Cash Flow simulation

First page of the Biz/ed Cash Flow simulation.

Cash Flow simulation

Welcome to the Biz/ed Cash Flow simulation. The aim of this resource is to develop an understanding of the main principles surrounding the issue of cash flow and to give you the opportunity to see if you can manage the cash flow of a company for a year!

Cash Flow simulation structure

Cash flow is one of the most important aspects of any business. Cash flow should not be confused with profit - they are different concepts! Cash flow shows the money flowing into a business from sales, interest payments received, and any borrowings and the amount of money flowing out of a business through paying for wages, rent, interest owing, paying back loans, buying raw materials and so on.

If the cash flowing into a business does not meet the cash flowing out, then eventually a company will be unable to meet its debts and could be forced out of business. Poor cash flow - represented by more cash flowing out than in - is the single biggest reason why many businesses, especially new business ventures, fail. The product or service they are providing may be excellent and the business could be sound in every other way but if cash flow is not managed, the business could disappear.

To understand cash flow there are a number of important points to remember.Businesses often have a gap between incurring costs and receiving payment. For example, the cost of setting up a business in the first place can be high. To give you an example, a landowner in the south west of England has taken steps to convert land to producing wine for a sparkling red. The cost of each vine was £3, and there are 4,000 planted, the cost of fencing to protect the vines against badgers and rabbits had to be considered and there will be costs incurred in maintaining the vines in the years it takes for them to become established and yield fruit. He does not expect to sell any wine (and therefore receive any income) for at least 7 years. In that time, therefore, he must ensure he has the funds to be able to meet the costs incurred.

A vineyard

Image: The time between the planting of a vineyard and the first drop of revenue can be lengthy.

The example above is an extreme one but goes to highlight the problems facing business in matching incomings and outgoings. For some businesses, certain times of the year may be very busy and they can expect sales to be strong and therefore income to be strong. Other times of the year may be very slow with a corresponding small inflow of income. However, all business will be incurring costs, in part, steadily throughout the year.

The main costs for many businesses will be the fixed costs. These are the costs incurred regardless of how much is produced or sold. The term 'fixed' can be a bit misleading. Fixed costs can change - but not in response to changes in output. Fixed costs are things such as some types of wages (e.g. salaries), insurance, rent or mortgage payments on property, administration costs, loan repayments and so on.

In addition to the fixed costs, there will be variable costs. These are the costs that vary directly with changes in output. Raw material costs are the most obvious but there are also costs that can change with output - some types of labour payment, some elements of energy costs and so on.

The crucial point is that these costs have to be paid to keep the business going. If a business cannot afford to buy new raw materials because it does not have the cash, it will have difficulty surviving in the long term! The way in which payments and receipts are managed is, therefore, an important part of running any successful business.

The matter becomes further complicated by the fact that many businesses operate various credit systems with regard to payments. Goods might be bought on 1st May but do not have to be paid for until 28 days later; in other cases, businesses may not pay for finished projects in full but retain a sum of money to cover for possible problems; and in some cases, larger companies may withhold payment for many months, preferring to pay out for work done every three or six months, for example. Equally, the company might be trying to stall its creditors as long as possible without incurring their wrath! A careful balance, therefore, has to be struck and this balance can often tip too far one way or the other causing the firm problems which can threaten its survival.

Next: Positive cash flow