Cash-⁠flow forecasting and working capital | IGCSE Class 10 Business Studies Notes

This note covers the importance of cash to a business, what a cash-flow forecast is and how a simple one is constructed, how to amend or complete a cash-flow forecast, how to interpret one, ways to overcome a short-term cash-flow problem, and the concept and importance of working capital.

Why is cash important to a business?

Cash is the money a business holds as notes, coins and funds in its bank account that it can use immediately to pay its bills.

A business needs cash to pay its day-to-day expenses such as wages, rent, suppliers and loan repayments on time. Cash is not the same as profit.

Profit is the surplus left after all costs are deducted from revenue over a trading period, but it is calculated on an accruals basis and includes sales made on credit that have not yet been paid for in cash.

A business can be profitable on paper and still run out of cash if customers are slow to pay or if it has spent heavily on stock or new equipment.

A shortage of cash is one of the most common reasons a business fails, even when its underlying trading is sound.

If a business cannot pay its suppliers, employees or lenders when payment is due, it may be forced to stop trading even though it is making a profit over the year as a whole.

For this reason, owners and managers plan cash movements carefully in advance, using a cash-flow forecast, so that they know when cash will be tight and can act before a shortage becomes a crisis.

What is a cash-flow forecast and how is it constructed?

Definition: cash-flow forecast. A cash-flow forecast is an estimate, usually prepared month by month, of the cash a business expects to receive (cash inflows) and the cash it expects to pay out (cash outflows) over a future period, together with the resulting cash balance at the end of each month.

Building the forecast step by step

A simple cash-flow forecast is built up in a set order for each month in the period being forecast.

1. Start each month with the opening balance, which is the cash the business has at the start of that month. This is simply the closing balance carried forward from the end of the previous month.
2. List all expected cash inflows for the month, such as cash sales, receipts from credit customers (debtors), new loans received and owner's capital introduced, and add them together to find total cash inflows.
3. List all expected cash outflows for the month, such as payments to suppliers, wages, rent, rates, loan repayments and interest, and add them together to find total cash outflows.
4. Calculate the net cash flow for the month by subtracting total outflows from total inflows.
5. Calculate the closing balance for the month by adding the net cash flow to the opening balance. This closing balance becomes the opening balance for the following month.

Net cash flow = Inflows - Outflows

Closing balance = Opening balance + Net cash flow

Setting out the forecast as a table

The forecast is normally set out as a table with a column for each month, so that the owner can see at a glance how the cash position is expected to change over time.

Worked example 1. A small bakery business begins Month 1 with $500 in the bank. In Month 1 it expects cash sales and receipts from credit customers of $3,000 in total, and cash outflows of $2,880 for ingredients, wages and rent. Calculate the closing balance for Month 1.

Answer: Net cash flow = $3,000 - $2,880 = $120. Closing balance = $500 + $120 = $620. This closing balance of $620 becomes the opening balance for Month 2.

How do you amend or complete a simple cash-flow forecast?

Examination and real business tasks often give a partly completed forecast with some figures missing, and ask the learner to fill in the gaps using the relationships between opening balance, inflows, outflows, net cash flow and closing balance. The same four-step relationship is used whichever figure is missing.

1. If the opening balance is missing, it equals the previous month's closing balance (or the figure given for the start of the forecast).
2. If total inflows or total outflows is missing, it can usually be found by adding up the individual items listed for that month, such as cash sales, debtor receipts, supplier payments and wages.
3. If the net cash flow is missing, subtract total outflows from total inflows for that month.
4. If the closing balance is missing, add the net cash flow to the opening balance for that month.

Because each month's closing balance is the next month's opening balance, an error in one month carries through to every later month, so figures should be checked in order from the first month to the last.

Worked example 2. A forecast shows Month 2 opening balance $620, total inflows $2,800, total outflows $3,600, and the closing balance is left blank. Complete the forecast for Month 2.

Answer: Net cash flow = $2,800 - $3,600 = -$800 (a net outflow). Closing balance = $620 + (-$800) = -$180. The business would be $180 overdrawn at the end of Month 2.

