Unit 3.

7
Cash Flow
Ms Diz
IB Business

In this unit we will learn the difference between Profits, cash flow and investments.
Cash Flow
In this chapter you will learn how to:

Distinguish between profit and cash flow

Working Capital Cycle

Construct and comment on cash flow forecasts

Explain the relationship between investment, profit and cash flow

Evaluate the strategies for dealing with cash flow problems.

Cash flow refers to the movement of the business’s cash inflows and outflows.

Cash flow forecasting and cash flow statements are often used to measure the
financial health of a business.This is because the comparison of inflows and outflows
enables managers to determine whether the organization is able to pay its costs in
order to maintain its business operations.
Concepts of Cash and Cash-Flow

Cash: Money that can enter the business through:

- Sales of goods and services
- Borrowing from financial institutions (banks)
- Investments by shareholders

Cash Flow: The money that flows in and out of the business over a given period
of time.

Cash Inflows: Money received by a business over a period of time.

Cash Outflows: Money paid by a business over a period of time.

Cash is the most liquid asset in a business and it is placed under “Current Assets” in
the Balance Sheet. Cash is essential in the running of a business, and the lack of it
could result in business failure or bankruptcy.

Cash flow is the money that flows in and out of a business, over a given period of
time.

Cash inflows are the monies received by the business over a period of time, while
cash outflows are the monies paid out by a business over a period of time.

Cash flow is a key indicator of a firm's ability to meet its financial obligations. A
positive cash flow will enable businesses to meet their day to day running costs.
Difference between Cash-Flow, Profit and Investment IB EXAM
Question
● Profit is the difference between Total Sales and Total Costs.
● Cash flow is the money that flows in and out of the business over a given period of
time.
● Investment is the act of spending money on purchasing an asset with the
expectation of future earnings. All investments come with a risk.

When a sale is made, customers can either use cash or credit. Either of these two methods will be
recorded as “sales revenue” for the company and count towards to “Total Sales”.

If Total Sales are greater than Total Costs, we will say the business has obtained
a profit.

However, if most of the sales were done on credit, the company

will not have received cash and the amount of cash in the
company will be different to its profits.

In Business Management, the term investment refers to the purchase of fixed

assets (such as equipment and machinery), with the intention of creating a
financial return (profit) in the future. It is therefore often referred to as capital
expenditure.

Investment often requires a large initial amount of cash (for purchasing the fixed
assets), so this can have a negative impact on the organization’s net cash flow.
HOWEVER, in the long run, the business intends for the investment expenditure to
generate a profit for the organization, and improve its net cash flow.

Despite the risks, investment expenditure is important for an organization’s survival

and sustainability. By contrast, the lack of investment can negatively affect
businesses as they fail to adapt to changing needs and wants in the marketplace.

—------------------------------------------------------

Profit is the financial return from the trading activities of a business. It is found
by subtracting the firm’s total costs from its total revenues. Profit is obtained by
subtracting total cost from total revenue:

Profit = Total Revenue - Total Costs

It is a profit if the difference is positive, and it is loss if the difference is negative. Profit
is a great indicator of the financial success of a firm.
—---------------------------------------------------

Cash flow is not the same as profit because a profitable business can still face
liquidity problems. This is because profit is declared if sales revenues exceed total
costs of production, whereas cash flow refers to the actual movement of money in
and out of the organization. The timing of these cash flows depends of the product’s
working capital cycle, so whilst it might be profitable, the firm can still experience cash
flow issues. Cutting costs by using a cheaper supplier might reduce cash outflows, for
example, but this can also reduce cash inflows if quality suffers which results in a fall
in sales.

Profit and Cash Flow are different. When buying goods or services, customers can
either use cash or they can buy on credit. However, if most of the purchases are
credit purchases then the cash flow position at that point in time for the business will
be different from its profitability.

Investment generally refers to the act or state of investing. In finance or business,

investing is spending money on purchasing assets with the expectation of future
earnings. Investing involves wealth creation, including hoping that the bought asset
appreciates and value over time. Examples include buying bonds, stocks, or property.
All forms of investment come with risks, especially risks brought about by unexpected
changes in the market condition in an economy.

—-----------------------------------------------------

In the short run, investment expenditure will negatively affect cash flow profit due to
the higher costs involved. However, in the long run, capital expenditure used to fund
the expansion of a business can increase the firm's cash flows and profits. The
challenge for managers is to strike the right balance between capital and
revenue expenditure. This will largely depend on the business objectives of the
organization (such as growth or profit).
The relationship between Cash-Flow, Profit and Investment IB EXAM
Question

Business Stage Investment Profit Cash-Flow

Start-up High-Investment No Profit Negative cash-flow

Growing High-Investment Small Profits. Costs Cash-flow could be

covered positive.

