UNIT 3.3 WORKING CAPITALLESSON 1: WORKING CAPITAL & CASH FLOWPP. 360-369

IB Business and Management

1. THINK ABOUT IT…

“Don’t empty the water jar until the rain falls.” - English proverb

What does this mean and how does it pertain to business?

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2. FOCUS QUESTIONS

1. What is cash? 2. What is the working capital cycle? 3. How is it possible to measure

liquidity? 4. Are there any differences between

cash and profit? 5. How can we forecast cash flow and

will there be any problems? …

3A. $$$ CASH $$$

What do you need cash for? Cash is also the lifeblood of a business.

Companies need cash to keep running. What do they need cash for?

Cash is: A current asset. How do companies get it?

By selling goods or services. Cash can be in hand (at the business) or at the bank. What are two other assets of a company?

Stocks and debtors. So, current assets = cash + stocks + debtors.

Remember this.

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3B. $$$ CASH $$$ Another way to obtain cash, is how easy it is to turn something into cash.

This is called liquidity. How liquid are you?

Highly liquid assets are those that can be turned into cash quickly and easily without losing its value.

For example, money in your bank account vs. raw materials at your warehouse. If your business has a cash flow problem and causes you to have insufficient

working capital, this will lead to insolvency. When you do not have enough working capital to meet current liabilities.

No money to run the business, you must close it down, and will lead to liquidation of the firm.

Liquidation = sell off firm’s assets to repay money owed to the creditors.

You do not want to be in this kind of situation. So in order to avoid this we need to look at several things:

Working capital cycle Understanding the difference between cash and profit Cash flow forecasts and problems it faces How to manage working capital

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4A. WORKING CAPITAL CYCLE Working capital is the money available for the daily running of a

business. It is also called Net Current Assets.

Working capital = Current Assets – Current Liabilities One of the main reasons businesses fail is because of a lack of

working capital. Current Assets are:

1. Cash (money on hand or at a bank) 2. Debtors (people who owe YOU money) 3. Stocks/inventories (unsold stocks of raw material)

Current Liabilities are: 1. Overdrafts (short-term finance that YOU owe) 2. Creditors (your suppliers who need to be paid) 3. Tax (money to the government)

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4B. WORKING CAPITAL CYCLE

You must consider the time difference between an order being placed and actually receiving the cash once your product has been delivered.

This time lag between cash payments for cost of production and receiving cash from the customer is called… Working Capital Cycle.

Firms should have enough working capital, but not too much liquidity.

Too much liquidity could be viewed as wasteful and could be invested.

You could use the money to be more profitable.

Production costs

Sales

Cash

5. DIFFERENCE BETWEEN CASH & PROFIT

CASH PROFIT

Cash inflows can come from sales revenues. Can also come from selling

off unused assets, too. Bank loans, donations,

and grants from governments.

You can also have a lot of cash and be unprofitable. How is this possible?

Remember cost can get out of control.

Profit= Revenue – Cost Once break-even point has

been reached, any sales beyond that is a profit.

Selling products on credit (you make a profit before you receive the cash). Can be profitable and cash

deficient. NOTE: it is important to manage

your working capital and cash flow position in order for your company to survive.

6A. CASH FLOW FORECASTS

This is a very important financial document you MUST learn how to read and understand. It shows the expected movement of cash

into and out of any business in a given time period.

It is based on three key concepts…

1. Cash inflows (receipts)

Sales revenue.Payment by

debtors.Loans from a

bank.

Interest from bank deposits.Sale of assets.Rental income.

2. Cash outflows (payments, expenses, or outgoings)

Labour.Purchase of stock.

Rent.Taxes.

Payments to creditors.

Advertising.Interest payments.

Dividends.

3. Net cash flow

The difference between cash inflows and cash outflows.

You want this to be positive.Your aim is to have the inflows

greater than the outflows.

6C. SO WHY THE NEED FOR A FORECAST? Reasons:

Banks will require you to have a cash flow forecast before lending you any money.

It is a tool to help YOU the manager to identify periods of cash deficiency.

Aids in the planning process and gives you better financial control.

Used as a guide to achieve your aims and objectives. Used to improve your predictions and future planning and

direction for the firm. Let’s take a look at an example of a cash flow forecast…taken from http://

wikitextbook.co.uk/images/5/51/Cash_flow_2.jpg Also on pages 366-367 of your text give another example of this.

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Opening balance is the amount cash at the start of the trading period.

Closing balance is the amount cash at the end of the trading period.

7.Causes of cash flow problems

Overtrading(expanding too

quickly)

Over borrowing (highly geared)

Overstocking(too much inventory)

Poor credit control

(too much credit to your

customers)

Unforeseen changes(seasonal

fluctuations)

UNIT 3.3 WORKING CAPITALLESSON 2: MANAGEMENT OF WORKING CAPITALPP. 370-376

IB Business and Management

1. FOCUS QUESTIONS

1. How can managers deal with liquidity issues?

2. What are three major ways to deal with liquidity problems.

3. What are the limitations on cash flow forecasting?

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2. DEALING WITH LIQUIDITY PROBLEMS Improving your cash flow position of a

business requires you to effectively manage the working capital. You must successfully manage its current assets

and current liabilities. Three major ways to do this:

1. Seek different sources of finance 2. Improve cash inflows 3. Reduce cash outflows

Let’s take a look at each… …

3.Alternative Sources of

Finance

Overdrafts

Sale and leaseback

Selling off fixed assets

Debt factoring (Unit 3.1)

Government assistance

Growth strategies (Unit

1.7)

4.Improving cash flow

Tighter credit control

Cash payments

only

Change pricing

policy (Unit 4.4)

Improved product portfolio (Unit 4.3)

Improved marketing planning (Unit 4.2)

5.Reducing

cash outflows

Seek preferential credit terms

Seek alternative suppliers

Better stock control

(Unit 5.7)

Reduce expenses (remember The Pareto principle:

80/20 rule)

6. HOW TO MINIMIZE THE RISKS & IMPACTS OF CASH FLOW PROBLEMS

Have a wider customer base. Avoid relying on a few big customers. Ask for part-payment on long term projects. Establish a way to pay large bills in regular installments. Make sure you have quality management systems in place (see

Unit 5.4) …

7. LIMITATIONS OF CASH FLOW FORECASTS

Inaccuracies occur due to a number of internal and external factors:

Marketing: poor market research or campaign Human resources: workforce may become less productive Operations management: machine failure or breakdowns Competitors: aggressive companies Changing fashion and tastes: is your product popular this year? Economic changes: see Unit 1.5 External shocks: war, oil crisis, etc.

So, there in NO guarantee that your predictions and assumptions made in the cash flow forecast will materialize.

A cash flow forecast is a continuous, ongoing process with regular revisions.

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END