How do you interpret a cash-flow forecast?

Interpreting a forecast means reading the pattern of figures to identify problems and opportunities before they happen, not simply calculating the totals.

A manager reading the table above would notice that the closing balance turns negative in Month 2, meaning the business is forecast to run out of cash and need extra funding, before recovering in Month 3 because inflows rise and outflows fall back.

Key points to look for when interpreting a cash-flow forecast include which months show a negative net cash flow, how large and how long any cash shortfall is expected to last, whether inflows are rising or falling over time, and whether outflows include one-off items (such as a large purchase of equipment) that will not recur.

A single month of negative net cash flow is less serious if the business holds reserves or has arranged a source of short-term finance in advance; a run of several negative months is a much greater warning sign, since it may point to a deeper trading problem rather than a timing issue.

Plot the month number on the horizontal axis and the closing cash balance in dollars on the vertical axis, with a horizontal line at zero.

A line falling below zero shows the months in which the business is forecast to be overdrawn, and the depth below the line shows how large the shortfall is expected to be.

How can a short-term cash-flow problem be overcome?

When a forecast reveals an expected cash shortfall, a business has several options for closing the gap, each with its own cost and risk.

Ways to close a cash shortfall

1. Arrange an overdraft with the bank, which allows the business to withdraw more money than it has in its account up to an agreed limit; this is flexible and quick to arrange but usually carries a relatively high rate of interest on the amount overdrawn.
2. Delay payments to suppliers, that is, take longer to pay for goods bought on trade credit; this keeps cash in the business for longer but may damage the relationship with the supplier and risk the loss of future credit or discounts.
3. Ask debtors (credit customers) to pay more quickly, for example by offering a cash discount for early payment or by chasing overdue accounts; this speeds up inflows but may not be fully within the business's control since customers may simply refuse.
4. Delay or postpone a planned purchase of fixed assets, such as new machinery, so that the cash outflow for the purchase falls later, when the business is in a stronger cash position.

Each of these methods closes the cash gap in a different way: the overdraft adds short-term borrowing to cover the gap, delaying supplier payments pushes an outflow into a later month, while offering an early-payment discount or chasing overdue debtors speeds up an inflow that is already expected. A manager choosing between them usually compares the cost of each option against how quickly the cash is needed and how it will affect relationships with the bank, suppliers and customers.

Worked example 3. A retailer's forecast shows a closing balance of -$800 in Month 2 because several large credit customers are due to pay in Month 3 rather than Month 2, and a supplier payment of $900 is due in Month 2.

The owner can arrange a $1,000 overdraft at 12% annual interest, or ask the supplier to accept payment one month later at no extra cost. Which option should the retailer choose?

Answer: Delaying the $900 supplier payment by one month turns the Month 2 balance from -$800 to +$100 (-$800 + $900), avoiding the cash shortfall at no interest cost, whereas the overdraft would cost roughly $800 × 12% × 1/12 ≈ $8 in interest for one month and still needs to be repaid.

The retailer should ask the supplier for an extra month to pay, provided the relationship allows it, since this removes the cash-flow problem at a lower cost than borrowing.

What is working capital and why is it important?

Definition: working capital. Working capital is the finance a business has available for its day-to-day running costs. It is the amount by which current assets exceed current liabilities, and it is also called net working capital.

Current assets and current liabilities

Current assets are assets that are normally turned into cash within one year, such as cash itself, debtors (amounts owed by credit customers), and inventory (stock of raw materials, work in progress and finished goods).

Current liabilities are payment obligations due within one year, such as creditors (amounts owed to suppliers) and short-term loans or overdrafts.

Working capital = Current assets - Current liabilities

A worked breakdown of working capital

The table below sets out the current assets and current liabilities of a single business, so that each item can be seen and added separately before the net working capital figure is calculated.

Why working capital matters

Working capital is important because it is the cushion of liquid resources a business uses to pay its everyday bills, such as wages, suppliers and running expenses, while it waits for sales revenue to come in.

