Cash Management

1 Introduction

A business can be highly profitable and still run out of cash. Profit is measured on the accruals basis: a credit sale is recognised as revenue when the goods are delivered, even though the cash may not arrive for another one or two months, and expenses such as depreciation reduce profit without any cash leaving the business at all. Cash management therefore has to be handled as a discipline in its own right, alongside the management of profitability.

Running out of cash – not making losses – is what forces companies into insolvency. A loss-making business can survive for years while it has cash; a profitable one can fail within months if it cannot pay its debts as they fall due.

The main tool for doing this is the short-term cash flow forecast, which is an explicit requirement of the 2027 syllabus. The forecast identifies exactly when cash inflows and outflows are expected to arise, month by month (or week by week), and therefore when the business will have either a cash surplus or a cash deficit.

• If the forecast shows a deficit, the business has time to arrange short-term finance – for example an overdraft – before the shortfall arrives (Chapter 16).

• If the forecast shows a surplus, the cash can be invested short term to earn a return rather than sitting idle (Chapter 16).

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2 The cash flow forecast

A cash flow forecast is a management accounting exercise, not a financial statement. Unlike the IAS 7 statement of cash flows there are no prescribed operating/investing/financing headings: we simply list expected receipts, list expected payments, and work down to the forecast bank balance for each period.

A typical layout for a three-month forecast:

Each month’s closing balance becomes the opening balance of the following month. The two lines that need most care – and the two that exam questions concentrate on – are receipts from credit customers and payments to credit suppliers, because both involve a time lag between the transaction and the cash movement.

3 Forecasting receipts from credit customers

Start from the sales budget. Split each month’s sales between cash sales (cash received immediately) and credit sales, then apply the expected settlement pattern to the credit sales: for example, 60% of credit customers may pay in the month of sale and 40% in the month after. A receipts working is built month by month – and note that you often need earlier months’ sales (before the period asked for) to pick up the cash still flowing in from them.

4 Forecasting payments to credit suppliers

Payments to suppliers take one more step, because purchases must be worked out first. The chain is:

1. Sales – from the sales budget.

2. Cost of sales – derived from sales using the cost structure given (a gross profit margin on sales, or a mark-up on cost).

3. Purchases – adjust cost of sales for the inventory-holding policy: purchases = cost of sales + closing inventory − opening inventory.

4. Payments – apply the credit terms taken from suppliers (for example, purchases paid one month after they are made).

5 Acting on the forecast

Preparing the forecast is only half the job – the point is what management does with it:

• Forecast deficit. Arrange short-term finance in advance (trade credit, an overdraft facility, a short-term loan or debt factoring), or take action to improve the cash cycle – chase receivables in sooner, negotiate longer credit from suppliers, or delay discretionary spending such as capital expenditure.

• Forecast surplus. Put the cash to work: invest it short term (bank deposits, treasury bills and similar instruments) for the period until it is needed, matching the maturity of the investment to the date the forecast says the cash will be required.

Both responses – the sources of short-term finance and the short-term investment of surplus cash – are covered in Chapter 16.

6 Cash forecasting in practice

In a modern finance function the mechanics above are rarely done by hand. Accounting and treasury systems can show the live bank position across all accounts, and forecasts are usually built in spreadsheets or dedicated treasury/ERP software that pulls actual receipts and payments automatically. Electronic and instant payments also mean cash moves faster – in both directions – than when settlement was by cheque.

Technology does not remove the judgement, though. A forecast is only as good as its assumptions about sales volumes, customer payment behaviour and cost levels, so in practice forecasts are prepared on a rolling basis – updated each month (or week) as actual figures replace estimates – and the further ahead the forecast looks, the less reliable it becomes.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.