Established Investment minimal High Profits Cash-flow is positive

The relationship between investment, profit, and cash flow can be linked to the
different stages of growth in a business.

● Startup: This involves very high investment due to the purchase of initial
assets or set-up costs. Profitwise, there is no profit because costs are not yet
met. Cash-flow is negative - cash outflow is significantly higher than cash
inflow
● Growing: Investment could still be high because the business is not yet fully
established. There is a small profit, as more revenue starts to be generated to
cover costs. Cash-flow may be positive.
● Established/thriving: Investment may be minimal as the business can reinvest
profits. High profit is achieves. Cash-flow is positive.

But it is important to note that the above features could be affected by qualitative
attributes beyond the control of the business.
Difference between Cash Flow and Profit

Cash ow relates to the amounts of cash coming into and going out of a business;
profit is the difference between revenue and expenses.

Income is not the same as cash inow because often goods are bought and sold on
trade credit, and there are many non-cash expenses such as depreciation. That is
why organizations create both a profit and loss account and a cash ow forecast.

Another way to view the difference between profit and cashflow is that cash flow (and
working capital) allows a business to purchase resources, transfer them into finished
products, and deliver them to customers. Then, on receipt of payment from the
customer, the business hopefully enjoys a small profitt (if the payment more than
covers the business’s costs for supplying the order).

Working capital and cash flow are the financial mechanisms for creating profits.
Example: Cash Flow vs. Profit

Business ABC Shares the following information for the month of January 2018.

- Total Sales = $ 10,000

- Total Costs = $ 4,000

The business offered is customers a one month credit of 50% to pay.

Profit = Total Sales - Total Costs → $10,000 - $4,000 = $6,000

Cash-Flow = Cash Inflows - Cash Outflows = $5,000 - $4,000 = $1,000

While the profit was $6,000 for that month, the cash-flow is +$1,000.

In this example, during the month in question the business incurred a profit of $6,000
but had a positive cash flow of only $1,000. the cash flow figure is lower than the
profit figure because even though the goods were sold, 50% of the money was not
received in that month. However, the sold goods counted as sales revenue for the
month.
Final Conclusions

A business could obtain high A business could have a

profits, but have very little or no positive cash flow, but be
cash. This concept is known as unprofitable:
- The cash flow could be obtained
insolvency. Why does this through bank loans
happen? - Gained through the sale of assets
- Problems collecting debt - Obtained through shareholder
- Paying suppliers too early funds
- Using too much cash to buy raw
materials instead of buying on credit
- Paying loans with cash

Two possibilities can arise in differentiating between profit and cash flow:
1) A business can be profitable but have little or no cash. this is also known as
insolvency and it may be brought about by:
a) poor collection of funds, possibly by allowing customers a very long
credit period.
b) paying suppliers too early and leaving little or no cash for operations
c) purchasing Capital Equipment or many non-current assets at the same
time
d) Overtrading, this is, purchasing too much stock with cash that is
eventually tied up in the business
e) Servicing loans with cash
2) A business can have a positive cash flow but be unprofitable. It can achieve
a positive cash flow in the following ways:
a) Sourcing cash from bank loans
b) Gaining cash from the sale of a firm’s fixed assets
c) Obtaining cash from shareholders’ funds
The working capital cycle (1)
Working capital enables the business to function and trade.
Working Capital = Current Assets - Current Liabilities
When Current Liabilities (creditors, bank overdrafts, short term loans) are greater
than Current Assets (cash, debtors, stock), we say the company is illiquid or is
facing a liquidity crisis.
If this happens the company may need to be liquidated
to face its debts. When a company is liquidated, all of
the firm’s assets will be sold off to pay for the
outstanding debt, followed by the company’s closure.
Important!
Liquidity position: it determines the solvency of the
business in its day to day operations. It is the ability of
the business to raise cash when it is needed.

Liquidity means the extent to which an organization is able to convert its assets
(items of monetary value owned by the business) into cash. Liquid assets are those
that can be converted into cash quickly and without negatively impacting its market
value. By contrast, illiquid assets are items of monetary value owned by a business
that cannot be converted into cash as easily or quickly (for example, properties, or
equipment).

Remember that working capital is a liquidity metric expressed as the difference

between a company’s current assets and its current liabilities.

Working capital (sometimes referred to as net current assets or circulating capital)

refers to cash or other liquid assets available to an organization for its daily
operations. Working capital is essential to pay for raw materials, utility bills, and staff
wages and salaries. Hence, working capital enables the business to function and
trade.

