Business Finance For Measuring Cashflow At Risk – Importance Of Cash And Profits For Business Survival

Describe about the Business Finance for Measuring Cashflow at Risk?

Introduction

Event Planners Ltd. carry on the business of planning the events for the clients such as weddings, birthdays, etc. It is a newly established business with only two shareholders. In the first year of the business, the company is in loss with major liquidity issues as the bank account has an overdraft balance and the company is unable to pay creditors on time. The company has appointed a manager to carry on the business of the company. But the director’s feels that he is using funds of the company recklessly and his acts are not in the interest of the company.

Difference between Cashflow & Profits for the business

Cashflow is the difference between the cash received during the year and the cash used during the year.

Profit is the revenue from the sale of goods & services, whether received in cash or yet to be received less all the expenses made during the year whether actually paid or yet to be paid.

Profit is not equal to the Cashflow during the year. Business can be in loss and at the same time positive Cashflow. Similarly, there may be negative Cashflow and business is still making good profit. (Bizfilings, 2012)

For a successful business, there must be a balance between both the Cashflow & profit. (Sharma, 1996)

Importance of Cash & Profits for the business survival

Profit making is the primary purpose of the business. It is a vital part of business, but profit is not the only purpose for the existence of the business. For the survival of business profit is essential, as profit has its own function in the business survival. Profit is required to pay the investors and stakeholders as return for the investment of money or time they invested in the business. Profit is needed for the running, expansion, growth and development of business. Profit also act as a financial indicator of how well business is working.

Cash plays a major role in the survival of the business. A business in loss can survive for short to medium duration if it is generating enough cash. As cash is needed for paying of any stuff. And no business can survive without enough cash to meet its immediate needs. At the same time holding excess cash is also of no use. It will be a loss of potential earnings. So, the liquidity should be maintained in any business to manage the balance of cash in the business as per the business requirement.

Identify and explain why business can report a profit, but be short of cash.

Profits and cashflows are related to each other. They are the financial measurement of the business. They are not directly related to each other, both depict different thing about the business. Cashflow measures the business ability to pay its expenses while profit measures the sustainability of the business. Cashflow is the cash balance after considering all the cash receipts and deducting cash payme/nts for the period. Whereas, profit is the result of deduction of expense for earning the revenue from the revenue. For the accounting purpose, an income & expense is recognized only in that period for which it actually takes place, whether received or paid in cash or not. (Vranceanu, 2014)

For example, a company sold the goods worth 100$, partially on credit, i.e. 50 $ will be received after 1 month and 50$ now at the time of sale. Expenses are payed off $ 45 and outstanding expenses are for 15$.

For calculating profit for the period= Revenue less Expenses

= 100$ (Total Sales) – 60$ (Total Expenses)

= 40$

For calculating Cashflow for the period = Cash inflow less Cash outflow

= 50 $ (Cash receipt) – 45$ (Cash payment)

= 5$

In this case, the company has an adequate profit, but short cash.

This difference in the profit and cash is mainly due to timing differences. For calculating profit, the company focuses on when the profit is earned and expenses incurred legally, without considering the cash position.  They follow accrual basis of accounting.  For calculating cash, the company only focuses on when cash is actually received and paid, without considering when it is actually earned or incurred.

Consequences to a business of being short of cash

Cash is the blood of the business. It acts as lifeline to the business. Shortage of cash in a business can harm it many ways. Such as:

Late payment to creditors, which lead to wrong image in the market and reduce the flow of material or goods.

Short cash will create liquidity problem in the business. If the business is short of cash, then it will create crisis kind situation like how to pay for expenses, how to purchase raw material, how to develop the business etc.

Cash shortage will lead to poor market image and also affect the goodwill of the business.

A  balance of cash is required in the business. Because cash is needed to earn profit for the business. Adequate cash is required to pay to employees and suppliers and other expenses. So that goods can be produced and profit can be generated by selling those goods. If business is short of cash than it will be unable to generate profit. So, business is to be managed in such a way to have positive cash flow for the growth and development of the business.

Identify and explain why business can report a profit, but be short of cash

Liquidity and profitability characteristics of new business as opposed to long standing business.

Business have different requirement in its different phases. A new business will have more liquidity as compared to long standing business. As for new business more cash is required for initial setup and for the purchase of resources to run the business. As this is the growing phase of the business, it will require more liquidity for the growth and development of the business. For the long standing business, an adequate liquidity is required, but not high as the business is already set up and running. So, it need liquidity only for smooth running of the business.

