As you will have seen your business needs money to cover its requirements for:

• working capital to allow it to trade from day-to-day and to meet its overheads, which will include funding for payments to the business’s directors and owners for their work in the business; and
• investment to allow it to develop and survive into the longer term, which will include funding for payments to give investors in the business a return and repay borrowings.

You will always need more than you think as these two real life examples show:

• The management bought out a specialist manufacturer that was turning over approximately £13 million. Within a year turnover had increased significantly, with prospects of hitting £20 million as a result of the failure of one of its main competitors. As a result within a year the business was seriously overtrading and came very close to collapse, only being saved by a sale and leaseback of its property (see Chapter 8) which released approximately £1 million of cash.
• At the same time (and only 20 miles down the road) the managers of an electronics business had bought their plant out of a receivership. Unfortunately in their case, rather than turnover recovering from the receivership level of £30 million to the expected £40 million, things got worse, falling to closer to £20 million. Given the business’s high overheads this translated into severe losses and as a result the business failed again within 18 months.

The business’s cash requirement will result from the complex interaction of its profitability, which generates cash, with its requirement for cash to meet its working capital and investment needs.

So how do you understand how this is working in your business, and then how do you establish what levels of funding you are likely to need going forwards?

The answer is that:

• to understand what is happening to the finances of your business as you trade you need to draw up a statement of source and application of funds; and
• to establish how much finance you are likely to need you need to draw up a cashflow forecast.

STATEMENT OF SOURCE AND APPLICATION OF FUNDS

Profitability is all very well, but it is actually cash that pays the bills. Sometimes it can be difficult to see whether the business is actually generating cash or not and if so, what is happening to it.

A statement and source of application of funds (SSAF or Source & Apps and now more properly known as a cashflow statement) can be used to demonstrate where the money has come from (the sources) and gone to (the applications).

In my view this is one of the best ways to obtain an overview of your business’s performance. In my experience it also mirrors the way bank managers tend to read accounts. They are, however, notoriously difficult to get to balance and you may find it easiest to ask your accountant to prepare it for you.

The beauty of the SSAF is that it provides a link that shows what has happened to the profit generated by or introduced into the business.

So for Widget Co Ltd, the company has apparently produced a net profit after tax of £50,000, yet the company’s overdraft has gone up by £24,000. So where has the cash gone?

A simple statement of source and application of funds can help explain (see page 71).

The net profit after tax for the year is after having suffered a £25,000 charge for depreciation, which is obviously not a real cash item. So adding this back, you find the net funds generated from operations ie the cash you would expect to see generated by these profits as a source of funding for the business of £75,000.

However, you know that £20,000 of this has been applied to paying out a dividend so this is no longer available for the business.

Then you can see that over the year the level of debtors and stock has gone up by a total of £80,000. As shown in the last chapter this translates into £80,000 more cash absorbed by the business tied up in stock and debtors than in last year. These funds have therefore been applied to building up assets.

On the creditors’ side of the balance sheet, trade creditors and the sum due for VAT have also gone up by a total of £56,000, but credit given by a trade creditor or by the Crown is in effect a loan to the business so it is a source of funds. If these organisations did not give you this extra credit then you would have had to spend (ie apply) more cash during the year to keep the balances down to the level that were brought forward from last year.

Meanwhile the balance due to the Crown for corporation tax has gone down by £5,000 while £50,000 of the mortgage debt has been paid off. So the company has applied funds generated by the business to reducing these liabilities.

The result of all these movements is that the company has required an extra £24,000 with which to make ends meet, which has come from increasing the company’s overdraft, which is exactly what has happened.

CASHFLOW FORECASTING

To predict what your financing requirements are likely to be you need to prepare a cashflow forecast. This will be a vital document, for:

• actively managing the cash in your business to extract maximum trading ‘value’ from it;
• obtaining and maintaining support from lenders for whatever facilities you may need.

Cashflow forecasting is essentially straightforward as you are dealing with real cash movements into and out of the business, not more abstract accounting transactions, such as accruals, prepayments or depreciation.

Forecasts can be prepared on, say, a monthly basis for the coming year, or for more detailed control on a weekly basis (say for 13 weeks), or in some crisis situations they have to be done on a daily basis. Obviously:

• the further into the future you are projecting, the more uncertain the outcome is likely to be;
• the longer the periods used to forecast, the greater the danger that the results may hide a mid-period spike, where for example the figure at the end of the month in your monthly forecast may look acceptable as it is within your overdraft limit, but this is hiding the fact that the PAYE payment due mid-month will push you well over the limit.

For any cashflow forecast, all you are looking to calculate is:

• the cash you are going to get in that period;
• less the cash you are going to pay out that period;
• to give a net movement (‘flow’) of cash into or out of the business.