Working capital is a common measure of an organization's liquidity, efficiency,

and overall financial health. It can be seen on the balance sheet by the difference
between a firm's current assets and its current liabilities, i.e., its net current assets.

Important!: The liquidity position of an organization indicates the extent to

which it has sufficient liquidity to continue its business activities. Being in a
good liquidity position means the business can avoid bankruptcy (business closure)
as the organization has sufficient liquidity to continue operating. A business in a poor
liquidity position may struggle to cover its current liabilities. If the business is not able
to improve its liquidity position, this can eventually lead to bankruptcy.

The liquidity position of a business is important as it shows its ability to repay

short-term liabilities without having to rely on external sources of finance, which could
dilute ownership and control and/or incur debt interest payments. The main method
of measuring a firm's liquidity position is liquidity ratio analysis (Current Ratio
and Acid Test).

It is vital for all businesses to manage their liquidity position in order to prevent a
liquidity crisis (the situation that arises when the organization is unable to pay its
short-term debts).
The working capital cycle (2)
Working capital Management refers to the Working capital cycle
administration of the current assets and the
current liabilities. Making sure there is
enough cash to face the upcoming debts in
the short term.

The working capital cycle is the period of

time between payment of goods
supplied to the business and the
business receiving cash from their
sales.

The working capital cycle of a business refers to the duration between the
organization paying for the production costs of a good or service and it
receiving the cash from customers purchasing the product.

For some businesses, the working capital cycle is very short (quick) as they receive
cash immediately from their sales. For example, cash is commonly used in hair
salons, convenience stores, and taxis. For other businesses, the working capital cycle
is much longer (slow) due to the long production process and/or the high price of their
products. For example, customers are likely to pay in instalments and/or purchase
using credit terms for products such as Lamborghini super sports cars, Airbus aircraft,
and diamond rings.

Positive working capital generally shows that a business is able to pay off its
short-term liabilities very quickly. Negative working capital generally indicates the
business is unable to do so. Therefore, businesses often have to borrow money (such
as using bank overdrafts) during periods of negative cash flow. Short-term finance
options, such as bank overdrafts and short-term loans, can enable the business to
survive whilst it waits for cash inflows to materialise. The longer the working capital
cycle (i.e., the longer inventory is left unsold), the more likely the business is to
face a cash flow crisis.
The working capital cycle (3)

Working capital may be:

- Positive: The business is able to pay off its short-term liabilities very
quickly.
- Negative: The business is unable to do so.

The longer the working capital cycle (i.e., the longer inventory is left
unsold), the more likely the business is to face a cash flow crisis.

The working capital cycle of a business refers to the duration between the
organization paying for the production costs of a good or service and it
receiving the cash from customers purchasing the product.

For some businesses, the working capital cycle is very short (quick) as they receive
cash immediately from their sales. For example, cash is commonly used in hair
salons, convenience stores, and taxis. For other businesses, the working capital cycle
is much longer (slow) due to the long production process and/or the high price of their
products. For example, customers are likely to pay in instalments and/or purchase
using credit terms for products such as Lamborghini super sports cars, Airbus aircraft,
and diamond rings.

Positive working capital generally shows that a business is able to pay off its
short-term liabilities very quickly. Negative working capital generally indicates the
business is unable to do so. Therefore, businesses often have to borrow money (such
as using bank overdrafts) during periods of negative cash flow. Short-term finance
options, such as bank overdrafts and short-term loans, can enable the business to
survive whilst it waits for cash inflows to materialise. The longer the working capital
cycle (i.e., the longer inventory is left unsold), the more likely the business is to
face a cash flow crisis.
Cash Flow Forecast
Cash Flow Forecast is the future predictions of a firm’s cash inflows and. cash outflows
over a given period of time..
Terms:
Liquidity Position: The ability of the business to raise cash when it is needed.
Opening Cash Balance: Cash the business has at the beginning of a particular period,
for example, every month. Or at the beginning of the trading year.
Total Cash Inflows: All cash inflows during a particular period.
Total Cash Outflows: All cash outflows during a particular period
Net Cash Flow: Difference between Total Cash Inflows and Total Cash Outflows.
Closing Cash Balance: Cash the business has at the end of a particular period

Liquidity is the ability of a business to raise cash when it is needed. It determines the
solvency of the business in its day-to-day operations. A business with the ability to
convert its assets to cash to pay off its debt obligations is in a good liquidity position. If
the opposite is the case, then the business could run into working capital problems
and face a serious liquidity crisis including insolvency. An illiquid business (one that is
not able to pay its short-term debts) could also eventually be liquidated (when all a
firm's assets are sold off to pay any funds owing – leading to its closure).

