3.7 Cash flow

Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!

The main point of this class is to learn what cash flow is and how to prepare cash flow forecast.

For starters, let’s define all the key terms of this class.

Cash is the most liquid asset of the business. It is like water of the business because it is essential and because it flows. As we learnt in 3.5, liquidity refers to the conversion into cash. The easier it is to turn the asset into cash, the more liquid it is. Essentially, the the most liquid asset is cash. In financial statements, cash is one of the current assets in the balance sheet.

Cash flow refers to money coming in and going out of the business. Money coming in are cash inflows, money going out are cash outflows. Ideally, businesses should have sufficient cash at any point in time. Cash deficiency might result in insolvency and even bankruptcy, but too much cash might mean that a business is holding too much of a depreciating asset because cash is losing its value over time due to inflation. So, sufficient cash or just enough cash is a virtue. Liquidity ratios are used to show how liquid businesses are (i.e. how much cash they hold).

I think that the video below explains what cash flow is better than any teacher. Please take a moment to watch it.

Profit is positive difference between revenue and costs. If this difference is negative (i.e. if costs exceed revenues), it means that a business is experiencing loss. We have already learnt different kinds of profits and ways to calculate them in 3.4. The financial statement that shows profit is called profit and loss account.

Investment (in IB BM course) refers to the purchase of non-current assets that generate future earnings. It can also refer to purchase of stock/shares, M&As and many other things, but let me make it clear to you once and for all. In the IB course, we learn the foundation of Business Management, so whatever investment we are talking about, it only refers to one thing — purchase of non-current assets that will generate earnings in the future. For example, purchase of a pizza oven for a pizza restaurant is an investment. More about investment later in Unit 3.

Now, once we are clear about what cash flow, profit and investment is, let’s see how different they are and how they relate to each other.

First of all, profit and cash flow are completely different. It is natural for students to think that if business has cash then it’s profitable, if business doesn’t have cash then it’s not profitable. Well, this is wrong! Business may be profitable and yet have no cash. This is because some products are sold on credit, i.e. customers buy products using trade credit: they get products now, but pay later. This way, it counts as profit, but the actual cash payment takes place later, which means that even though profit is made, there is no cash (yet). At the same time, business may not be profitable even though it has cash. This is because of loans: if you take a loan, it counts as a cash inflow, but since you are not selling anything by acquiring a loan, no profits are made. I hope now it’s clear why profit and cash flow are completely different.

Lastly, let’s see how investment relates to cash flow and profit. Please have a look at the table below.

Let me explain the table, if it’s unclear. When investment is made by an organisation, it is recorded as cash outflow, because investment means that organisation spent some cash purchasing a non-current asset. So, in the short-term, investment is a cash outflow. However, if investment is successful, it will generate earnings, so in the long-term, successful investment will result in cash inflows. This is how investment relates to cash flow.

With regards to profit, investment is usually made out of retained profit. Simply speaking, you take part of your profits and buy something for your business. So, investment has a similar effect on profit as that on cash flow. In the short term, profits might decrease because of the investment. However, in the long-term, if investment is successful, it will actually generate more profits.

To sum up, let’s illustrate the relationship between investment, profit and cash flow with the pizza oven for the restaurant. Once the restaurant purchases the oven, it immediately eats a chunk of restaurant’s profit and it is registered as a cash outflow because cash is spent. However, a few months after the investment (purchase of the oven) is made, more and more people buy pizza from the restaurant and consequently there are more cash inflows. In addition to that, if the managers are keeping costs low, profits of the restaurant also increase.

The main idea of this part of class may be summarised in one sentence: investment, cash flow and profit are all different and yet they are all related and impact each other.

Cash flow forecast is a document that shows predicted movement of cash in and out of business per time period. Cash flow forecast is a forwards-looking document, because it shows a prediction of the future cash flow. If the same document is backwards-looking and is based on existing past data, then it is called cash flow statement. Comparing cash flow forecast with cash flow statement helps businesses to predict their cash flow more accurately and reflect on the performance of the business in terms of cash flow. Thus, cash flow forecast is used for planning and reflection (if it is combined with cash flow statement).

Negative numbers in financial statements are usually taken into brackets, so instead of -1500, accountants record (1500).

As you can see in the picture above, there are five parts in cash flow forecast. Let me comment briefly on each part, so that it’s easier for you to prepare cash flow forecasts.

Opening balance is the amount of cash at the beginning of trading period. It equals to preceding month’s closing balance. For example, opening balance for June is the same figure as May’s closing balance.

Cash inflows come from sales revenue, debtors, loans, interest received, sale of assets, rental income, etc. Anything that refers to money going inside the business is a cash inflow.

Cash outflows are expenses, such as rent, wages, purchase of stocks, tax, creditors, advertising, interest payments, dividends, etc. Outflows are the opposite of inflows, i.e. they are money going out of the business.

Net cash flow is the difference between cash inflows and cash outflows. It needs to be positive to avoid bankruptcy. If net cash flow is negative for a few months in a row, it is a clear indicator of cash deficiency and liquidity problems. Remember that there are also liquidity ratios that serve as indicators of liquidity issues.

Closing balance is the amount of cash at the end of a trading period. In other words, closing balance equals to opening balance plus net cash flow.

Cash flow forecast is easy to prepare and calculate. The difficult part is categorising items into inflows & outflows and minding their timings. For example, if the case study says that electricity is paid every other month starting with January, then this cash outflow should only be recorded in January, March, May, July, September and November. Unfortunately, many students do not pay attention to these little details and produce inaccurate cash flows forecasts.