A business with too little working capital may struggle to pay its short-term debts, a situation sometimes called being in a liquidity crisis, and in a severe case this can lead to insolvency, where the business cannot pay what it owes when it falls due and may be forced to stop trading.

On the other hand, holding far more working capital than is needed is also inefficient, because cash and stock tied up in current assets earn little or no return compared with investing that money in the business's fixed assets or returning it to the owners.

Working capital is planned separately from, and in addition to, the long-term finance a business raises for its fixed assets, such as plant, machinery, buildings and equipment. A business that has raised enough long-term finance to build a factory still cannot begin trading on that finance alone: it also needs a further, separate amount of working capital to buy raw materials, pay wages and meet other short-term running costs before any sales revenue starts to come in. Setting the working capital requirement too low at this planning stage is a common cause of an otherwise well-financed new venture running into an early cash-flow problem.

Worked example 4. A business has current assets of $45,000 (cash $10,000, debtors $15,000, inventory $20,000) and current liabilities of $30,000 (creditors $22,000, short-term loan $8,000). Calculate the net working capital and comment on the business's short-term financial position.

Answer: Net working capital = $45,000 - $30,000 = $15,000. Since current assets exceed current liabilities by $15,000, the business has a positive working capital buffer and should be able to meet its short-term obligations as they fall due, provided the debtors and inventory can be turned into cash reasonably quickly.

How does working capital link to cash-flow forecasting?

Cash-flow forecasting and working capital are closely connected, because both are concerned with a business's ability to pay its short-term obligations, although they measure this in different ways and over different time horizons.

The cash-flow forecast predicts, month by month, whether the business will have enough cash available to meet its outflows as they fall due, while working capital measures, at a single point in time, whether current assets are sufficient to cover current liabilities. A forecast is forward-looking and detailed by month; a working capital figure is a snapshot taken from the balance sheet.

A business with healthy net working capital can still face a cash-flow problem in a particular month if too much of its current assets are tied up in slow-paying debtors or in unsold inventory rather than in cash itself. Conversely, a cash-flow forecast that reveals a recurring shortfall is often a sign that working capital is being managed poorly, for example because credit terms given to customers are too generous or stock levels are too high.

For this reason, a manager who is forecasting cash should also review the level and the components of working capital, rather than treating the two as unrelated. Improving the components of working capital, such as collecting debts faster or holding less inventory, is itself one of the ways a forecast cash shortfall can be closed, linking the two topics directly.

Going beyond the syllabus

What factors affect how much working capital a business needs?

The amount of working capital a business requires is not fixed; it depends on the nature and scale of the business and on how it manages its current assets and liabilities.

1. Nature of the business: a trading business that simply buys and resells goods usually needs less working capital than a manufacturing business, which has to hold raw materials, work in progress and finished goods before it can make a sale.
2. Scale of operations: a larger business with higher sales volumes generally needs a larger amount of inventory and debtors, and therefore requires more working capital than a smaller business.
3. Credit allowed to customers: a business that offers generous credit terms to its customers will have a larger amount tied up in debtors, which increases its working capital requirement.
4. Credit received from suppliers: a business that is able to negotiate longer credit terms from its own suppliers reduces its working capital requirement, because less of its own cash is needed to pay creditors in the short term.
5. Seasonal and cyclical factors: businesses with seasonal sales, or those affected by the wider business cycle, need more working capital during busy or boom periods, when production and sales are higher, and less during quiet or depressed periods.

A business that manages these factors well, for example by collecting debts promptly, agreeing longer supplier credit terms, and controlling stock levels carefully, can operate with a smaller amount of working capital tied up without harming its ability to trade. This is one reason why two businesses of similar size and industry can hold very different levels of working capital: the level needed reflects management decisions about credit and stock as much as it reflects the scale of the business itself.

