5.2.1 Cash flow
It is essential to produce rolling projected cash flows and profit-and-loss accounts – ideally using estimates to look forward at least six months. These are the measurements for your management control – without them you will not know your future, and you will find it very difficult to make plans. By understanding your cash flow and profit-and-loss accounts, you will have a competitive advantage by being able to plan to maximise cash availability and profit generation in order to provide for future expansion and selling price reductions.
We are going to look at a cash flow and profit-and-loss account in detail to understand their importance. The terms used are not accounting terms, and it is assumed that most organisations will use an accountant to produce the balance sheet and annual accounts. The focus here is on learning how to use cash flow and profit and loss as management tools – not on developing the skills of a bookkeeper or accountant.
We will discuss the construction of cash flow and profit-and-loss tables referring to a case study based on the fictional company Catterline. We will also explore how the information in these tables is invaluable to effective business decision-making and provide the means for monitoring the health of your new venture. The first step that Hannah, the managing director of Catterline, had to take in order to satisfy her bank manager was to construct a simple spreadsheet to see where the money goes (produced in March of Year 1).
Case study: Catterline background
Catterline is a newly formed, high-tech small company of five people. Catterline produces a sensor for oil storage tanks that detects dangerous gas build-ups in empty or near-empty tanks. To manufacture the sensors it buys in a circuit board produced to their design in China and a radio transmitter board manufactured to their design in South Korea. Catterline assembles these two components in a sealed box with a built-in sensor produced in Switzerland, wiring up all the components and programming the chip on one of the boards to the exact requirements of the oil company that will buy the sensors.
Hannah is the founder of the company, managing director and the designer of the sensor. Austin is the sales director, having worked as a safety expert for a large oil company. There are three semi-skilled assemblers and Hannah does the final programming. Hannah has worked out the costs for the first 18 months. Austin has agreed a salary of £4,000 a month for the first six months and then £4,000 plus five per cent of sales on payment for the goods by the customer. The occupancy costs, such as cover rates, rent and electricity, are paid monthly to the landlord.
There will be no sales (or assemblers) for the first five months while Austin ties up orders for August delivery. The order will be placed in March and will take three months to manufacture. They ordered boards and boxes in January for June delivery to meet expected demand. When they moved into their premises in January, they needed £20,000 to equip. Hannah has to pay for components in May before they are shipped. Deliveries to customers in August will be paid for in September; Catterline’s terms are 30 days.
Preliminary investigation by Hannah and Austin has assured their first order. They would expect a similar order in November of Year 1 for delivery one month later and again in March and April of Year 2 for delivery one month later. Hannah has put £30,000 of her own money into the start up, and Austin £20,000. They have negotiated a bank borrowing limit of £150,000 secured on Hannah’s house. The bank wants to see profit-and-loss accounts and cash flows for the next 15 months. The shaded area in Catterline’s cash flow spreadsheet provided as an Excel file shows historic figures, and the unshaded area shows projected figures.
Hannah’s cash flow table is still incomplete because she has to calculate the all-important cumulative cash balance less all her fixed and variable costs. Catterline’s cash flow table already contains a wealth of information and gives some sign of the likely peaks and troughs of business activity. However, the really valuable information lies in the bottom line, which is currently incomplete.
Task 33: Cash flow projection (over 18 months)
- Finish off Catterline’s cash flow spreadsheet which is effectively a cash flow projection that takes into account the effects of credit sales.
- List the conclusions that you can draw.
- Complete your own 18 month cash flow projection.
- List the areas of potential concern.
The first important bit of information that emerges from the data in the tables is that in July, August, November and December of Year 1 Hannah is dangerously near her bank borrowing limit. If anything goes wrong with money coming in, she could be in trouble. In February, March and April of Year 2 she has gone over the limit considerably. She will need to monitor the cash flow carefully.
The second important point to emerge is that before completing her first profit-and-loss account it appears that her cash flow is showing £50,150 at the end, which is almost equal to the start up money. She does not seem to have generated any cash by the end of the period. It is very uncertain whether she has made an overall profit up to June of Year 2. She will also have to monitor her profit forecasts and adjust her operation to ensure a profit – otherwise the bank will be unhappy.