2.1.4 Planning and Cash Flow

Planning and Cash Flow

Key Definitions

Cash Flow: The money that moves in and out of the business, also called the working capital. 

Cash Flow Forecast: A tool used by businesses to estimate future monthly cash inflows and outflows to calculate the net cash flow. 

Inflow: The money moving into the business. 

Outflow: The money moving out of the business. 

Opening Balance: The amount of net cash the business has at the start of the given time period, often shown in the month.

Closing Balance: The amount of net cash the business has at the end of the given time period, often shown in the month. 

Receivables: The money owed to a business by its customers.

Payables: The money a business owes to its suppliers. 

Best Case: An optimistic estimate of the best possible outcome - for example, if sales prove to be much higher than expected. 

Business Plan: A document setting out a business idea and showing how it is to be financed, marketed and put into practice. 

Just-In-Time: Ordering stock so that it arrives just before it is needed, leaving no stockpiles to cover for late delivery. 

Overdraft: When the business borrows just the amount of money it needs to cover short term cash flow problems. 

Worst Case: A pessimistic estimate assuming the worst possible outcome, such as disappointing sales figures. 

The Relevance of a Business Plan in Obtaining Finance

A good business plan is persuasive to an outside investor and useful to the entrepreneur. It should explain what makes the business "unique" and help the entrepreneur to focus on what it is they are trying to achieve. The plan will also help the outsider understand the risks and rewards involved in the business proposal. The outsider could be a bank or a venture capitalist. A bank's main concern is whether the start-up would be a safe investment, whereas a venture capitalist would be mainly interested in the potential to make a huge profit. Any type of financier, however, would want to see a carefully prepared plan with a well-considered proposal for the sums of money needed. 

The heart of the business plan should be based around the competitive advantage, which means identifying the features of your own product or service that will make it special and succeed against competitors. This could be based on a unique idea, a better product or service, or the protection provided by a patent or copyright. On the other hand, a business may decide to focus on making the product the cheapest of that product on the market. 

A business plan usually contains the following sections:

1. Executive Summary
This should be short, but interesting enough to make the reader want to continue reading. It should say who you are, what the customer's 'problem' is and how you will 'fix' it, why your team is ideal for the task, how much capital is needed and how much capital is being invested by yourself. 

2. The Product or Service
Explain the product or service from the point of view of the customer. If others are already offering a similar product or service, you must explain what is different about your product or service. 

3. The Market
Focus on the market trends instead of market size, for example whether the market is growing and, if so, the rate of growth. Also, there is a need to provide a brief analysis of the key competitors on the market. 

4. Marketing Plan
Who is being targeted and how do you plan to communicate with them? What will this cost? This section should contain an explanation and justification for the prices you plan to set as well as a forecast of likely sales per month for the first 2 years. 

5. Operational Plan
How will the product be produced and delivered? This could involve production in a foreign country, in which case you would need to have made contacts with willing suppliers in these places already. 

6. Financial Plan
The heart of this part is the cash flow forecast - the prediction of monthly cash in and out of the business from the start-up until at least 2 years after trading has begun. This will give an idea of the bank balances over the start-up period, and therefore will give an idea of the financing needs of the business. 

7. Conclusion
This will include some idea of the longer-term plans for the business, including any 'exit strategy' for the business - such as a plan to sell the business after 5 years of trading. 

Interpreting a Cash Flow Forecast

A cash flow forecast is done by estimating the totals of the money coming in and out of the business on a monthly basis. These flows of money are then set onto a grid that shows the cash movements for each month - and how those movements affect the overall net cash flow. The key parts of a cash flow forecast are the following:

1. Cash Inflow

This is the money that is expected to come into the business each month, either from financial sources or from customers. 

2. Cash Outflow

This the money that is expected to leave the business each month through payments including wages, bills, paying suppliers and paying landlords. 

