Did you know that many companies spend more than they receive? Although they are profitable, there is often more money flowing out of their bank accounts than into. In doing so, they might be unable to pay off their financial obligations. A way to avoid it is to make financial plans and forecast outflows and inflows. In order to stay solvent, companies need to budget and be aware of cash flow.
Cash flow is a movement of money. It can be either physical or virtual. It is when an amount of cash and cash equivalents are being transferred into and out of a business.
Solvency is an ability of a firm to meet long-term financial obligations.
Budget is a form of financial planning and forecasting.
Cash flow versus revenue and cost
Whereas revenue is the value of sales made, it is not the same as money in. For revenues, there has been a transaction made. However, for cash inflows, there has also been cash exchanged.
Cash sales made to customers are both revenues and cash inflows. However, credit sales made to customers are revenues but not cash inflows. This is because there has been a transaction but cash has not yet been exchanged.
Similarly to revenue and cash inflow, for costs, there has been a transaction made. However, for cash outflows, there has also been cash exchanged.
Cash payments to suppliers are both costs and cash outflows. However, credit payments to suppliers are costs but not cash outflows. This is because there has been a transaction but cash has not yet been exchanged.
Cash flow formula
Free cash flow determines how much cash a business is generating after paying the costs of remaining in business. There are three methods of calculating it.
These methods include:
Cash flow calculation (based on the cash flow statement of the company below):
If operating cash flow is £22,700 and capital expenditures are £15,000, then the free cash flow is £7,700.
This means that the company's cash flow is positive.
Positive cash flow is when there are more cash inflows than outflows. The opposite it negative cash flow which is when there are more cash outflows than inflows.
Cash flow statement
Similar to the income statement, cash flow statements show the profit earned and loss sustained by a business entity over a particular period (usually 12 months) and how this figure is concluded. However, instead of showing revenues and costs, the cash flow statement includes cash inflows and outflows.
A company is selling jackets. In 2021, it bought 2,000 jackets for £20 each and sold all of them for £45 each. No other inventory was traded that year. Other payments were: rent and rates £5,000, heat and light £4,000, fixtures and fittings £30,000 (expected to last 5 years), and staff wages £18,000.
Based on the information, we know that:
Turnover (total revenue) is £90,000 (£45 x 2000).
Cost of sales is £40,000 (£20 x 2,000).
Gross profit is £50,000 (£90,000 - £40,000).
Other expenses are rent and rates, heat and light, fixtures and fittings, staff wages, and they equal £33,000 (£5,000 + £4,000 + £6,000 + £18,000).
Net profit is £16,000 (£50,000 - £34,000).
Based on these figures, we can create an income statement of the company:
Table 1. Income statement of the company in 2021
| turnover | £90,000 |
| cost of sales | £40,000 |
| gross profit | £50,000 |
| Rent and rates | £5,000 |
| Heat and light | £4,000 |
| Depreciation of fixtures and fittings | £6,000 |
| Staff wages | £18,000 |
| Other expenses | £33,000 |
| net profit | £17,000 |
Depreciation refers to allocating costs of assets over their life expectancy.
The business was created on 1.01.2021. On that day the owner put £30,000 of their own money into the business bank account. There were no other assets or liabilities.
On 31.12.2021:
A customer owed £900 to the company in return for 20 jackets sold on credit.
The company owed £1,600 to a supplier in return for 80 jackets bought on credit.
The owner withdrew £15,000 from the business bank account.
Table 2. Financial Statement of the company at the end of 2021
| Cash: (31.12.2021) | |
| + Opening capital | £30,000 |
| + Cash from sales | £89,100 (£90,000 - £900) |
| - Cash paid for inventory | £38,400 (£40,000 - £1,600) |
| -Other cash expenses | £28,000 (£6,000 + £4,000 + £18,000) |
| - Fixtures and fittings | £30,000 |
| - Owner's drawings | £15,000 |
| Total cash | £7,700 |
Table 3. Assets of the company at the end of 2021
| Assets: (31.12.2021) | |
| + Fixtures and fittings | £24,000 (£30,000 - £6,000) |
| + Inventory | £0 |
| + Prepaid rent | £1,000 |
| + Receivables | £900 |
| + Cash | £7,700 |
| Total assets | £33,600 |
Receivables refer to money owed to a firm by its customers.
| Capital and liabilities: (31.12.2021) | |
| + Payables | £1,600 |
| Capital: | |
| + Opening capital | £30,000 |
| + Net profit | £17,000 |
| - Drawings | £15,000 |
| = total capital | £32,000 |
| Total capital and liabilities | £33,600 |
Payables refer to money owed by a firm to its suppliers.
