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Let’s get technical: forecasting cashflows

Gareth John serves up some mouth-watering advice on forecasting cashflows

June 2016

I love the festive season and even though it is still only May I am already looking forward to my favourite meal of the year: Christmas dinner with all the trimmings. Among my many talents I am pretty handy in the kitchen so I tend to take control of the cooking on the big day. Something that in the past I was never quite sure about was exactly how to cook the turkey – there seemed to be as many different ways as there are cooks. But what I have learned in recent years is that while there is indeed more than one way to cook a turkey they all taste great with cranberry sauce and sprouts… mmm!
A few months ago I wrote an article on cashflow forecasting (see www.firstintuition.co.uk/pq-article-on-cash-flow-forecasting/), a key topic in the level 4 cash management paper and also a critical part of running a successful (and solvent) business. That article focused on what is sometimes known as the ‘receipts and payments method’ of forecasting cashflows. This method involves:
• Identifying the various cash receipts the business expects: cash from customers, proceeds from asset disposals, issues of shares, etc.
• Identifying the various cash payments the business will need to make: payments to suppliers, wages and salaries, rent payments, etc.
• Comparing receipts to the payments in each month to predict whether the cash balance will increase or decrease

However, there is more than one way to cook a turkey! Another important way that we can forecast cashflow is the ‘statement of profit or loss account and balance sheet method’. In this method (as the name may suggest) we use information contained in the P&L and balance sheet to predict the overall cashflow in a period.

The starting point
If we have a forecast statement of profit or loss we can identify the expected operating profit for the period we are forecasting. This operating profit figure is a good starting point as it will include all of the transactions for the period (such as sales, purchases and other expenses). However, we will need to make a few adjustments.

Dealing with non-cash items that are included in operating profit
The first thing that we need to recognise is that the operating profit figure includes certain transactions that are not actual cashflows. A good example would be depreciation. