Business Studies Cash Flow Forecasts

For first teaching from September 2009 For first award in Summer 2011

GCSE

Cash flow forecasts At the end of this unit students should be able to: Explain the difference between cash flow and profit Explain the purpose of cash flow forecasts Construct and interpret a cash flow forecast from given information Analyse the consequences of incorrect forecasts

Setting the scene: Keanes Klothing Keanes Klothing was set up by fashion design student Robert Keane in 2009. The company sold individualised, high quality clothes for the fashion conscious. Roberts had developed a reputation while in fashion school for innovative designs and high quality finishes and had sold quite a number of his pieces to local shops. Robert decided to open his own company when he graduated and was sure that his business would be a success as a large number of people had expressed an interest in purchasing his designs. However, only 6 months after opening the business, with the help of his savings and a 4,000 loan from the bank, Robert had to close the business, despite having lots of orders and a net profit margin of around 80%. The problem was Robert had to spend money on rent, electricity, phones, wages and raw materials while he was working on his clothing. However Robert did not receive any money until he had sold the final piece. After 6 months of paying bills and receiving little income Robert simply ran out of cash. The difference between profit and cash flow Profit refers to the difference between the income of the business and all its costs/expenses. It is calculated by subtracting total costs from total revenues. Whereas cash flow refers to the money that enters and leaves the business over a period of time as it makes and receives payments. Net cash flow is calculated by subtracting cash outflows from cash inflows. Keanes Klothing was forced to shut down, not because it was unprofitable but because it experienced problems with cash flow. It did not have enough money coming in over the first 6 months to cover all its outgoings. Had Keanes Klothing managed to stay in business until it had received money from selling some of its clothes it might have become quite a profitable and successful business. Cash flow forecasting As the story of Keanes Klothing illustrates, maintaining adequate cash flow is vitally important for the success of a business. An important element therefore of business planning is the preparation of a cash flow forecast. Like any forecast, a cash flow forecast is an estimate or prediction in this case of the likely cash inflows and outflows over a period of time.

For an established firm, cash flow forecasts are based on past company data and estimates of what is likely to happen in the future. However for a new firm such as Keanes Klothing they are based on market research information collected as part of the overall business plan. Purpose of a cash flow forecast Identify periods of shortfall One of the primary reasons for carrying out a cash flow forecast is to identify periods of time when the firm is likely to experience cash flow problems. This allows the firm to plan appropriate loans and overdrafts to ensure that it can meet its commitments. Identify opportunities for expenditure Cash flow forecasts allow firms to predict periods of surplus cash. Firms can use this information to plan for the repayment of loans or the purchase of high costs items without the need for further borrowing. Help in the application for loans or other sources of finance Banks will expect firms to have prepared detailed cash flow forecasts prior to any application for a loan. A cash flow forecast will show the bank when and how the money could be repaid. Constructing a cash flow forecast A cash flow forecast has 3 sections: 1. Cash inflows money received by the firm from sales, investments and other sources; 2. Cash outflows money paid out by the business on wages, raw materials and other items; and 3. Balances the opening and closing balance on a monthly balance. Fig 1: A typical cash flow forecast Cash flows Cash inflows New capital Sales Total cash inflow (1) Cash outflows Rent Wages Advertising Utilities (electricity, telephone) Equipment Jan 10,000 4,000 14,000 Feb 0 18,000 18,000

500 2,000 1,500 500 8,500

500 2,000 1,500 500 0

Materials Total cash outflow (2) Opening balance (3) + Net cash flow (1-2) = Closing balance

4,000 17,000 5,000 -3000 2,000

4,000 8,500 2,000 9,500 11,500

Activity Complete the cash flow forecast for March and April using the following information: Sales are expected to increase to 19,000 in March and April The cost of materials increases to 5,000 in March but returns to 4,000 in April The firm purchases a new piece of equipment in March which costs 6,000 All other items remain the same as in February January 10,000 4,000 14,000 February 0 18,000 18,000 March April

Cash flows Cash inflows New capital Sales Total cash inflow (1) Cash outflows Rent Wages Advertising Utilities (electricity, telephone) Equipment Materials Total cash outflow (2) Opening balance (3) + Net cash flow (1-2) = Closing balance

500 2,000 1,500 500 8,500 4,000 17,000 5,000 -3000 2,000

500 2,000 1,500 500 0 4,000 8,500 2,000 9,500 11,500

The need for accurate forecasting Cash flow forecasting, like weather forecasting, is an inexact science. No one can see into the future and therefore there may be huge differences between the predicted cash flow and the actual cash flow. The difference between predicted performance and actual performance is known as variance. If the variance is large and adverse (actual

performance is worse than predicted performance) it can cause huge problems for the business. If the firm does not have enough cash to meet its commitments it may be forced to shut down as was the case with Keanes Klothing. Even when a firm is able to remain in business it may have to arrange an overdraft or short term loan to cover its cash flow problem. Alternatively the firm may decide to sell some of its assets to free up cash. Case study: Petes Pizza Slices Peter Smith plans to open a pizza slice shop in the centre of Belfast. Peter will use his savings of 14,000 to get the shop up and running. The rent for the pizza shop is set at 200 per month. Peter will employ one full-time chef and one part-time chef. The fulltime chef will be paid 1500 per month and the part-time chef will be paid 600 per month. The phone package that Peter has will cost 40 per month and has unlimited calls. Pete expects his electricity bill to be approximately 800 per quarter and is payable in March, June, September and December. Peter expects to spend 8000 kitting the pizza shop out and expects to spend 1000 per month on ingredients in January and February and 1500 in March as demand picks up. Peter expects his sales to be 2000 in Jan and February and 3500 in March. 1. Prepare a cash flow forecast for Petes Pizza Slices for January, February and March. 2. Explain why the actual cash flow situation might be different from Petes forecasts 3. Look at the closing balance for March. What advice would you give Pete to help him deal with this situation? Knowledge review/ Key terms Profit refers to the difference between the income of the business and all its costs/expenses. It is calculated by subtracting total costs from total revenues. Cash flow refers to the money that enters and leaves the business over a period of time as it makes and receives payments. Net cash flow is calculated by subtracting cash outflows from cash inflows. A cash flow forecast is an estimate of the likely cash inflows and outflows over a period of time. Cash inflows are the money received by the firm from sales, investments and other sources. Cash outflows are the money paid out by the business on wages, raw materials and other items.

Revision questions: 1. Explain how a profitable firm may experience cash flow problems. 2. Give 3 reasons why a firm should carry out a cash flow forecast. 3. Explain the three main sections of a cash flow forecast. 4. What is meant by the term variance? 5. Explain 3 consequences of an inaccurate cash flow forecast.