Cash Flow
Cash flow is the amounts of money flowing into and out of a business over a period of time.
Too much cash = Firm will have less machinery and stock than it can afford and so make less profit.
Too little cash= Threaten survival if a bill cannot be paid.
To get the right balance= Plan its cash holdings --> By having a cash-flow forecast --> Firm can identify problems and take appropriate action (e.g. arranging a bank overdraft)
Causes of cash-flow problems
1. Seasonal Demand
Companies typically incur costs in producing in advance of the peak season for sales. However because the problem is predictable, it is easy to persuade suppliers to provide credit or to negotiate a bank overdraft.
2. Overtrading
Firms become too confident and expand rapidly, not organising sufficient long-term funds. Putting a strain on working capital. Businesses often give credit to customers. Rapid expansion = Businesses to buy more materials but lacks money, this is because customers are not paying for the goods as soon as they are sold. This leaves the business short of cash.
3. Over-investment in fixed assets
Firms invest in fixed assets to grow, but leaves them with inadequate cash for day-to-day payments. Could drain the business of finance and lead to cash-flow problems. Equipment and buildings cannot easily be turned back into cash. Extreme situations = Can't pay debts, even though the business has plenty of assets.
4. Credit sales
Marketing dep. would want to give credit to customers --> To encourage them to buy --> lead to lack of cash in the organisation if sales are not leading to immediate receipts of cash.
5. Poor stock management
Hold excessive stock levels, tying up cash that could be used for other purposes.
High level of stock= Danger --> Stock becomes worthless as it is --> out-of-date or unfashionable.
But Low stock levels= Limit sales --> esp. impulse buys
Buying large quantities of stock --> Business benefits from discounts. Can this offset the costs of carrying high stock levels?
6. Poor management of suppliers
A well managed business should be able to negotiate a credit period with suppliers so that payment from customers reaches the business at the same time the business needs to pay suppliers.
Good supply chain management also means negotiations on a reasonably low price so money won't be wasted. It also ensures prompt deliveries of materials so customers will not be lost.
7. Unforeseen changes
Internal changes --> e.g. machinery breakdown
External Factors --> e.g. a change in government legislation
Due to? Management errors? Poor planning? Bad luck?
8. Losses or low profit
Remember that cash flow and profit is different but linked.
Sales revenue less than expenditure --> Usually have less cash than one making a healthy profit.
Also creditors and investors would be less likely to put money into a business that is not expecting to make profit in the future.
Unless a loss-making business can prove it will be profitable in the future, it will be difficult to overcome cash-flow problems.
Methods of improving cash flow
1. Bank overdraft
An agreement whereby the holder of a current account at a bank is allowed to withdraw more money than there is in the account. The agreement specifies the maximum level of the overdraft.
Benefits of an overdraft:
- Administrative convenience - Easy to arrange, once agreed= Confirmation only needed on an annual basis
- Flexibility - Flexible because it can be used to pay for whatever the business requires at the time
- Interest is paid on the amount owed - Only pay interest on the amount of the overdraft that is actually used. Paid on a daily basis.
- No security necessary - Unlike a bank loan, no collateral needed.
Problems of an overdraft:
- Variable interest payments - Based on flexible interest rates. The interest paid will rise and fall with the Bank of England's base rate. Difficult to budget accurately, as the bank may change its rate of interest on a monthly basis.
- Higher interest rate - Higher than a short-term bank loan. Overdraft can prove to be more expensive than a loan.
- Immediate repayment - Agreement to an overdraft means bank can demand immediate repayment. Business with cash flow problems may be forced to pay back the money to the bank at exactly the same time the business is most vulnerable.
2. Short-term Loan
A sum of money provided to a firm or individual for a specific, agreed purpose. Repayment of the loan will take place within two years, and possibly much less.
Benefits of a bank loan:
- Fixed interest repayments - Fixed rate of interest. The interest and repayment schedule is calculated at the time of the loan, so it is easy for a business to know whether it can afford to repay the loan. Easy to budget the loan repayments, can pay the same amount each month over the duration of the loan.
- Lower interest rate - Less than the rate charged on an overdraft. A cheaper solution to a cash-flow problem.
