What is meant by cash flow?
Cash is a liquid asset, meaning that i can be spent on goods and services any time. Many business experience cash flow problems, meaning that they do not have enough cash to do what they want to do. Cash flow means "the flow of money in and out of a business". These are ways cash flow can occur:
* Sale of goods for cash.
* Payment from debtors.
* Borrowing from a source (but will inevitably lead to cash outflow in the future).
* Sale of unwanted assets.
* Investment from investors: shareholders and owners
* Purchasing goods for cash.
* Payment of wages, salaries and others in cash.
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This creates something known as insolvency:
* Profitable business could run out of cash because of various reasons. This is called insolvency and it is one main reason why businesses fail.
* This can be because of several reasons:
* Allowing customers too long to pay back, so that they will not have paid off the debts yet by the time the business has run out of cash.
* Purchasing too many assets at once.
* Producing or purchasing too much stock/inventory when expanding too quickly. This is called over trading.
Here is an example of a cash flow statement:
As you can see, the closing bank balance in February is negative, which means that it has become overdrawn.
Cash flow forecasts
Because of the aforementioned problems, it is important for the manager to get an idea of how much cash will be available for which months. A cash flow forecastcan tell the manager:
* How much cash is available for paying bills, loans and other fixed assets.
* How much the bank might need to lend to avoid insolvency.
* Whether the business has too much cash which could be more useful if used.
Uses of cash flow forecasts:
* Starting up a business: In the first months of a business, a lot of capital will be needed to set it up properly. The problem is, not everybody realises that the amount of money they needed is much more than they had expected. Therefore, a cash flow forecast will give them a better idea of how much money will be needed.
* Keeping the bank manager informed: It needs to be shown to the bank to inform it of the size of the needed loan/overdraft, when it is needed, how long it is needed and when it could be repaid. Only then will the bank give you a chance to get a loan.
* Running an existing business: It is important to know the cash flow of a business so that loans could be arranged in advance in order to get the least interest possible. If a firm has cash flow problems and goes to the bank for a loan for the next day, it will charge high interests because it knows that the business has no choice. Also, if a business exceeds the overdraft limit without informing the bank, it could be asked to repay the overdraft immediately and could result in closure of the business.
* Managing cash flow: If a business has too much cash, it should put the cash to some good use quickly. Some examples of this is: repaying all loans for less interest, paying creditors immediately to get discounts.
How can cash flow problems be solved?
Here are some steps to solve cash flow problems:
* Arrange for future loans with the bank when you anticipate negative cash flow.
* Reduce or delay planned expenses until cash is available, e.g. ask to pay in credit.
* Increasing forecasted cash inflow, e.g. by getting a part-time job.
For more information on the importance of cash flow visit page 132 in the book. This case study will give you a lot of information.
Chapter 9: Financing business...