Financial Training: The Importance Of Cash & Cash Flow Forecasts

There is an old banking mantra which sums up the very essence of financial control:

"Turnover is vanity, profit is sanity but cash is reality"

Business owners and managers often make the mistake of focusing on sales growth thinking that it will automatically lead to profit, only to discover at the end of the year that price reductions have caused the margins to collapse.

Even more serious is that as a business grows it often consumes rather than generates cash.

More stock is needed if goods are sold. Debtors/accounts receivable increase much faster than creditors/accounts payable. Extra capital expenditure may be needed to provide the extra infrastructure and equipment for the growth.

It works the other way around as well.

As a business contracts and sales get smaller, the business can incur losses but generate cash.

Financial Control - Turnover, Profit & Cash

You can't use your turnover as a reliable guide to your financial health and that's why the banking mantra tells you to look at profit and cash.

For information about profit, you look at the Profit & Loss Account. For more information, read Understanding Financial Statements although I will be looking at the Profit & Loss Account in more detail in future articles.

Today you will learn to understand, monitor and control the cash aspects of your business.

As with Profit, you should look at historical cash flows and also try to predict the future with a cash flow forecast.

There are two main formats:

1. Receipts & Payments
    
2. Reconciliation from the Profit (this will be covered in a separate article)

The receipts and payments format is the easiest to understand and the best for day to day control of cash although the other format explains the common question "We made a profit but where has all the cash gone?"

Receipts & Payments

The format is simple.

Receipts minus Payments equals Cash Flow.

Cash Flow plus the Bank Balance at the start of the period equals the Bank Balance at the end of the period.

Sources Of Receipts

1. Receipts from cash sales which may also include debit card and credit card sales
    
2. Receipts from credit sales which you will collect from your trade debtors/accounts receivable after a credit period
    
3. New bank loans
    
4. New cash introduced from the business owners, either as equity or loans
    
5. Sundry receipts

The credit sales are the items which cause the timing of cash flow to differ from sales by a period which is often between 30 and 90 days and sometimes even longer.

Credit control is a subject of a different article but the amount of credit you give to your customers is a critical factor and must be tightly managed. Sales people should not have the authority to agree delayed terms because they are not in a position to understand the consequences.

In general I have a dislike of bank loans since they can be used to cover up symptoms of poor profitability and bad cash management. Banks also expect security for their money and this puts the business owner's personal assets at risk. If you need a bank loan, I recommend an ebook "The Secrets of Getting Your Bank Manager To Say Yes"

Sources of Payments

In many ways payments are the opposite of receipts but payments are made to a wide variety of stakeholders like suppliers, employees and the government.

1. Cash payments including debit and credit card payments
    
2. Periodic payments, standing orders and direct debits
    
3. Payments to creditors/accounts payable which will reflect the credit you take from your suppliers/vendors
    
4. Net wages and salaries paid to employees
    
5. Payment of employee taxes, social security and benefits
    
6. Business tax payments on the profit of the business
    
7. Value added tax / sales tax
    
8. Capital expenditure
    
9. Interest payments on bank loans and overdrafts
    
10. Repayments of bank loans
     
11. Dividends payable to the business owners
     
12. Other payments

Credit will be available from suppliers but extended terms often require careful negotiation as it may be seen as a sign of financial weakness.

Payments for employees in the UK are split between the net payment made to employees in the month and the associated PAYE tax and national insurance/social security which is paid by the 19th of the following month.

Value added tax is an issue if your company is over the VAT limit and will have to be added to your sales but the VAT charged and paid on your purchases can be reclaimed.

Unless much of your sales are outside of the scope of VAT (eg insurance), zero rated (e.g. basic food) or you export, your VAT on sales (known as output VAT) will be more than your input VAT (on purchases) and this has to be paid to the taxman. There are a number of different schemes so you need to talk to your accountant or HM Customs & Excise to make sure that you use the scheme which best suits your business.

Corporation tax or business tax is easily forgotten about in the rush to make a profit. Again talk to your accountant about arranging your tax affairs in the most beneficial way whilst staying on the right side of the law.

Forecasting Cash Flows

Cash needs to be managed and it is best done by using a cash flow forecast to make sure that you have cash available throughout the year.

It is far better to talk to the bank about an increase in overdraft or an extra loan well in advance of the need for the money. Going to your bank manager at the last minute when you have found out you can't make the payroll payment this month sends out a clear message "You are not in control of your cash." This is not something you want to be telling your bank manager and you will have a very difficult meeting.

Long Term Cash Forecasting

I like a long term cash forecast which is linked to a forecast Profit & Loss Account for the next twelve months. It is also best to have a Forecast Balance Sheet to complete the picture and check for errors and inconsistencies.

The long term cash flow forecast will be for 12 months and you should prepare it before the year starts and then update it periodically if the underlying forecasts prove to be inaccurate.

The long term cash forecast is particularly important if you have a business where sales fluctuate sharply across the seasons or where you have very "lumpy" payments and/or receipts.

It is less important if your transactions are small and regular and one month is very much like another and if you have plenty of cash, you may be able to use simpler controls.

Short Term Cash Forecasting

I like the discipline of short term cash forecasting to cover the next one to three months where you can take the information from your sales ledger/accounts receivable and purchase ledger/accounts payable together with current payroll expectations and other known payments.

The level of detail required will depend on the level of cash crisis. I like to see a forecast by week but if your business is in a cash crunch, the forecast will have to be daily to make sure you don't commit yourself to non-priority payments on the assumption that receipts may come to allow you to meet the payroll.

The next step is to monitor how the actual receipts and payments compare with your forecasts for the month. Building up a monthly record of actual payments and receipts together with notes on unusual items, helps you to prpeare your long term forecast the following year.

The short term cash flow gives you the ability to manage your cash on a day to day basis and if customers are paying slower than expected, you can decide to hold back your payments to your suppliers.

Cash Is King

I am writing about business turnaround in other articles around this one so it is always important to remember that a business is bankrupt when it runs out of cash and can no longer make the payroll or pay suppliers.

Cash is also black and white and not the shades of grey which Profit can be.

Profit depends on estimates and the accounting policies which are used so talk to five accountants and they may give you five different profit numbers.

Cash is reality and you can see it in the receipts and payments.

To Your Success

Paul Simister

Your Profit Coach, business coaching for customer focused entrepreneurs

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