- Higher interest repayments - Interest is paid on the whole of the sum borrowed. If the business has a healthy balance in its current account, it will not help reduce the interest repayments on the bank loan. Such payments will be a fixed sum every month. Consequently, bank loans can be more expensive than an overdraft despite the overdrafts high interest rate.
- Security - Must provide ban with security (collateral). Difficulties paying back the loan --> Bank can claim the amount owed by forcing a sale of asset. Major difficulties if asset is a large part of the business' operations.
3. Factoring (Debt factoring)
Factoring is when a factoring company (usually a bank) buys the right to collect the money from the credit sales of an organisation.
- Factoring agent usually pays the firm about 75% of its sales immediately and approximately 15-20% on receipt of the debt.
- Firm therefore loses some revenue (about 5-10% depending on length of time and current interest rate), which is the factoring company's charge for its service.
Benefits of factoring:
- Improved cash flow in the short term - Save expenses like overdraft interest charges and in extreme cases the immediate receipt of cash may keep the business alive by allowing it to pay off debts on time. Businesses who offer long credit periods to their customers in order to boost sales revenue, the immediate receipt of cash may be essential as it would be impossible for the business to wait a year for payment.
- Lower administration costs - Collecting and chasing debts is time-consuming and costly. The factoring agent specialises in this and could possibly collect more than one debt from the same firm.
- Reduced risk of bad debts - Factoring agent takes the risk and not the original company. Factoring agent can refuse to factor a debt which is too risky. Some firms contact the factoring agent before giving credit to a customer. Factoring companies have lists of customers who may be a high risk.
- Increased efficiency - Encourages companies to be more careful with their provision of credit. If the business has a reputation for having no customers with bad debts attached to them, the factoring company will reduce the cost of factoring to that business. This will give firms an incentive to be more efficient in their provision of credit.
- Loss of revenue - Business using factoring will lose 5-10% of its revenues. Reducing profit. But is possible to increase price charged to customers where credit terms are being offered.
- High Cost - Business pays more for the factoring company's services than it would to pay a bank for a loan (as there are admin expenses involved in chasing up debts). But there are admin savings from the business not having to chase up debts itself....
- Customer relations problems - Customers may prefer to deal directly with the business that sold them the product. An aggressive factoring company could upset certain customers, who will blame their bad experience on the original seller of the product.
4. Sales of Assets:
When a business transfers ownership of an item that it owns to another business or individual, usually in return for cash.
- Sales of assets --> Most likely to be used to overcome cash flow problems --> when a business is changing direction or moving out of a particular market.
- Sales of assets could be used to: ~ Pay a debt or ~ Build up a bank balance.
2 main benefits of sales of assets:
1. Income - It can raise a considerable sum of money particularly in the case of a large asset such as a building.
2. Profitability - A particular asset may not be contributing towards the business's overall success. In this case, the sale of the asset may ease cash-flow problems and enhance its overall profitability (as it is just adding to costs unnecessarily)
Problems of sales of assets:
1. Receiving a low value for the asset - Assets such as buildings or machinery --> Difficult to sell quickly, the business is looking for a quick sale --> Must accept a much lower price than true value.
May not be a good strategy --> damaging effect on long-term profitability.
2. Reduced ability to make a profit - Fixed assets enable a firm to produce the goods and services that create its profit. Exceptions= When assets are no longer required or when the cash-flow situation threatens the survival of the organisation.
5. Sale and leaseback of assets:
When assets that are owned by a firm are sold to raise cash and then rented back so that the company can still use them for an agreed period of time.
Other ways of improving cash flow
1. Improving working capital control
Working Capital: The day-to-day finance used in a business, consisting of assets (e.g. cash, stock and debtors) minus liabilities (e.g. creditors and overdrafts)
- Must manage working capital to stay solvent (solvent means you are able to pay off your debts)
- Involves careful control of firm's main current assets (cash, stock and debtors) to ensure enough is there to pay creditors and make other immediate payments.
2. Cash Management
If a firm is short of cash it has 2 main options:
- Agree to an overdraft with the bank
- Set aside a contingency fund so firm can meet unexpected payments or cope with lost income. In industries subject to more rapid change, a higher contingency fund should be kept.
3. Debt Management
4. Stock Management
5. Other Methods
(See Below)
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