Cash flow forecasting is a quantitative technique used by business managers

to predict how cash is likely to flow into and out of the organization for a
particular period of time, such as for the next twelve months.

Cash flow forecasting is a management tool used to monitor an organization’s cash

flows in order to avoid liquidity problems. Knowing in advance when the business is
likely to face a period of cash shortages (or a liquidity problem) can help it to plan
accordingly so that it can continue to operate.

The forecast is a financial document that shows the expected month-by-month

receipts and payments of a business that have not yet occurred.

Cash inflows are: Cash sales from selling Goods or selling business assets, payments
from debtors, cash investments from shareholders, and borrowings from Banks.

Cash outflows are: Purchasing materials or fixed assets, cash expenses such as
rent, wages, and salaries; paying creditors; repaying loans; and making dividend
payments to shareholders.

Closing cash balance: this is the estimated cash available at the end of the month.
It is found by adding the net cash flow of one month to the opening balance of the
same month.

Closing balance = Opening balance + inflows - outflows

 Cash flow forecast for (Business X), for the first three months of 20XX
All figures in $'000

Jan Feb Mar

Opening balance 10 20 15

Cash inflows
- Cash sales revenue 200 180 190
Cash-Flow Forecast - Tax refund 10

Example Total cash inflows 200 190 190

Cash outflows
- Rent 20 20 20
This is the - Packaging 5 5 5
- Salaries and wages 30 30 30
recommended IB - Cost of sales 100 110 105
- Heating and lighting 20 15 10
format (applies to For - Delivery 15 15 15

Profit and Non-For Total cash outflows 190 195 185

Profit businesses).
Net cash flow 10 (5) 5

Closing balance 20 15 20

Note that: Closing balance = Opening balance + Net cash flow

Important: Note that on the official IB format used, negative numbers are written in
brackets.

Cash flow forecasts are based on estimates, its accuracy depends on the business’s
ability to predict its future cash inflows and cash outflows.

To calculate cash flows for each time period, the following items are needed:

- Opening balance: refers to the value of cash held by a business at the start of
a trading period (usually the beginning of the month).
- Net cash flow: is the numerical difference between an organization’s total cash
inflows and its total cash outflows, per time period.
- Closing balance: refers to the value of cash held by a business at the end of a
trading period (usually the final day of the month), which therefore becomes
the opening balance for the next time period.

Remember that a cash flow forecast (CFF) is different from a cash flow statement
(CFS). A CFF is a prediction of the cash flows in and out of a business over the
foreseeable future. The CFS shows the actual cash inflows and outflows for a
specified time period.
Cash Flow Forecasting Formulae

Cash flow forecasting formulae

Net cash flow = Total cash inflow – Total cash outflow

Closing balance = Opening balance + Net cash flow

Opening balance = Closing balance in previous month

Note that these formulas will not be provided by the IB in the final examinations.
 Cash Forecast for XYZ Ltd for the first 5 months of trading
All figures in $ January February March April May

Opening Balance $2,000 $4,500 $5,600 $4,650 $3,250

Cash Inflows

Cash sales revenue $10,000 $9,000 $8,000 $9,500 $7,500

Payments from
debtors $6,000 $5,000 $4,500 $4,000 $4,750
Rental Income $4,000 $4,000 $4,000 $4,000 $4,000
Another Cash-Flow
Total Cash Inflows $20,000 $18,000 $16,500 $17,500 $16,250
Forecast Example
Cash Outflows
Electricity $1,500 $1,800 $1,750 $2,000 $1,900

What do you think Raw Materials $5,000 $4,000 $4,500 $5,500 $6,000
Rent $3,000 $3,000 $3,000 $3,000 $3,000
about this business’s Wages $5,000 $5,000 $5,000 $5,000 $5,000

cash flow situation? Telephone $500 $600 $700 $900 $450

Loan Repayments $2,500 $2,500 $2,500 $2,500 $2,500

Total Cash
Outlfows $17,500 $16,900 $17,450 $18,900 $18,850
Net Cash Flow $2,500 $1,100 ($950) ($1,400) ($2,600)
Closing Balance $4,500 $5,600 $4,650 $3,250 $650

In the above example, XYZ Ltd. shows a positive closing balance at the end of May.
However, this amount has been reducing since March. This can be attributed to the
negative net cash flows in March, April and May.