The cash flow forecast is completed by calculating the following:

1. Monthly Balance

This is the cash inflow for the month minus the cash outflow for the month. Each monthly calculation will result in either a positive or negative movement of cash - when the outflow is greater than the inflow the monthly balance will be negative; when the inflow is greater than the outflow the monthly balance will be positive. The negative figure is always shown as a bracketed figure. 

Equation: Monthly Balance = Total Inflows - Total Outflows

2. Opening and Closing Balance

This shows what cash the business has at the start (the opening balance) and at the end (the closing balance) of the month. The closing balance is the opening balance plus the monthly balance, no matter if the monthly balance is negative or positive. The closing balance shows the overall state of the bank account at the end of the month. The negative figure is always shown as a bracketed figure. 

Equation: Closing Balance = Opening Balance + Monthly Balance

As there is no such thing as "negative money", the cash flow forecast shows what action the business needs to take to avoid cash flow problems in the early months of trading. The easiest remedy for these problems is to negotiate an overdraft with the bank. 

Analysis of Cash Flow Forecasts

There are 3 main ways to analyse a cash flow forecast:

1. Calculating the Net Cash Flow

This would involve calculating the difference between the opening balance and the closing balance for each month, giving a sense of what is happening within the business finances over time. If the overall net cash flow balance is increasing, the inflows are greater than the outflows and the business's situation is 'comfortable'. If the balance is decreasing the business will need to quickly take action to resolve it. 

2. Assessing the Trends

This involves using the monthly closing balance to analyse trends in the data. This could help managers evaluate the business's situation in the short and long term, especially if shown on a line graph. This could help managers see if the business will recover after a plunge into a period of decline. 

3. Analyse Timings

This involves using the figures to analyse timings of cash inflows and outflows for the business. The longer inflows take to come in, the longer the business has to deal with a reduced net cash flow. Any method of speeding up customer payments will in turn boost the business's net cash flow. The sum of money owed by a customer is know as the 'receivables', and the money owed to a supplier is known as the 'payables'. When goods or services are bought by the business on credit the money owed is the payable. A business wants to keep these as low as possible. 

If a company has customers who pay them in 30 days and the suppliers are paid in 30 days, business call this the 'cash-to-cash' figure of 0. If customers pay take 60 days to pay the business, but the suppliers need to be paid in cash, the cash-to-cash figure would be 60 - straining the cash flow of the business. 

Uses and Limitations of a Cash Flow Forecast

If a business forecasts a period of negative cash flow it can work to improve its position in several different ways:

1. Getting goods to the market in the shortest possible time

The sooner the goods reach the customer, the sooner the customer will pay. For this the production and distribution should be as efficient as possible. 

2. Getting paid as quickly as possible

The ideal arrangement is to be paid cash on delivery of the goods. Most businesses work on credit however. Even worse than this is the occasional use of interest-free credit - the customer has little incentive to pay up quickly when this is used. Each payment should be encouraged by offering incentives, such as discounted early payment.

3. Keeping raw material stocks at a minimum

Good stock management, such as a just-in-time system, means that the business is not paying for the stock before the stock is needed for production. 

Cash flow can also be improved by keeping the cash within the business. Minimizing short term spending on new equipment helps to keep cash in the business. Things that the business can do to help this includes:

1. Leasing instead of buying equipment

This increases expenses in the long term, but also helps to conserve the working capital for the business. 

2. Renting instead of buying buildings

This can also help conserve capital for the business. 

3. Postponing expenditure - for example, on company cars

This form of credit will help conserve cash in the short term that can be used elsewhere. 

Cash flow forecasts do, however, have limitations for their usefulness. These include the following:

• They are only as good as the raw data that is put into them. Entrepreneurs have to be optimistic when starting a new business, but this could lead to overestimated sales and underestimated operational difficulties and cash outflows.
• They risk giving the impression of certainty where there is none, especially at the business start-up stage, where the cash inflows could easily be overestimated.
• These issues make it essential that the forecast is given leeway for inaccuracies or errors in the calculations. A clever cash flow forecast will include a planned overestimate of costs to allow for unexpected problems.