Chapter 6 of the Business finance basics section in the 'Achieving financial success' series

Chapter 6 of the Business finance basics section in the 'Achieving financial success' series
Chapter 6: Managing cashflow

By Jackie Russell-Green*

Cash and profit

You know now that profit is made from selling your goods or services for a price higher than what it cost to make or deliver to your customers.

Cash is generated from these transactions as well as other activities that the business may undertake (such as selling assets).

The key to a successful business is good profitability and adequate cash flow.

This means, if you manage your margins properly, your trading should always be profitable and hence show positive cash flow, right?


A business can be profitable but still encounter cash flow issues.

How does this happen? Well, it’s all about timing.

The profit of a transaction is calculated when the sale is made. If you are in a business that offers goods or services on credit, then the profit is generally assessed at the time of the sale; however, you may not receive the cash until some time later.


There are two ways the transaction can be recorded: either on a cash basis or on an accrual basis. Let’s explain.

When working out if your transaction is going to be profitable, these are probably the questions you will need to answer:

• How much will it cost you to buy or make the product, or provide the service (hours paid)?

• What is a realistic price that your customer will be willing to pay?

• What do your competitors charge for the same or similar products or services?

The next step is to compare the price you will receive with the cost paid, and if price is higher than cost, the transaction is profitable.

Again, let’s go back to the profit and loss statement of Joe’s Motorbike Tyres, which we looked at in Chapter 1.

Using Joe’s example, let’s assume he sells 500 tyres at $52 per tyre to a motorbike manufacturer on 30 days’ credit, which means he will receive $26,000 from this customer at the end of month 1. He also is able to export 200 tyres at $52 per tyre, which means the payment of $10,400 from the overseas customer is not received until the second month from delivery. The balance of his stock will be sold later in the year. All of the tyres were imported at the beginning of the year and cost $34,320 in total, which was paid at the end of the first month of trading.

When we look at the cash flows from Joe’s sales, it becomes clear that the cash flows will not equal the profit until the total transaction in completed - that is, when all the money is received from all the sales.

A business can be profitable but still have cash flow issues. It is important to implement procedures in your business that will ensure cash flow is appropriately managed.

In month 1, Joe collects only $26,000 from sales but has to buy all the motorbike tyres in the same month. He receives the cash for sales of a further 200 tyres only in month 2, and the rest through the balance of the year.

So the above table shows that at the end of month 1 he will need an extra $10,400 to cover the purchase of the tyres, and by the end of the year his bank balance will match his gross profit. Of course, he will also have to cover the operating expenses throughout the year, which have not been included in the above table.

The timing of when cash is received is the most important issue when managing cash flow.

Cash flow drivers in your business

Even where your business is profitable, managing cash flow in your business can be very important. By identifying what “drives” the cash flow in your business, it will be easier to manage your cash flow. What do we mean by “drivers” of cash flow? They are the things in your business that most affect your cash flow. For most small businesses, this will be sales. However, for some businesses, it could be something else. To help you determine the key drivers of cash flow in your business, let’s look at the most common key drivers of cash flow.

Cash flow is the lifeblood of every business. A profitable business can still suffer from shortages in cash, so it is important to understand what “drives” your cash flow.

Accounts receivable (debt collection)

For all businesses, sales are important. After all, this is what ultimately generates profits for your business. From Joe’s example on the previous page, it can be seen that the collection of cash from sales is critical to ensuring he has cash in the bank. So, if sales are the key cash flow management issue for you, then you must have good procedures in place to ensure you can convert sales to cash as quickly as possible. The best way to do this is to manage the collection of cash from your customers using the checklist in the previous chapter.

Accounts payable (creditor payments)

Where the supply of stock or services is critical to your business, managing your supplier relationships will be important. If you have only one or two suppliers that can provide your business with stock or services, then ensuring you pay them on time and maintain a good relationship will be critical. If this is the case, then payment of accounts can be a key driver of your cash flow. (For tips on managing supplier payments, refer to the previous chapter.)


For some businesses, the supply of goods is very important in ensuring the supply of quality stock in time to meet customer requirements.

To determine if this is a key driver, you might consider whether the supply of goods is critical to your business’s operations. If it is, then maintaining the right amount of stock will have an impact on cash flow.

Capital expenditure

Where a business relies on the most up-to-date technology, whether this is new equipment or resources, to keep market share, capital expenditure can be a key driver of cash flow. For example, a research and development business depends on the most up-to-date equipment to develop the most current product or service, and it will need sufficient cash flow to support this capital expenditure.

