IB BUsiness MAnagement:
3.7 CASH FLOW

Cash is needed to pay for daily costs such as wages and electricity charges. failure to pay suppliers, wages and utility bills may eventually result in a business being declared bankrupt. The term liquidity refers to how easily an asset can be turned into cash. Evidence from around the world has consistently shown that insufficient cash flow is the single largest from of business failure, rather than lack of profitability.

Key Learning Outcomes:

  • Explain the relationship between investment, profit and cash flow
  • Define working capital and explain the working capital cycle
  • Prepare a cash flow forecast from given information
  • Evaluate strategies for dealing with liquidity problems

Cash flow - Working Capital

Cash is often referred to as the 'lifeblood' of a business. All businesses need finance to pay for everyday expenses such as wages and the purchase of stock. Without sufficient cash flow or working capital a business will be illiquid - unable to pay its immediate or short term debts. Either the business raises finance quickly, such as a bank loan, or it may be forced into liquidation by its creditors, the firms it owes money to.
Working capital = current assets - current liabilities.
Working capital - definition: The capital needed to pay for raw materials, day-to-day running costs and credit offered to customers. In accounting terms: 

Working capital = current assets - current liabilities.

Liquidity - definition: The ability of a firm to be able to pay its short-term debts.

Insolvent - definition: When a business cannot meet its short-term debts.   

What is working capital?

What is cash flow?

Working Capital: 
In-depth explanation 

Indepth information about the different problems associated with working capital and different financing options.

Working Capital ManagEment

There are many different options available to businesses to more effectively manage their working capital requirements.

The working capital cycle:

Working Capital Cycle - definition: The period of time between spending cash on the production process and receiving cash payments from customers.
Picture
The simple working capital cycle
The longer this cycle takes to complete, the more working capital a business will need.

What is free cash flow?

Cash flow - definition: The sum of cash payments to a business (inflows) less the sum of cash payments made by it (outflows).
Cash inflows - definition: Payments in cash received by a business, such as those from customers (debtors) or from the bank; e.g. receiving a loan.
Cash outflows - definition: Payments is cash made by a business, such as those to suppliers and employees.

The importance of cash flow

Cash is always important - short-term and long-term. Cash flow relates to the timing of payments to workers and suppliers and receipts from customers. if a business does not plan the timing of these payments and receipts carefully, it may run out of cash even though it is operating profitably. If suppliers and creditors are not paid in time, they can force a business into liquidation of its assets if it appears to be insolvent.

Note: Cash is not the same as profit. It is very common for profitable businesses to run short of cash. On the other hand, loss-making businesses can have high cash inflows in the short-term.
The diagram on the right explains the links between cash inflows - in the form of revenues - and cash outflows - the costs of production. Working capital is what keeps a business solvent.

Cash inflows and outflows

Picture
A business must maintain cash in hand

Cash Flow forecasting

Forecasting cash inflows, examples include:
  1. Owner's own capital injections
  2. Bank loan payments
  3. Customers cash purchases
  4. Debtors payments
Forecasting cash outflows, examples include:
  1. Lease payment for premises
  2. Annual rent payment
  3. Electricity, water and telephone/internet bills
  4. Labour cost payments
  5. Variable cost payments; e.g. raw materials

Preparing a Cash Flow Forecast:
Mr Burton explains

Why cash flow matters

An example cash flow forecast

Key Terms:

Cash flow forecast: Estimate of the firm's future cash inflows and outflows

Net monthly cash flow: Estimated difference between monthly cash inflows and outflows

Opening cash balance: Cash held by the business at the start of the month

Closing cash balance: Cash held at the end of the month becomes next month's opening balance

Causes of cash flow problems:   

1. Lack of planning
2. Poor credit control
3. Allowing too much credit
4. Expanding too rapidly
5. Unexpected events

Credit control

Credit control: Monitoring of debts to ensure that credit periods are not exceeded

Bad debts

Bad debts: Unpaid customers' bills that are now very unlikely to ever be paid.

Improving Cash Flow

3.7 Cash Flow:
  Summary PowerPoint notes

3.7 Cash Flow:
Mr Burton Explains

Exam Tips! 

  1. When answering an exam question about improving cash flow, just writing the firm  should "increase sales" will not demonstrate a true understanding of the difference between sales revenue and cash flow.
  2. If you suggest "cutting staff and cheaper materials", this may reduce cash outflows, but what will be the negative impact on output, sales and future cash inflows? This suggestion will nearly always be inappropriate for an examination question about improving cash flow.

Progress check - test your understanding by completing the activities below

You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Business  Management requirements for the Finance and Accounts 3.7 Cash Flow topic.

Test yourself

Use the Flashcards in ALL THREE STUDY MODES

Habits of successful IB students

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IB BUSINESS MANAGEMENT QUIZZES AND TWO CLASSROOM GAMES

Test how well you know the IB Business Management Finance and Accounts - 3.7 Cash Flow topic with the self-assessment tool. Aim for a score of at least 80 per cent.