The cash-flow statement of the company would look as follows:
Table 5. Cash flow statement of the company in 2021
| + Net profit | £17,000 |
| + Depreciation | £6,000 |
| = | £23,000 |
| - Receivables | £900 |
| - Prepayments | £1,000 |
| + Trade payables | £1,600 |
| = Net inc. working capital | -£300 |
| Operating cash flow | £22,700 (£23,000 - £300) |
| - Investing in non-current assets | £30,000 |
| + Financing | £15,000 |
| = | -£15,000 |
| Net cash flow | £7,700 (£22,700 - £15,000) |
Important points to mention:
Since cash paid for the depreciation is already included in the £30,000 investment in non-current assets, depreciation is added back onto the profit figure. £6,000 was taken off the profit to avoid double-counting it.
An increase in receivables is negative to cash flow because by giving credit to customers, the company does not receive cash for sales.
An increase in payables is positive to cash flow because by receiving credit from suppliers, the company keeps cash.
An increase in prepayments is negative to cash flow because by paying in advance, the company gets rid of cash.
'Financing' consists of new capital introduced and capital withdrawn (can also include loans).
Budget
As you already know, a budget is a form of financial planning. It is forecasting of cash received and cash payable, of incomes and revenues, and the resulting state of the financial health of a company where:
cash received and cash payable = cash flow forecast (cash budget),
revenues and expenses = budgeted income statement,
state of financial health = budgeted balance sheet.
Types of budget
A balanced budget is when revenues are equal to expenses.
A budget surplus occurs when revenues exceed expenses.
A budget deficit occurs when expenses exceed revenues.
Cash budget
A cash budget is an estimation of a business's cash flows over a period of time.
The cash budget can also be defined as a forecast of a company's future financial position. It is usually based on anticipated payments and receivables.
It is 1.01 of year 1 and a company has just issued £100,000 worth of share capital. Its rent of premises costs £8,000 per quarter to be paid quarterly. Salaries cost £15,000 per quarter and will be paid quarterly as well. Patent agents need to be paid £8,000 due in quarter 2, and £12,000 in quarter 4. The initial value of this is £50,000 in quarter 7, rising by 5% per quarter thereafter. Revenues will be received in the same quarter as they are earned. In this case, a revenue stream will begin to accrue in quarter 7. Leases on equipment are to be paid annually in advance: £7,500 per quarter in year 1 and £10,000 per quarter in year 2. It is anticipated that in quarter 6, the company will enter into its first license-to-manufacture agreement.
Table 6. Cash budget of the company (all figures £1000):
| year 1 | | | | year 2 | | | |
| Q1 | Q2 | Q3 | Q4 | Q5 | Q6 | Q7 | Q8 |
| Opening balance | 100 | 47 | 16 | -7 | -42 | -105 | -128 | -101 |
| License balance | 0 | 0 | 0 | 0 | 0 | 0 | 50 | 52.5 |
| pension | 8 | 8 | 8 | 8 | 8 | 8 | 8 | 8 |
| salaries | 15 | 15 | 15 | 15 | 15 | 15 | 15 | 15 |
| IP costs | 0 | 8 | 0 | 12 | 0 | 0 | 0 | 0 |
| lease equipment | 30 | 0 | 0 | 0 | 40 | 0 | 0 | 0 |
| Total outflows | 53 | 31 | 23 | 35 | 63 | 23 | 23 | 23 |
| Net cash flow | -53 | -31 | -23 | -35 | -63 | -23 | 27 | 29.5 |
| Closing balance | 47 | 16 | -7 | -42 | -105 | -128 | -101 | -71.5 |
Important points to mention:
Total outflows = rent + salaries + IP costs + equipment lease
Net cash flow = license balance - total outflows
Closing balance = opening balance + net cash flow
Based on the cash budget, the company's closing balance in the first two quarters of 2021 will be positive. Unfortunately, later on, it is expected to drop to below 0 and the company might become insolvent. To keep prospering in the future, the company will need external funding.
Advantages and disadvantages of budgets
| Advantage | Disadvantages |
| Budgets help manage cash flow. | Budgets can prevent a company from overspending. |
| Budgets may identify a possible shortage of cash. | Budgets can change and therefore be misleading. |
| Budgets allow for planning. | Budgets can eliminate rewards. |
| Budgets help to reach goals. | It can be hard to estimate the amount of money to be spent and create a budget. |
Cash Flow and Budgets - Key takeaways
Cash flow is a movement of money.
Cash flow statement shows the amount of cash inflows and outflows.
Budgets refer to financial planning and forecasting.
There are three types of budgets: balance budget, surplus budget and deficit budget.
Cash budget shows predicted cash based on earnings and expenses.
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