Cash flow forecasts are based on estimates, its accuracy depends on the business’s
ability to predict its future cash inflows and cash outflows.
Examples of INFLOWS (on IB papers)
● Bank loans ● Interest received on savings in
a business bank account
● Bank overdrafts
● Crowdfunding sources
● Business angels
● Government grants and/or
● Capital injections from the owners of the subsidies
business
● Payments made to the
● Cash injection from sponsor business from its debtors

● Cash used by customers to pay for the ● Tax refunds from the
sale of goods and services government

Remember that with a new business start-up it is assumed that the opening
balance is zero before owners inject their startup capital.
Examples of OUTFLOWS (on IB papers)
● Advertising costs ● Packaging costs

● Cost of sales ● Purchasing of stock (inventory)

● Delivery charges ● Rent of buildings and premises

● Financial perks (benefits given to ● Staff wages and salaries

customers)
● Telecommunications, including
● Heating and lighting costs Internet charges

● Insurance premiums ● Utility bills, e.g. gas, water, electricity,

and telephone
Cash-Flow Forecast Activity
1 John injects $4,000 of his own money into the business
John plans to open a restaurant 2 He has obtained a $6,000 bank loan.
next year beginning in January. 3 Wages are $5,000 per month.
Use the following information to Sales revenues for the first five months are estimated
at: $2,000, $4,000, $5,000, $5,500, and $6,000
construct a cash-flow forecast for 4 respectively

the first five months of operation.

Material expenses are 50% of sales revenue, paid in
When you are done, comment on 5 cash

the situation of the restaurant. Total Advertising costs of $6,000 are paid in two
6 installments on February and April.

7 A loan repayment of $500 per month

8 Rent of $6,000 every month

Advantages of Cash-Flow Forecast

1) Useful as a planning document for anyone in the initial stages of the business.

2) Useful to apply for financing from financial institutions.

3) Useful to predict slow periods or periods with less cash and act accordingly.

4) Assists in monitoring and managing cash-flow. Finding differences between

estimates and observed figures a company might find the source of a
problem.

Cash flow problems arise when an organization has insufficient funds to run its
business, i.e. when net cash flow is negative. Such problems can arise due to
internal reasons (such as poor cash flow management) and external factors (such
as changes in consumer preferences and tastes).

● A cash flow forecast is a useful planning document for anyone wishing to start
a business because it helps to clarify the purpose of the business and
provides estimated projections for future performance.
● It provides a good support base for businesses intending to apply for funding
from financial institutions. this is because they enable the banks to check the
business's solvency and credit worthiness.
● Predicting cash flow can help managers identify in advance. When the
business may need cash and therefore plan accordingly to source it
● Cash flow forecast can help with monitoring and managing cash flow. By
making comparisons between the estimated cash flow figures and its actual
figures, a business should be able to assess where the problem lies and see
the respective solutions to solve it.
Limitations of Cash-Flow Forecast

1) Mistakes can be made by inexperienced entrepreneurs or staff

2) Unexpected cost increases can lead to inaccuracies.

3) Incorrect assumptions in estimating sales revenues (due to poor market

research, for example), leading to inaccurate inflow forecasts.

● Mistakes can be made in preparing the revenue and cost forecasts or they
may be drawn up by inexperienced entrepreneurs or staff
● Unexpected cost increases can lead to major inaccuracies in forecasts. For
example, fluctuations in oil prices can cause the cash flow forecasts of major
airlines to be misleading.
● Incorrect assumptions can be made in estimating the sales of the business,
perhaps based on poor market research, and this will make the cash inflow
forecasts inaccurate.
Examples of Cash-Flow Problems
Cash flow problems arise when an organization has insufficient funds to run its
business. Such problems can be due to internal reasons (such as poor cash flow
management) and external factors (such as changes in consumer preferences and
tastes).
● A lack of financial planning (lower sales revenue)
● Poor credit control (bad debts: debtors who are unable to pay for their
purchases that have been bought on trade credit)
● Poor cost control, higher costs of production than budgeted
● Poor inventory control (overstocking of products)
● Overtrading (i.e. the firm expanding too fast)
● Seasonal fluctuations in demand
● Unexpected events, such as a crisis or unforeseen costs that arise rapidly.

Cash flow problems arise when an organization has insufficient funds to run its
business, i.e. when net cash flow is negative. Such problems can arise due to
internal reasons (such as poor cash flow management) and external factors (such
as changes in consumer preferences and tastes).

Examples of causes of cash flow problems include:

- A lack of financial planning resulting in sales revenue being lower than

expected
- Poor credit control, which can lead to bad debts (debtors who are unable to
pay for their purchases that have been bought on trade credit)
- Poor cost control, resulting in costs of production being higher than budgeted
- Poor inventory control, resulting in overstocking of products (which have cost
money to purchase but have yet to be sold to customers)
- Overtrading, i.e. the firm expanding too fast, which increases cash outflows,
but not necessarily with the cash inflows
- Seasonal fluctuations in demand for the firm’s goods and/or services
- Unexpected events, such as a crisis or unforeseen costs that arise rapidly.
Strategies for improving Cash-Flow
There are three general ways for an organization to improve its cash flow position:

● Strategies to reduce cash outflows

● Strategies to increase cash inflows
● Strategies that seek additional sources of finance.

