Improving Cash Flow

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

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

Loans from bank Dividends paid to shareholders

Share capital invested Repayment of loans

Why Businesses Need Cash

Finance is needed for…

Business Set-up

Day-to-day trading (working capital)

Growth

A Typical Cash Flow Cycle

Stocks ordered

from supplier

Production turns stocks

into products

Products sold to

customers

Customers pay for

their purchases

Stocks held until a

customer is found

Outflow - cash paid to

suppliers & employees

Inflow – cash paid by customers

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

What is cash flow problem?

When a business does not have

enough cash to be able to pay

its liabilities

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

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

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

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

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”

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

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

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

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

Handling Cash Flow Problems

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

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

Managing Working Capital

Stocks Debtors Creditors

Focus on

Improving working capital

DebtorsAmounts owed by customers

CreditorsAmounts owed to suppliers

Stocks Cash tied up in stocks

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

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

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

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

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

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

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

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

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

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

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

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

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 levelsBut • 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

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?

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 borrowed under the facility

Appropriate method of financing fixed assets

Not secured on assets of business

Disadvantages

Can be withdrawn at short notice Requires security (collateral)

Interest charge varies with changes in interest rate

Interest paid on full amount outstanding

Higher interest rate than a bank loan Harder to arrange

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

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!

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Improving Cash Flow