Business Finance Fundamentals: Costs & Cash Flow

Understanding Business Costs

In business, understanding different types of costs is crucial for effective financial management. Costs can be categorized based on how they behave in relation to production levels or how directly they can be attributed to a product or service.

Key Cost Classifications Defined

• Variable costs change in proportion to the amount of output produced.

• Fixed costs remain the same, no matter how much the business produces.

• Semi-fixed costs are costs which only change when there is a large change in output. For example, costs associated with buying a new machine to cope with increased production.

• Direct costs are costs which can be identified directly with the production of a good or service; e.g., raw materials.

• Indirect costs are costs which cannot be matched against each product because they need to be paid whether or not the production of goods or services takes place; e.g., rent on the premises.

Cash Flow Forecasting Explained

The cash flow forecast predicts the net cash flows of the business over a future period.

The forecast estimates what the cash inflows into the bank account and outflows out of the bank account will be. The result of the cash flow forecast is an estimate of the bank balance at the end of each period covered (normally this is for each month). An example of a simple cash flow forecast is shown below:

Purpose of a Cash Flow Forecast

A business uses a cash flow forecast to:

• Identify potential shortfalls in cash balances. For example, if the forecast shows a negative cash balance, the business needs to ensure it has a sufficient bank overdraft facility.
• Assess whether the trading performance of the business (revenues, costs, and profits) translates into actual cash.
• Analyze whether the business is achieving the financial objectives set out in the business plan, which will almost certainly include a cash flow budget.

The Critical Importance of Cash Flow Forecasting

If a business runs out of cash and is not able to obtain new finance, it will become insolvent. It is no excuse for management to claim that they didn’t see a cash flow crisis coming.

Here are the key reasons why a cash flow forecast is so important:

• Identifies potential shortfalls in cash balances in advance. Think of the cash flow forecast as an “early warning system.” This is the most important reason for a cash flow forecast.
• Ensures the business can afford to pay suppliers and employees. Suppliers who don’t get paid will soon stop supplying the business; it is even worse if employees are not paid on time.
• Helps identify problems with customer payments. Preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note: This is not really a problem for businesses (like retailers) that take most of their sales in cash or via credit cards at the point of sale.
• Serves as an important discipline of financial planning. The cash flow forecast is a crucial management process, similar to preparing business budgets.
• External stakeholders, such as banks, may require a regular forecast. Certainly, if the business has a bank loan, the bank will want to look at cash flow forecasts at regular intervals.