Shortening the working capital cycle can improve cash flows

A business can be profitable yet insolvent, which means it is facing a liquidity crisis
and is having difficulties in sustaining its working capital to run its day today
operations.

The major causes of cash flow problems in a business are a lack of effective planning
and poor credit control. The following strategies can be used to deal with these
problems:

- Reducing Outflows: The first thing we can do is reduce cash outflows which
aim to decrease the amount of cash leaving the business
- Increasing inflows.
- Seeking additional sources of finance.

When answering exam questions about how an organization can improve its cash
flow position, avoid generic statements such as improving cash inflows, reducing
cash outflows, or looking for alternative finance. Context is important, not just content.
Make sure you write your answers in the context of the case study; read the following
slides for more specific answers.
Strategies to improve cash-flow problems (1)

Strategy Type: Reducing Outflows

Strategy Drawback

Delay payments to suppliers or creditors Damage future relationship. Refusal of

supply

Delay payments/purchase of Fixed Assets Decreased efficiency and higher costs

Decrease expenses (advertising) Demand goes down

Source cheaper supplies Quality goes down

Possible strategies to reduce cash outflows include:

- Negotiate with creditors and suppliers to improve trade credit terms.

Securing a longer credit period helps to delay cash outflows. This helps it to
have working capital for its short-term needs. The drawbacks with this are the
negotiations may be time-consuming and delaying payment to suppliers could
affect future relationships (suppliers May refuse to supply in the future).

- A business could look into sourcing cheaper suppliers. This will help to
reduce costs for materials or essential stock, decreasing the outflow of funds.
A possible danger of this is that the quality of the finished product may be
compromised affecting future consumer relationships.

- Pay for purchases of goods and services on trade credit, rather than using
cash.

- Opt for leasing capital equipment instead of purchasing such assets.

Although this reduces the organization’s net assets on its balance sheet, it can
provide much needed liquidity for the firm. Assets such as machinery and
equipment may take up a lot of the business's cash, and leasing them or
delaying purchases of them helps to avail cash in the business. However, if
the machines or equipment are becoming obsolete or outdated, delaying the
purchase or replace an replacement may lead to decreased efficiency and
higher costs in the long term.
- A business can decrease specific expenses that will not affect production
capacity, such as advertising costs. If not well checked, though, this may
reduce future demand for a business products.

- Reducing stock levels (inventories), as this can reduce cash outflows

needed to pay for purchasing stocks. This is particularly important for
organizations with a long working capital cycle.
Strategies to improve cash-flow problems (2)

Strategy Type: Increasing Inflows

Strategy Drawback

increase/ Decrease prices Might reduce revenue if done incorrectly

Reduce credit period: i.e. allow only cash Loss of customers

payments from customers.

Offer discounts to debtors for early Business receive less cash

payments

Diversify product offering. More goods on Producing different goods comes at a

sale will increase sale revenue higher cost.

Use debt factoring Business receive less cash

Possible strategies to increase cash inflows include:

- Raising prices of the products the business sells that have few substitutes
or a high degree of brand loyalty. Loyal customers are not overly sensitive
to higher prices, so this earns a greater profit margin for the business.

- Reduce prices of the products the business sells that have a high degree
of competition. This can help to attract customers from rival firms.

- Reducing the credit period helps to improve the cash flow cycle, because
customers buying on credit pay within a shorter time period. However, some
customers may be unhappy about having to pay earlier, so may seek
alternative providers that offer better credit terms. I.e.: A business can insist
that customers only pay with cash when buying goods.This avoids the problem
of delaying payments from debtors, which ties up cash. The disadvantage is
that the business may lose customers who prefer to buy goods on credit.

- Encourage debtors to pay their invoices early by offering discounts. This

shortens the working capital cycle. Offering discounts or incentives can
encourage debtors to pay early. This will reduce the debt burden on debtors as
they will pay less than earlier agreed. The limitation here is that, after the
discount, businesses will receive less cash than previously expected.

- A firm may diversify its product offering. This will help to increase the variety of
- goods on offer to customers, potentially increasing sales. It is worth
remembering that diversification comes with higher costs and with no clear
guarantee of sales.

- Improved marketing strategies to attract customers, raise brand awareness,

boost sales and develop customer loyalty.

- Use a debt factoring service to chase up outstanding debtors.

