Working capital cycle, Cash-flow forecasts, and Management of working capital
1. Define working capital and explain the working capital cycle.
2. Prepare a cash-flow forecast from given information.
3. Evaluate strategies for dealing with liquidity problems.

1. Define working capital and explain the working capital cycle.

Working Capital
- money that is available for the daily running of a business (aka net current assets)
- show the funds available for a business to pay for its immediate costs and expenditures (running costs: wages, raw materials/suppliers)
Working Capital = Current Assets – Current Liabilities

  • Net cash flow is the difference between cash inflows and cash outflows over a period of time (e.g. monthly)
  • Ideally, net cash flow should be positive, although a firm may be able to temporarily survive if it suffers from negative net cash flow
  • Even if a firm is profitable, it can only survive in the long run if receipts are greater than cash outflow

Working Capital Cycle:


2. Prepare a cash-flow forecast from given information.

Cash- current asset ($ received through selling of goods/services)

Current/Liquid Assets = Cash + Stocks (inventories) + Debtors (used within the next 12 months)
($ in bank/business) + unsold stocks of raw materials, semi-finished goods + ppl/org that owe $ to the business as they have purchased goods on credit

Current Liabilities- $ that a business owes that needs to be repaid within the next 12months
- eg. Overdrafts, Creditors, Tax

Liquidity- how easily an asset can be turned into cash (high liquid assets= easily converted to cash without losing their monetary value eg. cash in bank (high) vs. raw materials (low) )

Insolvency- working capital is insufficient to meet current liabilities
Voluntary or compulsory closure--> liquidation of firm (sell off all its assets to repay $ owed to creditors)

Cash Flow Forecast
Why do we need Cash Flow Forecast?
  • banks and other lenders requires cash flow forecast to better assess financial health of the business
  • help manager to anticipate and identify periods of potential cash deficiency (deal with liquidity problem, adjust the timing of receipts and payments)
  • aids planning process, cash flow forecast compared with actual figure to improve future predictions

Cash Inflow
  • usually comes from sales revenue when customers pay for products
  • calculations require accurate sale forecasts for the period
  • can also come from payments by debtors, loans from bank, interest received, etc.
  • also referred as receipt
  • if the sales are paid on credit, it will be accounted when the actual cash is received

Cash outflow
  • Cash usually leaves a firm when bills have to be paid
  • e.g. labour, purchase of stocks, rent, taxes, etc.
  • a.k.a. payments, expenses or outgoings

Current Ratio
Current Assets : Current Liabilities
If it is below 1:1, the company has liquidity problems because it cannot meet all its current liabilities

Cash and Profit
Profit= Total Revenue- Total Costs
-Difference between sales revenue and cash inflow:
*sell on credit: profit is made before cash is received
*cash inflow can come from selling of assets, loans, donations, gov. grants (not trading)
Profitable but Cash Deficient:
*sell on credit
* profitable business tries to expand too quickly à run out of cash
Unprofitable but Cash Sufficient
*new product bring $$ to company but cannot manage costs (eg. fixed/indirect costs:
machine, rent)

Video: Introduction/Summary of Cash Flow Forecast

Very Clear tutorial on how to calculate working capital:

3. Evaluate strategies for dealing with liquidity problems.

Improving Cash Flow Position
Seeking for alternative sources of finance
-sale and leaseback (eg. building and vehicles)
-selling off assets
-debt factoring: external party taking over the collection of money from debtor
-government assistance: state grants
-growth strategies

Improving Cash Inflows
-tighter credit control: reduce debtor periodà receive $ sooner
-cash payments only
-change pricing policy
-improve product portfolio
-improve marketing planning

Reducing Cash Outflows
-seek preferential credit terms
-seek alternative suppliers
-better stock control
-reduce expenses

Causes of Cash Flow Problems
-Overtrading: business attempts to expand too quickly (consumer a lot of cash when buying fixed assets) without the sufficient resources to do so
-Overstocking: stocks cost money to buy, produce and store
-Poor Credit Control: selling too much things on credit
-Unforeseen change: unexpected change in demand

Limitations of Cash Flow Forecast
-marketing: inaccurate and poor market research
-human resources: demoralized workforce becomes less productive
-operations management: machine failure
-competitors: rival firms (esp. market leaders)
-changing fashion and taste: change in demand
-economic changes: opportunities and threats to business
-external shocks: war, oil crisis, health