Labelling (writing the title, the organisation's name and date/period) of financial statements (balance sheet, profit and loss account, cash flow forecast) is extremely important. You will definitely not get full mark in the IB exam if your statements aren't labelled. Rule of a thumb: label everything. It wouldn't hurt.

First of all, let's clarify what cash flow problems are and how different cash flow is from liquidity. Cash flow is the movement of cash in and out of the business, usually per month. It is recorded in cash flow statement if it’s cash flow for the past and it’s predicted in cash flow forecast if it’s for the future. So, these two documents are the indicators of cash flow. And again, the key word here is movement of cash, which is usually registered per month. Liquidity is a measure of how convertible the current assets are into cash. The indicators of liquidity are current ratio and acid test ratio. Liquidity doesn’t show movement of cash, it shows how liquid a business is at a point in time. So, even though liquidity and cash flow are related, they are not the same.

Another thing that cash flow is directly related to is working capital — the capital that is used in day-to-day operations of the business (= current assets – current liabilities). Basically, it refers to money that an organisation uses day-to-day to support its operations: wages, salaries, bills, overheads. If it’s insufficient, then the business might experience liquidity problems and insolvency. In order to avoid it, there are two major strategies: either to increase cash inflows or (surprise-surprise!) to decrease cash outflows. These can be achieved in several ways that are summarised below. Please copy the table and fill in the pros and cons columns of it as you read.

Firstly, let’s discuss the strategies to increase cash inflows:

• If you are a creditor (you sell products to your debtors and let them pay later), then you might shorten credit period (the time period within which your debtors are obliged to pay). On the one hand, you will receive cash payments earlier. On the other hand, the relationships with debtors might deteriorate and they might be looking for new suppliers.
• If you have too many debtors or even bad debt (a situation when you aren’t able to get payment for your products) then you might use a source of finance that is called debt factoring. The way it works is debt factor buys debts from you in exchange for a fee. For example, A owns $100 to B by next year. If A needs cash urgently, then debt factor may pay $90 to A right now and collect the debt from B in the due time, earning $10. On the one hand, A might get cash payment earlier and improve working capital. On the other hand, A won’t get full payment because debt factors always work for a fee that is a certain percentage of the debt.
• Overdraft is another solution to cash deficiency. If cash flow forecast shows the periods when cash is insufficient, then the organisation might plan an overdraft beforehand. The upside is that it is easy to obtain cash using overdraft: the procedure is usually simple and quick. But the downside is that delayed overdraft repayments have enormous interest rate, so it is better not to delay overdraft payments to avoid the risk of overpaying.
• Sale-and-leaseback is another source of finance that can enhance cash inflows. The way it works is by selling non-current assets and leasing them back immediately. For example, a restaurant sells its pizza oven to someone, but this pizza oven is leased by the restaurant immediately at the time of purchase. It never has to leave the restaurant. The only thing that’s changed, is that restaurant is no longer the owner of that pizza oven and it has to lease it from the new owner, paying a fee every month for using it. On the one hand, in the short-term, you have significant cash inflow for selling a non-current asset. On the other hand, in the long-term, you lose ownership over your asset and you have to pay for using it every month.

Now let’s discuss the strategies to decrease cash outflows:

• If you are a debtor, you may ask your creditors (suppliers) to postpone payment for you, i.e to increase credit period. On the one hand, you are delaying cash outflows. On the other hand, you are ruining relationship with creditors.
• Another way to decrease outflows is to find suppliers who are cheaper. On the one hand, you’ll decrease the outflows and will retain more cash. But, the downside is that “cheaper” often means “worse”, so the quality of produced goods may deteriorate.
• Another way is to reduce expenses. This can be any overhead (indirect cost): internet fee, advertising costs, coffee machine in the office, etc. Cutting some of the expenses will release some cash, but might also result is staff demotivation (if you take away the coffee machine, haha), or decreased brand awareness (if you cut advertising costs).
• Another way to improve cash flow is to use hire purchase — a source of finance that allows to pay for the purchase of non-current (long-term) assets in several instalments, as opposed to one-off payment. This way, if the organisation is in need of some non-current assets (machinery, equipment, etc.) but does not want to spend too much cash at once, payment may be broken down into several smaller instalments. On the one hand, the first payment is lower than paying full price at once. But on the other hand, in the long-term, it means that there will be regular cash outflows monthly and the overall sum paid is usually larger than with the regular one-off purchase.
• Another strategy is to postpone the purchase of non-current assets. It’s more extreme than the aforementioned hire purchase. This way, you are not getting any non-current assets at all… But on the other hand, you save more cash and maintain a sufficient working capital.
• The last strategy that I want to discuss is to improve stock control. Keeping high levels of stock (of finished goods or raw materials) is expensive because it takes substantial place, it should be insured, it should be stored securely, the appropriate temperature needs to be maintained… The extreme idea is to use just-in-time production, that we’ll talk about in Unit 5, when there are no stocks at all. On the one hand, it has a similar effect as cutting down some expenses, i.e. it frees up some cash and improves working capital. But on the other hand, keeping insufficient stocks might result in not being able to sell enough goods to customers, when there is high demand, thus missing an opportunity to make profits.

That is all with regards to strategies for dealing with cash flow problems. I hope you have already filled in the table in Figure 6 and thus you are able to evaluate (discuss pros, cons and implications) of all the strategies. Good job!

Make sure you can define all of these:

1. Cash
2. Cash flow
3. Profit
4. Loss
5. Investment
6. Cash flow forecast
7. Cash flow statement
8. Opening balance
9. Cash inflows
10. Cash outflows
11. Net cash flow
12. Closing balance
13. Working capital
14. Debt factoring
15. Sale-and-leaseback
16. Hire purchase