Strategies to improve cash-flow problems (2)

What is Debt Factoring?

Debt factoring is a financial service provided to business who are struggling to collect
money from their debtors and/face liquidity problems.

The debtor factoring service provider, such as a commercial bank, takes over the
responsibility for collecting the debt owed to the business.

In return for its services, the debt factor will keep 10 to 20 percent of the amount
owed as its fee.

Debt factoring is a financial service provided to business who are struggling to collect
money from their debtors and/face liquidity problems. The debtor factoring service
provider, such as a commercial bank, takes over the responsibility for collecting the
debt owed to the business.

The debt factor will usually pay the business 80 to 90 per cent of its outstanding
invoices, and pursue the debts from the firm’s debtors. In return for its services, the
debt factor will keep 10 to 20 percent of the amount owed as its fee. Hence, the
higher the amount owed, the keener debt factors will tend to be as the potential profit
is higher.

The advantages of debt factoring as a source of external finance include:

The debt factor provides much needed cash to a business, especially if it is facing a
liquidity problem; getting 80 or 90 per cent of the amount owed by its debtors is better
than getting zero amount.

It frees up the organization to focus on its core business operations, rather than
having to personally spend time and resources to chase outstanding payments from
its customers.

The disadvantages of debt factoring as a source of external finance include:

The debt factor will charge up to 20% of the value of amount owed by the firm’s
debtors as its fee; this is a significant amount of money for the business to pay for
such a service.

Being able to chase up its own debtors means the business would have all of the
money owed to it, even if this means waiting a bit longer for the money to be paid.

It is usually used as a last resort, especially as the demands from the debt factoring
service provider can be perceived as ‘threatening’. This can damage the firm’s
relationship with its customers, even though they have yet to settle their invoices.
Strategies to improve cash-flow problems (2)

Debt Factoring Advantages

The advantages of debt factoring as a source of external finance include:

The debt factor provides much needed cash to a business, especially if it is facing a
liquidity problem; getting 80 or 90 per cent of the amount owed by its debtors is better
than getting zero amount.

It frees up the organization to focus on its core business operations, rather than
having to personally spend time and resources to chase outstanding payments from
its customers.

Debt factoring is a financial service provided to business who are struggling to collect
money from their debtors and/face liquidity problems. The debtor factoring service
provider, such as a commercial bank, takes over the responsibility for collecting the
debt owed to the business.

The debt factor will usually pay the business 80 to 90 per cent of its outstanding
invoices, and pursue the debts from the firm’s debtors. In return for its services, the
debt factor will keep 10 to 20 percent of the amount owed as its fee. Hence, the
higher the amount owed, the keener debt factors will tend to be as the potential profit
is higher.

The advantages of debt factoring as a source of external finance include:

The debt factor provides much needed cash to a business, especially if it is facing a
liquidity problem; getting 80 or 90 per cent of the amount owed by its debtors is better
than getting zero amount.

It frees up the organization to focus on its core business operations, rather than
having to personally spend time and resources to chase outstanding payments from
its customers.

The disadvantages of debt factoring as a source of external finance include:

The debt factor will charge up to 20% of the value of amount owed by the firm’s
debtors as its fee; this is a significant amount of money for the business to pay for
such a service.

Being able to chase up its own debtors means the business would have all of the
money owed to it, even if this means waiting a bit longer for the money to be paid.

It is usually used as a last resort, especially as the demands from the debt factoring
service provider can be perceived as ‘threatening’. This can damage the firm’s
relationship with its customers, even though they have yet to settle their invoices.
Strategies to improve cash-flow problems (2)

Debt Factoring Disadvantages

The debt factor will charge up to 20% of the value of amount owed by the firm’s
debtors as its fee; this is a significant amount of money for the business to pay for
such a service.

Being able to chase up its own debtors means the business would have all of the
money owed to it, even if this means waiting a bit longer for the money to be paid.

It is usually used as a last resort, especially as the demands from the debt factoring
service provider can be perceived as ‘threatening’. This can damage the firm’s
relationship with its customers, even though they have yet to settle their invoices.

Debt factoring is a financial service provided to business who are struggling to collect
money from their debtors and/face liquidity problems. The debtor factoring service
provider, such as a commercial bank, takes over the responsibility for collecting the
debt owed to the business.

The debt factor will usually pay the business 80 to 90 per cent of its outstanding
invoices, and pursue the debts from the firm’s debtors. In return for its services, the
debt factor will keep 10 to 20 percent of the amount owed as its fee. Hence, the
higher the amount owed, the keener debt factors will tend to be as the potential profit
is higher.