The importance of knowing what the key drivers of your cash flow are should not be underestimated. In order to maintain adequate cash flow, these drivers should be a priority for your business and be well managed.

Cash flow forecasting

Cash flow planning is essential for business success, and a cash flow forecast is the most important tool for business.

The forecast will predict the ability of your business to create the cash necessary for expansion or to support its operations. It will also indicate any cash flow gaps the business may experience - periods when cash outflows exceed cash inflows. It uses estimated or real figures you collect and add to a simple worksheet from the day you start the business.

You can also develop a cash flow forecast from your existing information if you are already in business. After 12 months you’ll have a good idea as to what your cash balance will be, month by month, for your next year of operation.

Remember that cash flow is all about timing and the flow of cash, so when preparing your cash flow forecast, make sure you are as accurate as possible on the timing of the cash flows.

There are a few ways to use a cash flow forecast as a planning tool:

• in short-term planning, to see where more cash than usual is needed in a month - for example, when several large annual bills are due and the cash in the bank is likely to be low

• in business planning (long-term planning), to find where cash flow could break the business, especially when you want to expand. For example, a seasonal swimwear retailer, after months of quiet winter trading with a low cash flow, has to buy new season’s stock, employ extra staff and advertise but they may also be planning to extend into the shop next door. After several lean months the cash supply may be at its lowest, even without the added expense of the new premises, so the cash flow would need careful planning.

The easiest way to prepare a cash flow forecast is to break up the forecast into smaller areas and then bring all the information together at the end. The five steps in preparing a cash flow forecast are:

1. Prepare a list of assumptions.

2. Prepare the anticipated income or sales for the business (called a sales forecast).

3. Prepare detail on any other estimated cash inflows.

4. Prepare detail on all estimated cash outflows.

5. Put all the gathered detail together.

Step 1: Assumptions

The assumptions used in the cash flow forecast are the same as those used for the income and expenditure budget process (refer to Chapter 3).

Step 2: Sales forecast

For any business, sales are the key to business success. Whether you are starting a new business or have an existing enterprise, estimating sales is often one of the most difficult tasks in the forecast process.

If you think about it, your sales will be dependent on many variables, such as the types of customers you have, the terms you offer your customers, economic events such as interest rate increases or employment rates, or competitive influences. It is not possible to predict all the events that may have an impact on your sales over the time frame of the forecast. This is why many businesses do not do forecasts.

However, if you accept that your forecast sales will most likely not match your actual sales, you can then focus on determining a “realistic” figure for the sales of the business over the period for which the forecast will be prepared.

For existing businesses, the best starting point will be looking at last year’s sales figures. Do you believe you will continue to achieve these figures, or have you implemented improved business operations to increase sales over the coming year?

Once you have determined the likely adjustment needed to your historical sales figures, you can then estimate the forecast sales for the period.

After you have determined the sales for the period, the next step is to break up these numbers into “sales receipts” - the actual timing of receipt of the cash from sales. Remember we talked about the timing of cash as the key to the cash flow forecasts. Again, this information will be a projection, although existing businesses will have some history to help estimate actual sales receipts.

If the business is purely a cash business (such as a fruit stall at a market), then the sales will equal the “sales receipts”. However, as noted earlier, where credit terms are offered there will be a delay in receiving the proceeds from the sale, and this is where we need to estimate the timing of receipts.

Applying your accounts receivable collection pattern from the past to your sales forecast is the best way to predict your cash receipts from the collection of accounts receivable. To see how this is done, we have provided an example of how to calculate the timing of cash receipts.

After reviewing his sales collection history, Joe has determined that the following sales receipt pattern occurred in year 1.

Percentage of cash sales  -  40%
Percentage of credit sales -  60%

Applying these percentages to the estimated sales for year 2, Joe completes the tables below.

Step 3: Other cash inflows

To complete the cash inflow information in the cash flow forecast, you will need to identify any additional cash coming into the business. Of course, the types of cash inflows for each business will vary, but the following list may help you recognise other cash inflows in your business:

• GST refunds

• additional equity contribution

• income tax refunds

• grants

• loan proceeds

• other income sources not included in sales (such as royalties, franchise and licence fees)

• proceeds from sale of assets.

Given you are preparing a cash flow forecast for additional financing, don’t forget to include the loan funds in your inflows.

Step 4: Cash outflows

As we have indicated, one of the major inputs into the forecast is sales. Coupled with this inflow is the cost of purchasing or manufacturing those goods to sell.