Glossary

• Cash-flow forecast: an estimate, usually month by month, of a business's expected cash inflows, outflows and resulting cash balance over a future period.
• Cash inflow: any cash received by a business, such as cash sales, receipts from debtors or a new loan.
• Cash outflow: any cash paid out by a business, such as payments to suppliers, wages or rent.
• Opening balance: the amount of cash a business has at the start of a period, equal to the previous period's closing balance.
• Closing balance: the amount of cash a business has at the end of a period, found by adding net cash flow to the opening balance.
• Net cash flow: the difference between total cash inflows and total cash outflows for a period.
• Working capital: the finance available to a business for its day-to-day running costs; the excess of current assets over current liabilities.
• Current assets: assets normally expected to be turned into cash within one year, such as cash, debtors and inventory.
• Current liabilities: payment obligations due within one year, such as creditors and short-term loans.
• Debtors: customers who owe the business money for goods or services bought on credit.
• Creditors: suppliers or others to whom the business owes money for goods or services bought on credit.
• Overdraft: an arrangement with a bank allowing a business to withdraw more than it holds in its account, up to an agreed limit.
• Trade credit: an arrangement allowing a business to receive goods or services now and pay for them at a later agreed date.
• Liquidity: the ability of a business to meet its short-term debts as they fall due using cash or assets that can quickly be turned into cash.
• Insolvency: a situation in which a business cannot pay what it owes when payment is due.

Common errors and misconceptions

• Misconception: cash and profit are the same thing. Correct: profit is revenue minus costs over a trading period on an accruals basis, while cash is the money actually held or received; a profitable business can still run short of cash.
• Misconception: a cash-flow forecast shows what will definitely happen. Correct: it is an estimate based on assumptions about future sales and costs, so actual figures usually differ from the forecast.
• Misconception: a negative net cash flow in one month means the business is failing. Correct: a single month of negative net cash flow can be a normal, manageable timing issue if the business has reserves or arranged finance; it is a repeated or growing shortfall that signals a deeper problem.
• Misconception: an overdraft is always the best way to solve a cash shortage. Correct: an overdraft carries interest costs and should be compared with cheaper options, such as delaying supplier payments or collecting debts more quickly.
• Misconception: working capital is the same as capital invested in the business. Correct: capital invested usually refers to long-term finance used partly for fixed assets, whereas working capital specifically refers to current assets minus current liabilities, used for day-to-day running costs.
• Misconception: more working capital is always better for a business. Correct: holding far more working capital than needed ties up cash and stock that could otherwise be invested elsewhere, so a business aims for a sufficient, not maximum, amount.
• Misconception: the opening balance in a cash-flow forecast can be any figure the business chooses. Correct: except for the very first month of the forecast, the opening balance must equal the closing balance carried forward from the previous month.

Exam-style questions with model answers

Q1. Define the term 'cash-flow forecast'. [2 marks]

1. It is an estimate, usually prepared month by month, of a business's expected cash inflows and outflows over a future period.
2. It shows the resulting cash balance at the end of each month, so the business can plan ahead.

Q2. State three items that might appear as cash outflows in a business's cash-flow forecast. [3 marks]

1. Payments to suppliers for goods bought.
2. Wages paid to employees.
3. Rent or loan repayments due in that month.

Q3. A business has an opening balance of $300 in July, total cash inflows of $2,500 and total cash outflows of $2,900. Calculate the business's closing balance for July and state whether it is overdrawn. [4 marks]

1. Net cash flow = inflows minus outflows = $2,500 - $2,900 = -$400.
2. Closing balance = opening balance plus net cash flow = $300 + (-$400) = -$100.
3. The closing balance is negative, so the business is overdrawn by $100 at the end of July.
4. This figure would become the opening balance for August, carrying the problem into the next month unless action is taken.

Q4. A business forecasts a cash shortfall next month. Explain three ways it could try to overcome this short-term cash-flow problem. [6 marks]

1. It could arrange an overdraft with its bank, allowing it to withdraw more than its account balance up to an agreed limit, so it can still pay its bills.
2. This is quick to arrange but the bank will charge interest on the amount overdrawn, adding to costs.
3. It could ask suppliers for longer to pay, delaying cash outflows into a later month.
4. This keeps cash in the business for longer, but may harm the relationship with the supplier or risk losing future credit terms.
5. It could ask its own credit customers (debtors) to pay more quickly, for example by offering a discount for early payment.
6. This brings cash inflows forward, but customers may refuse, so the business cannot fully control the outcome.