The advantages of debt factoring as a source of external finance include:

The debt factor provides much needed cash to a business, especially if it is facing a
liquidity problem; getting 80 or 90 per cent of the amount owed by its debtors is better
than getting zero amount.

It frees up the organization to focus on its core business operations, rather than
having to personally spend time and resources to chase outstanding payments from
its customers.

The disadvantages of debt factoring as a source of external finance include:

The debt factor will charge up to 20% of the value of amount owed by the firm’s
debtors as its fee; this is a significant amount of money for the business to pay for
such a service.

Being able to chase up its own debtors means the business would have all of the
money owed to it, even if this means waiting a bit longer for the money to be paid.

It is usually used as a last resort, especially as the demands from the debt factoring
service provider can be perceived as ‘threatening’. This can damage the firm’s
relationship with its customers, even though they have yet to settle their invoices.
Strategies to improve cash-flow problems (3)

Strategy Type: Looking for additional finance sources

Remember from previous chapters, a business can look for additional sources of
finance by:

- Selling assets: focus on selling obsolete assets. Selling assets that are still
needed could reduce production.

- Using bank overdrafts: high interest rates

- Selling and leasing back:Assets are sold and hired back for production. In the
long run might be costly.

- Sale of assets: the focus should be on selling obsolete fixed assets to

generate cash. Selling assets that are still needed could lead to reduced
production.

- Arranging a bank overdraft: this is a short-term loan facility that allows firms
to overdraw from their accounts. It is a great help during times of immediate
cash setbacks. However, there will be interest payments on the overdraft,
which are usually high.

- Sale and leaseback: assets can be sold to generate cash and these assets
can then be hired back by the business for use in production. The
disadvantage is that leasing can prove costly in the long run, and this also
denies the business the use of the asset as collateral when seeking future
loans.
 Strategies to improve cash-flow problems

IB EXAM
Question

- A business can insist that customers only pay with cash when buying
goods.This avoids the problem of delaying payments from debtors, which ties
up cash. The disadvantage is that the business may lose customers who
prefer to buy goods on credit.
- Offering discounts or incentives can encourage debtors to pay early. This will
reduce the debt burden on debtors as they will pay less than earlier agreed.
The limitation here is that, after the discount, businesses will receive less cash
than previously expected.
- A firm may diversify its product offering. This will help to increase the variety of
goods on offer to customers, potentially increasing sales. It is worth
remembering that diversification comes with higher costs and with no clear
guarantee of sales.
Limitations of cash-flow forecasting

1) Unexpected changes in economy

2) Poor market research
3) Difficulty in predicting competitor’s behavior
4) Unforeseen machinery or equipment failure
5) Demotivated Employees

A cash flow forecast is generally a prediction, and inaccuracies are bound to occur
that limit the forecasts effectiveness. Some of the causes of these inaccuracies
include the following:

- Unexpected changes in the economy: for example, fluctuating interest rates

could affect borrowings by firms and have a negative impact on their cash flow
needs
- Poor market research: improperly done sales forecasts due to poor demand
predictions can have a negative effect on future cash sales, thereby affecting
cash inflows
- Difficulty in predicting competitor’s behavior: competitors may change their
strategies often and make it hard for other businesses to predict their actions
and compete with them. this can negatively affect the cash flow of a struggling
business.
- Unforeseen machine or equipment failure: breakdown of machinery is difficult
to predict, and it can drastically affect the cash position in a business.
- Demotivated employees: being demotivated can negatively affect the
productivity of workers, reducing output or sales and leading to less cash
inflow.
 January February March April May
Solution Opening Balance 0( ($500) ($13,00)0 ($22,000) ($33,750)
Cash Inflow
Share Capital Injection $4,000

Solution to John’s Bank Loan $6,000

Sales Revenue $2,000 $4,000 $5,000 $5,500 $6,000
Restaurant
Cash-Flow Total Cash Inflows $12,000 $4,000 $5,000 $5,500 $6,000

Forecast. Cash Outflows

Wages $5,000 $5,000 $5,000 $5,000 $5,000
For more exercises,
reference the Material Expenses $1,000 $2,000 $2,500 $2,750 $3,000
Advertising Costs $0 $3,000 $0 $3,000 $0
documents on Loan Repayment $500 $500 $500 $500 $500
google classroom Rent $6,000 $6,000 $6,000 $6,000 $6,000

Total Cash Outflows $12,500 $16,500 $14,000 $17,250 $14,500

Net Cash Flow ($500) ($12,500) ($9,000) ($11,750) ($8,500)
Closing Balance ($500) ($13,000) ($22,000) ($33,750) ($42,250)

With a new business start-up it is assumed that the opening cash balance is zero
before owners inject their startup capital.