Therefore, when determining your cash outflows, it is useful to calculate your cost of goods sold in line with your sales forecast. By doing this, if you do need to change your sales numbers, an automatic change to the cost of goods sold figure should occur.

Many computer programs will allow you to set up a link between two items, such as your sales and cost of goods sold, to make the process of forecasting a little easier. In Chapter 1, the calculation of cost of goods sold was discussed, so refer back to this section or use the gross margin percentage discussed in chapter 4 when estimating the cost of goods sold for your forecast.


Expenses are those cash outflows relating to the operations of the business that are not included in the cost of goods calculation. These outflows are often referred to as “administration” or “operational” expenditure. Again, the items of expense will depend on the type of business you are starting or currently operating.

One of the important areas to focus on when forecasting expenses is classification.

When putting together your forecast, the variable expenses will be directly related to the forecast sales numbers, so if you adjust your sales, these expenses will need to be amended in line with the sales adjustment. Of course, the fixed expenses will remain the same, although you may need to consider adjusting these for increases, for example for inflation.

Other cash outflows

In addition to cost of goods sold and operational expenses, you may have other cash outflows during the operations of the business.

Examples of cash outflows include:

• purchase of assets

• one-off bank fees (establishment fees)

• principal repayments of the loan

• payments to the owner(s) (for example, dividends)

• investment of surplus funds.

Step 5: Finalising the cash flow forecast

Now all the relevant information has been collected, it is time to prepare the forecast.

At the beginning you will have determined the time period the forecast is to cover. Remember, cash flows are all about timing and the flow of cash, so you will need to have an opening bank balance and then add in all the cash inflows and deduct the cash outflows for each period, usually by month. The number at the end of each month is referred to as the “closing” cash balance, and this number becomes the opening cash balance for the next month.

An example of Joe’s cash flow forecast for year 2 is provided above. This cash flow forecast shows that his business is going to borrow $20,000 to purchase a car so he can assist in his sales and marketing by visiting his potential customers. Remember that Joe included this in his assumptions (refer to Chapter 3).

The forecast shows that the $20,000 is borrowed in February and the car is paid for in the same month. The cash inflows include anticipated sales receipts, as shown in the table on page 40. Remember, this is cash collected from sales, not actual sales made.

In the cash outflows section, all the monthly expenses (inclusive of GST) as they are paid have been included, as have cash outflows from expenses incurred for the loan (such as the establishment fee).

By preparing the cash flow forecast, it can be easily seen that if Joe is to borrow the $20,000 to purchase the car, he will still not have enough cash to cover all expenses for the period for which the forecast has been prepared. The main reason for this is that a percentage of sales is made on credit.

This means that while sales will increase after the purchase of the car, the time lag between buying the car and increase in sales, and the cash being collected, means his business will need an additional $3,267 (maximum overdrawn amount as shown in month 5) to ensure he has enough cash to cover these timing differences. Joe will have to consider how he is going to fund this cash shortfall. Most likely he will have to consider approaching his bank for additional funding.

There are two important additional points to note here. Firstly, the bank is most likely to request details of the assumptions in the forecast. Secondly, if the business were to request additional funds of only the extra $3,267, there would be no “buffer” in the event that some of the anticipated cash flows changed (for example, interest rates rose and the interest expense increased).

Once the forecast is completed, you can run some “what if” scenarios to measure how reactive your business cash flows will be to certain changes in events, such as a decrease in sales or increase in fuel costs. This will show you how quickly you may run out of cash if any of these events occur.

To fully understand the implications of choosing debt, equity or internal funds to fund your business, ask yourself what would happen if something went wrong.The answer will help you make the right choice.


The full Guide is available in the .pdf attachment, or here »


Jackie Russell-Green is the National Technical Manager of Staples Rodway who assisted in the development of this guide for CPA Australia, New Zealand Division . You can contact them directly here »

You can read the Introduction to this series here »  The related Glossary is an important resource. And readers are encouraged to read this page first »

Chapter 1 is about Understanding financial statements and you can read it here »
Chapter 2 is about Assessing your busines's financial health and you can read it here »
Chapter 3 is about the Importance of Budgeting and you can read it here »
Chapter 4 is about the Maintaining Profitability and you can read it here »
Chapter 5 is about the Improving Cashflow and you can read it here »

Chapter 7 is about Debt, Equity, or Internal Funds? and will follow next week.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

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