Adding the net inflow (or deducting the net outflow) of cash to the balance held at the start of the period gives the balance at the end as shown below:

Widget Co Ltd has produced a cashflow forecast as shown in Figure 4. This type of forecast lends itself to being set up on a spreadsheet so that it can be updated easily.

The secret of cashflow forecasting is to keep it simple, and to work methodically and logically down the page through all the cash coming in and going out of the business.

For example, your cash received will come from the following:

• Existing debtors who pay during the period. Look down your list of debtors, decide who is likely to pay in which period, and fill in the boxes.
• New sales. Prepare a simple sales forecast by branch, line of business, contract, customer, or whatever is most appropriate for your business. Widget Co Ltd has forecast a turnover of £1.2 million, a 20% growth on last year, but it has also shown its seasonal pattern of sales in its forecast which are heavier in the second half of the year. Then calculate how much of these sales will be for cash (and so received immediately) and which will be on credit, where Widget Co Ltd knows that its customers take on average two months to pay. Then fill in the appropriate boxes (remembering to add VAT as your receipts will be gross).
• Any other sources. Will you be injecting any new funds, receiving any insurance payouts or generating any other cash from anywhere at all, like Widget Co Ltd which is planning to sell off an old machine? If so, estimate how much and when the cash will be received (don’t forget VAT where it applies), and enter the figures.

You can now total all these to obtain your estimated total weekly inflows.

Outflows are calculated on exactly the same principles.

Your trade creditor (or purchase ledger) list also tells you who you owe money to for purchases and expenses. So in the same way that you forecast receipts from debtors, you can go down this list and plan when you are going to pay what to whom. Bear in mind that you will also need to continue to make purchases as you trade, so these can be forecast in the same way as you forecast sales (Widget Co Ltd is assuming purchases of 50% of sales and two months to pay) and plan in the payments (gross of VAT) for when you are going to make them.

Wages may be paid weekly or monthly so the net amounts should be shown when they will go out.

PAYE is due once a month in respect of last month’s wages (so you will see that for Widget Co Ltd this rises the month after the wages figure goes up to reflect increased overtime to cater for the increased sales). VAT is normally due at the end of the month following the end of the business’s quarter, so predicting the dates of both these types of payments should be straightforward.

You will need to plan payments for rent, heating, lighting, power, telephone, and your other commitments in the same way, as well as remembering to estimate how much VAT will need to be paid, and when.

The keys to successful cashflow forecasting are the following.

• Know where you are starting from. As you stand today you have a balance at the bank; you are owed money by your debtors that you are expecting to receive; and you will owe money to trade creditors, the Inland Revenue, HM Customs & Excise (now combined into one organisation, HM Revenue & Customs), and so on. Use these figures as your opening balances. If you do not have exact figures (why not?) then use your best estimates. If you have cheques sitting in the drawer that have not been sent out, add these back to your creditors and adjust your cashbook so as to show a real position.
• Forecast on a cashbook basis. This means that you post payments immediately they are made, but recognise receipts only when they have cleared the bank. The advantage of this is that it will always show a worst case position since it will always take a few days for cheques and other payments to actually hit your account and be reflected in your bank statement. So your position at bank per the bank statement will always be better than the forecast by the value of this float.
• Be realistic in your estimates of timings and amounts. Your forecast needs to take into account:
  • What level are sales/purchases running at now?
  • What changes are really likely to happen over the period?
  • What have you experienced in prior periods? (How quickly do your customers actually pay?)
  • What are your terms of trade? (What length of credit do you allow customers/are you allowed by suppliers?)
  • What are your due dates for statutory payments? (For example, the 19th of the month for PAYE.)
  • What are your periodic payments? (For example, quarterly bills for utilities and rent.)
  • What capital expenditure (capex) (purchases of fixed assets such as machinery) are you planning?
• When in doubt be prudent. Be pessimistic about when, and how much people are going to pay you, and when you are going to have to pay others.
• Make your assumptions explicit. If you tell your bank manager that sales are going to increase by 20% the week after next, you can then also tell them that this is because your contract with XYZ plc comes on stream. Otherwise they may just think that you are relying on the new sales fairy to wave a wand and make this happen.

Widget Co Ltd’s assumptions are shown in the example on page 78.

• Check that you are showing all aspects of any transaction. Widget Co Ltd has its sales peak from June through to November so to build stock to deal with this it has budgeted for temporary extra staff and overtime from April through to October.
• Experiment with sensitivities. Flex some of your key assumptions (what if sales go up by only 10% instead of 20%, what if customers take 90 days to pay instead of 60?) to see how sensitive the forecast is to these fluctuations. Make sure that you fully reflect all aspects of any change, however. But remember to ensure you flex all the linkages; if sales go down, then purchases and wages should fall as well.
• Think widely. Check that you have allowed for all possible payments that may need to be made by comparing the type of items with last year’s detailed profit and loss account.
  • Have you allowed for corporation tax, redundancy payments, pension top ups, or repairs if any of these are likely to fall due in the period?
  • Go through some old bank statements and cheque book stubs. Have you allowed for all the types of payment that you find?
• Check carefully to make sure it all adds up! Widget Co Ltd’s cashflow has check totals built in at the end. These are simply sums adding up the elements of the table in different ways to ensure that nothing has been left out. An example of the principle is illustrated below, where the first 9 is calculated by adding together the values of all of the column totals, while the second is calculated by adding all of the row totals. If the two check sum totals match, you can be confident that there are unlikely to be any basic arithmetic errors in the table.

