting realistic credit limits
• Monitoring the age of debts and chasing up
bad debts
• Determine appropriate terms and conditions
for credit
• Chasing up debtors will get payment in
sooner but may upset customers
30. Trade creditors
• Amounts owed to suppliers for goods supplied
on credit and not yet paid for
• Delayed payment means that the firm retains
cash longer
• Have to be careful not to damage firm’s credit
reputation and rating
• Trade creditors are seen (wrongly) as a “free”
source of capital
• Some firms habitually delay payment to
creditors in order to enhance their cash flow - a
short sighted policy and raises ethical issues
31. Managing Stocks
• Stock refers to goods purchased and awaiting
use or produced and awaiting sale
• Stocks take the form of raw materials, work-
in-progress and finished goods
• Stockholding is costly and therefore it is
sound business to:
– keep smaller balances (just in time stocks)
– computerise ordering to improve efficiency
– improve stock control
• This will cut down the spending on stock but
may leave the firm vulnerable to stock out
32. Cash management
• Always necessary to hold some cash for
transactions, precautionary reasons and for
speculative purposes (awaiting a business
opportunity)
• Cash management involves the construction
of a cash budget
• Cash flows should be monitored
• Excess cash should be profitably invested
• Provision of overdraft facilities should be
negotiated in case of cash shortage
33. Improving the cash position
• Short term
– Reduce current assets (stock and debtors)
– Increase current liabilities (delaying payment)
– Sell surplus fixed assets
• Long term
– Increase equity finance
– Increase long term liabilities
– Reduce net outflow on fixed assets
34. Should selling prices be discounted?
• Price discounting is designed to improve the
cash flow into the business
• It generates cash through increased sales
• Also reduces stock levels
But
• It may undermine the firm’s pricing structure
• It may leave the firm with low stocks
• Its success does depend on price elasticity of
demand
35. Bank overdraft v Bank loan
• Banks are the traditional “port of call” for
businesses with cash flow problems
• However, the Credit Crunch has made
banks much more wary of lending to
troubled businesses
• Assuming this finance is available, which
one should a business go for?
36. Bank overdraft v Bank loan
Bank Overdraft Bank Loan
Advantages
Relatively easy to arrange Greater certainty of funding, provided
terms of loan complied with
Flexible – use as cash flow requires Lower interest rate than a bank
overdraft
Interest – only paid on the amount Appropriate method of financing fixed
borrowed under the facility assets
Not secured on assets of business
Disadvantages
Can be withdrawn at short notice Requires security (collateral)
Interest charge varies with changes in Interest paid on full amount
interest rate outstanding
Higher interest rate than a bank loan Harder to arrange
37. Sale of assets
• Selling spare or surplus
assets is a way to achieve a
short-term boost to cash
flow
• Good examples: spare land,
surplus equipment
• Note – not all businesses
have spare assets
38. Sale and Leaseback
• Specialist method of raising cash
• Involves selling fixed assets and then
leasing them back from new owner
• Tends to involve business properties (e.g.
Hotels, supermarkets, offices – popular
when property market was booming
• Note: can only be done once!
