Cash Flow Forecasts (AQA A Level Business): Revision Note

The purpose and value of cash flow forecasts

• A cash flow forecast is a financial document that predicts the amount of cash expected to flow into and out of a business over a future period

  • They are typically presented month by month

• It shows whether the business is expected to have enough cash to meet its obligations at any given point in time

Key purposes

Identifying future cash shortfalls

• The forecast highlights months where outflows are expected to exceed inflows

• This allows the business to arrange finance, such as an overdraft, in advance rather than running out of cash

Planning for large expenditures

• Significant one-off costs, such as equipment purchases or tax payments, can be planned for and their impact on the cash position assessed before they occur

Supporting applications for finance

• Banks and investors routinely ask for cash flow forecasts as part of a business plan

• They demonstrate that the owner has a realistic understanding of the business's financial needs

Monitoring and control

• By comparing forecast figures with actual cash flows each month, managers can identify where performance differs from the plan and take corrective action early

Managing seasonal variation

• Businesses with uneven cash flows across the year can use forecasts to plan for quieter periods and ensure cash reserves are in place

Limitations of cash flow forecasts

• Forecasts are usually based on estimates

  • In reality, inflows and outflows may differ significantly from the estimates

• Cash flow forecasts require appropriate skills, insight, research and time to prepare and update adequately

• External factors that can impact inflows and outflows may not be reflected in the cash flow forecast

Constructing cash flow forecasts

Key terminology associated with cash flow forecasts

Step 1 - Calculate total cash inflows

• In this instance, the business expects to receive cash inflows from sales in June, July and August

• Owners' capital of £10,000 will be introduced in June

• The total for each month is calculated by adding cash from sales to capital introduced

Step 2 - Calculate total cash outflows

• In this instance, the business expects to pay rent of £3,000 in June, July and August

• It will purchase a significant amount of inventory in June with smaller amounts in July and August

• Wages are expected to be £3,800 each month

• Utilities of £540 will be paid each month

• Marketing costs are expected to vary

• Total cash outflows each month is calculated by adding these together

Step 3 - Calculate net cash flow

• The net cash flow is calculated by subtracting total cash outflows from total cash inflows

• In June the net cash flow is £14,200 - £14,240 = £(40)

  • Net cash flow is expected to be negative as cash outflows are greater than cash inflows

• In July the net cash flow is £9,600 - £8,990 = £610

  • Net cash flow is expected to be positive as cash inflows are greater than cash outflows

• In August the net cash flow is £10,400 - £10,430 = £(30)

  • Again, net cash flow is expected to be negative as cash outflows are greater than cash inflows

Step 4 - Calculate opening and closing balances

• The opening balance is the previous month’s closing balance carried forward

• The closing balance is calculated by adding the net cash flow to the opening balance

• In June the opening balance of £0 is added to the net cash flow of £(40) to leave a closing balance of £(40)

• In July the closing balance from June is carried forward to become its opening balance of £(40)

• This opening balance is added to July's net cash flow of £610 to leave a closing balance of £570

• In August the closing balance from July is carried forward to become its opening balance of £570

• This opening balance is added to August's net cash flow of £(30) to leave a closing balance of £540

The complete cash flow forecast

• The cash flow forecast shows that the business may require a small overdraft facility initially as its cash flow is forecast to be negative

• A longer-term forecast will be needed to determine whether the business will need further use of this overdraft

Analysing cash flow forecasts

• When analysing a cash flow forecast, the goal is to identify where, when and why the cash position becomes problematic

• Rather than simply noting that a closing balance is negative, a thorough analysis considers the trend across months

  • Is the cash position improving or deteriorating?

  • Is the problem caused by a one-off event or a recurring pattern?

  • Is the shortfall likely to be temporary or structural?

• A temporary cash flow problem, such as a large payment in a single month, is very different from a situation where outflows consistently exceed inflows over several months

  • The latter is a more serious concern and may indicate that the business model itself is not generating sufficient cash to survive

• It is also important to remember that a cash flow forecast is based on estimates

  • If sales come in below forecast, or if customers take longer to pay than expected, the actual cash position could be significantly worse than the forecast suggests

  • Analysing a forecast, therefore, also means asking how realistic the predictions behind it are

Spotting cash flow problems

• A business can also have too much cash

  • If it holds large amounts of cash, it may miss out on the benefits of investing it in fixed assets or savings

  • This may represent a significant opportunity cost, especially when interest rates are high

• Further information on solutions to cash flow problems