• Tie your forecast into an integrated package. Your cashflow forecast should link to your profit and loss forecast and balance sheet forecast and the whole package should balance. This type of integrated forecast can be set up on a set of spreadsheets, but you will need to be careful to ensure it is set up so that it balances properly. This can be complex so it may be easiest to either use one of the commercially available packages to prepare it (such as Win Forecast) or to have your accountant prepare a forecasting model for you. If you do so, it is important, however, that you own the model and operate it on an ongoing basis, as it is you and not your accountant who is responsible for understanding and managing your business’s finances.
• Finally, remember that you do not have a 100% reliable crystal ball. Build in a margin as a round sum contingency to allow for the cost of things that will inevitably come crawling out of the woodwork. The more uncertain your starting point, the larger this needs to be, up to say, 10% or 20% of payments in some cases.

Part of the reason for cashflow forecasting is to ensure your lender’s confidence that you are in control of your finances. Having a contingency in place is not only prudent, but if it helps ensure that you beat your forecast cash performance, it will also help to ensure that your lender’s confidence in your management skills, and hence their willingness to lend you money, will increase.

The technique can also be used to review any large contract or project that the company is planning to undertake.

Whatsit Ltd is at the limits of its overdraft when it receives news that it has won a large contract, the details of which are:

While the company has one month’s credit from its suppliers for materials, it has to pay its labour monthly (but labour is paid gross with no PAYE deductions). There is no retention on the contract and the company is to bill at the end of each month for the materials delivered, labour and one sixth of the profit, and the client will pay at the end of 30 days.

The directors are jubilant, and are convinced that this is going to save the company.

Undoubtedly, it is a profitable contract. But should Whatsit Ltd take it? The answer lies in looking at the cashflow. To simplify matters, VAT has been omitted.

The answer then, is clearly no, not as it stands. The project’s early cash outflows mean that Whatsit Ltd, which is at the edge of its facility, will immediately run out of cash if it accepts the contract and starts work.

Instead, Whatsit Ltd must explore whether the proposed payment terms can be changed to speed up receipt of cash (eg an upfront payment), greater credit can be obtained from the labour and material suppliers, and/or negotiate increased facilities with its bank to enable the project to be undertaken.

Once you have prepared your forecast, use what you have produced.

• Review it critically. Having prepared it on a prudent basis, now see what scope there is for moving payments or bringing forward receipts. Compare the balance at the end of each week with the facility you have with the bank. Are you going to remain within your overdraft facility (in banking jargon to have headroom) or are you going to go over your overdraft limit (be in excess)?
• Use it to plan. If you are going to be in excess the way Whatsit Ltd is going to be according to its cashflow forecast on page 74, plan what you are going to do about it. Look at what payments or receipts you can change. Whatsit could for example look at:
  • offering settlement discounts to encourage debtors to pay immediately;
  • stretching its payments to its suppliers to take more credit from them;
  • reducing its level of purchases required by working down its existing stock holding before buying new supplies of materials;
  • negotiating a reduction in the capital repayments on the mortgage to reduce the contingency it is allowing;
  • put off replacing its machine until next year (or arrange to buy it on finance that spreads the payment over a number of years);
  • cancelling any dividend payments; or
  • reducing the allowance made for contingencies.

Managing your cash tightly so as to maximise the amount retained in the business is known as bootstrapping as it is the business pulling itself up with its own bootstraps and generating funds with which to grow from within the business.

You should however also speak to your bank as far in advance as possible about any expected excess to agree a temporary extra facility.

• Use it to obtain facilities. By working on the cashflow forecast you can use it to explain to your bank or other lender why you are going to need further facilities, how much these will be, how long it will be for, and how you are going to then pay them back.
• As a word of caution, however: don’t run to the bank with your first draft cashflow forecast as this is likely to show a dreadful cash position (you have been pessimistic after all). Only discuss your forecast with your bank once you have had a chance to review it thoroughly to amend and adjust it for the things that you are realistically going to be able to manage to improve the position. You need to discuss a final working forecast that is challenging, but realistic and prudent, not ultra pessimistic.
• Use it to monitor. Roll the forecast forwards, week after week or month after month, comparing what actually happens to your forecast. Ask yourself where they differed and why. Then ask what that tells you about your estimates going forward and where you can/should amend your forecast to improve your estimates.