Q5. Define working capital. [2 marks]

1. Working capital is the finance available to a business for its day-to-day running costs.
2. It is calculated as current assets minus current liabilities.

Q6. A business has current assets of $60,000 and current liabilities of $38,000. Calculate the net working capital and explain what the result means for the business's ability to pay its short-term debts. [4 marks]

1. Net working capital = current assets minus current liabilities = $60,000 - $38,000 = $22,000.
2. This is a positive figure, meaning current assets exceed current liabilities.
3. This suggests the business should be able to meet its short-term payment obligations as they fall due.
4. However, the result depends on how quickly the current assets, such as debtors and inventory, can actually be turned into cash.

Q7. Explain the importance of working capital to a business. [5 marks]

1. Working capital provides the funds needed to pay everyday running costs such as wages, suppliers and rent.
2. It allows a business to continue trading smoothly while it waits for sales revenue to be collected from customers.
3. Insufficient working capital can prevent a business from paying its short-term debts, which may lead to insolvency.
4. Too much working capital is also undesirable, because cash and stock tied up in current assets earn little return compared with other uses.
5. The right level of working capital therefore balances the need for liquidity against the cost of holding idle current assets.

Q8. Distinguish between cash and profit. [3 marks]

1. Profit is the surplus of revenue over costs calculated for a trading period, including sales made on credit that have not yet been paid for.
2. Cash is the actual money a business holds or has received, and only counts amounts that have physically been paid or collected.
3. Because of this difference, a business can be making a profit while still running short of cash, for example if many customers have not yet paid what they owe.

Key takeaways

• Cash and profit are different: profit includes credit sales not yet collected, while cash is money actually received.
• A cash-flow forecast estimates monthly cash inflows, outflows, net cash flow and closing balance in advance.
• Each month's opening balance equals the previous month's closing balance, so one error carries through later months.
• Net cash flow equals total inflows minus total outflows; closing balance equals opening balance plus net cash flow.
• Interpreting a forecast means spotting which months show a cash shortfall and how serious or long-lasting it is.
• Short-term cash problems can be eased by an overdraft, delaying supplier payments or asking debtors to pay sooner.
• Working capital is current assets minus current liabilities, and funds a business's day-to-day running costs.
• Too little working capital risks an inability to pay debts; too much ties up funds that could be used more productively.
• Working capital needs depend on the nature of the business, scale of operations, and credit terms given and received.

Test yourself

What is the difference between a cash inflow and a cash outflow?

A cash inflow is money received by the business, such as cash sales or debtor receipts; a cash outflow is money paid out, such as payments to suppliers or wages.

How is net cash flow calculated for a given month?

Net cash flow is calculated by subtracting total cash outflows for the month from total cash inflows for the month.

Why might a profitable business still face a cash-flow problem?

Profit includes sales made on credit that have not yet been paid for, so a business can show a profit on paper while still lacking enough actual cash to pay its bills.

Name two ways a business can overcome a short-term cash shortfall.

It can arrange an overdraft with its bank, or delay payments to suppliers, or ask its own credit customers to pay more quickly.

How is net working capital calculated?

Net working capital is calculated by subtracting current liabilities from current assets.

Why is it a problem for a business to hold too little working capital?

With too little working capital, a business may be unable to pay its short-term debts, such as suppliers and wages, as they fall due, which can lead to insolvency.

Why is it also a problem to hold too much working capital?

Holding far more working capital than needed ties up cash, debtors and inventory that earn little return, rather than being invested more productively elsewhere.

Give one reason why a manufacturing business usually needs more working capital than a trading business.

A manufacturing business has to hold raw materials, work in progress and finished goods before a sale can be made, whereas a trading business simply buys and resells goods.