At the initial stage of business, it will have low profitability. As the business is trying to set up, building customers and goodwill in the market. In case of long standing business, there will be higher profitability. As the business has grown upto a level to give good returns and have high profitability. (Sasaki, 2015)

How Cashflow problems can arise

Cashflow problem arises due to following reasons:

Low Profits – Lower profit generally lead to cashflow problems for the business.

Over Investment – When more cash is invested in the machinery or equipment that required. This excess capacity will not generate revenue, so it is a waste of cash.

Excess stock- Holding of excess stock than the required quantity for smooth working of business is just a waste of cash and also lead to the risk of stock become obsoltee.

Higher credit period- Selling goods on credit is a good way of sales promotion. But providing very high credit period will lead to shortage of cash in the business.

Expanding fastly – Business in expanding very fast, so it will need more resources for the business. It will create a shortage of cash in the business.

Declining sales – Reduction in the turnover of the business lead to a reduction in the cash receipt. So shortage in cash arise.

Excessive debt – Excess of debt lead to the use of major cash in the payment of debt and shortage in cash arise.

High capital Expenditure – Higher capital expenditure will lead to higher cash flow and case cash reduction.

Methods for dealing with cash flow problems

Following are the methods for dealing with the cashflow problems:

Cost cutting – This is the best method for dealing with a cash flow problem by reducing the non essential costs of the business. This will help in reducing cash outflows for the business.

Consequences to a business of being short of cash

Reduction in stocks – Reduction in the cash tied up in the raw material and goods by ordering only minimum goods or raw material required for running the business. This will reduce the cash utilization in the stock.

Late payments to suppliers – Try to increase the credit period for making payment to the suppliers. This will reduce the cash engaged in the business.

Reduction in the credit period offered to the customer – Selling goods on credit is a good way of sales promotion. But providing high credit period will lead to shortage of cash in the business. So by reducing the credit period will allow more cash inflow in the business.

Delay in the growth and expansion plans – Delay of the expansion plan of the business for the future. This will deffer the cash outflow from now and reduce cash crisis.

Increasing the selling price – Increase in selling price will increase the cash inflow in the business and reduce cash crisis.

Cash Flow Management

A proper management of the cash outflow and inflows will help in maintaining required cash in the business by proper planning the cash inflows and outflows.

By keeping the cash flow forecast to remain prepared for future outflows in advance and manage cash flow problems. (Stein, 2001)

References

1. Stein, J, C, Usher, S, E, LaGattuta, D & Youngen, J 2001, ‘A comparables approach to measuring cashflow at risk for non financial firms’, Journal of Applied Corporate Finance, vol. 13 , no. 4 , pp. 100-09.

2. Sharma, D 1996, ‘ Analysing the Statement of Cashflows’, Australian Accounting Review, vol. 6 , no. 12 , pp. 37-44.

3. Morley, S 2002, The Financial Appraisal of Development Projects, in Development and Developers: Perspectives on Property, Blackwell Science Ltd, UK.

4. Vranceanu, R 2014, ‘Corporate profit, entrepreneurship theory and business ethics’, Business Ethics: A European Review, vol. 23 , no. 1 , pp. 50-68.

5. Ang, A & Liu, J 2004, ‘How to discount cashflow with time varying expected return’, The Journal Of Finance, vol. 59 , no.

6 , pp. 2745-83.6.  Brown, C & Burrows, G 2003,  ‘Risk-Adjusted Discount Rates and Projects of Unequal Lives’  Australian Accounting Review, vol. 13 , no. 29 , pp. 57-65.

7. Sasaki, T 2015, ‘The Effects of Liquidity Shocks on Corporate Investments and Cash Holdings: Evidence from Actuarial Pension Gains/Losses’. Financial Management, vol. 44 , no. 3 , pp. 685-707.

8. Albuquerque, R & Schroth, E 2015, ‘The Value of control and the costs of illiquidity, The Journal Of Finance, vol. 70 , no. 4 , pp. 1405-55.

9. LANG, M, LINS, K, V & MAFFETT, M 2012,  ‘Transparency, Liquidity, and Valuation: International Evidence on When Transparency Matters Most’, Journal of Accounting Research, vol. 50 , no. 3 , pp. 729-74.

10. Amihud, Y & Mendelson, H 2012, ‘Liquidity, the Value of the Firm, and Corporate Finance’, Journal of Applied Corporate Finance, vol. 24 , no. 1 , pp. 17-32.

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