3.7 Cash Flow

Cash - Liquid asset used to cover revenue expenditure and short-term liabilities.

Profit - The positive difference between a firm’s total revenue and its total costs of production.

Profit and cash flow are essential elements of a healthy and sustainable business, but they do not come hand-in-hand. A profitable business may still not be generating sufficient cash flow to operate, grow, or even survive.

When making a purchase, customers may have the option of paying by cash or credit. If they pay by cash, the business’ profit increases in hand with its cash inflow. However, if the customer pays by credit, the profit of the business increases, but without immediate payment, there is no cash inflow. Therefore, it is possible for a firm to be profitable but cash deficient if its debtor days ratio is too high.

Working Capital - The cash or liquid assets available to cover revenue expenditures, it shows the funds available for immediate access to cover costs. A lack of working capital means that the firm has insufficient cash to fund its daily operations.

Working Capital = current assets - current liabilities

Working Capital Cycle - The interval between cash payments for costs of production, and cash receipts from customers. For most businesses, there is a delay between paying for costs of production, and receiving the cash from the sale of the final product, and this delay is due to the time taken during the production process.

Cash Flow Forecast - Shows the expected movement of cash into and out of a business per time period. A cash flow forecast consists of these concepts:

Opening Balance - The amount of cash at the beginning of a trading period.

Cash Inflows - Cash received by the business from product sales, payments from debtors, loans from a bank, and other sources of finance. Predicting cash inflows requires accurate sales forecasting.

Cash Outflows - Cash spent by the business to cover costs and expenditures.

Net Cash Flow - The difference between cash inflow and outflows, per time period. Ideally, net cash flow would be positive, as a business cannot survive for long without adequate net cash flow.‍

Closing balance - The amount of cash at the end of a trading period.

Overtrading - When a business attempts to expand too quickly, without sufficient reserve capital to fund the increasing scale of operations. For example, when a business accepts more orders than it has the capacity to handle, thereby increasing the production costs without immediate cash inflow to cover the costs due to the working capital cycle.

Overborrowing - The larger the proportion of capital raised through external sources of finance, the more interest costs incurred by the business, leading to greater outflows in the future, which the business may not be able to cover.

Overstocking - Producing too much stock that does not sell will waste the resources used to produce the goods and storage capacity.

Reducing Cash Outflow

Seek preferential credit terms - Businesses can negotiate extended credit terms with suppliers and creditors to lengthen the time taken before the business has to pay the full amount.

Seek alternative suppliers - Globalisation has opened access to suppliers from around the globe for a business. This competition among suppliers will lead to more competitive offers from each supplier. Seeking alternative suppliers that are cheaper or who offer preferential credit terms can help reduce costs, but may result in a drop in quality of output.

Better stock control - An accurate forecast of appropriate stock levels to meet market demands will reduce liquidity being tied up in unsold stocks.

Reduce expenses - Businesses can cut costs wherever possible, especially overhead costs that will not affect the quality of the product.

Leasing - Rather than investing a large amount of capital in new fixed assets, businesses can choose to lease machinery and equipment and pay in installments instead.

Improving Cash Inflow

Tighter Credit Control - Firms can limit trade credit to their customers or reduce the credit period in order to improve its debtor days ratio and shorten the working capital cycle; the earlier cash inflow will balance out the cash outflow from the costs of production within the trading period. 

Cash Payments Only - Requiring customers to pay only by cash will significantly shorten the working capital cycle. However, this will put the firm in a disadvantage to competitors who offer trade credit.

Looking for Additional Sources of Finance

Sale of Assets - Businesses can sell dormant or inessential assets, such as old equipment and machinery, or land they own. However, businesses usually only tap into the sale of fixed assets when severe liquidity problems arise, as it is a short-term fix and they would have to purchase the fixed assets after the problem diminishes.

Share Capital - Finance raised from the sale of shares in the company. This is particularly useful for public limited companies who are able to sell its shares on a stock exchange. To repeatedly earn money from selling shares, businesses tend to perform stock buybacks using retained profits just to sell the stock again once its value rises.

Loan Capital - Finance obtained from commercial lenders such as banks, which tend to be weighed against collateral. Taking a loan is the easiest way for businesses to obtain urgent financing, but businesses face interest charges on the capital they borrowed.

Overdrafts - Businesses can temporarily overdraw on the money available in its bank account. This tends to only be used in emergencies, as overdrafts incur high interest charges, but allows a business to access immediate funds whenever needed.

Debt Factoring - A financial service that allows businesses to ‘sell’ the debts owed to them in return for the cash amount up front, less the service fee of debt factors. This is used by businesses when urgent cash inflow is required.

Venture Capital - Capital obtained from venture capital firms in a form of loans or the sale of shares to the firm. This is most commonly used by businesses in the incubation phase, enabling them to obtain the capital required to start up. The business will also benefit from the advice and mentorship received from the venture capitalists, who want to see their investments in the business gain value.

Business Angels - Capital obtained by selling shares to extremely wealthy individuals who recognise the growth potential of the business. Like venture capitalists, business angels will take an interest in the performance and development of their investment, so the business can gain from the experience and guidance of the angel investors.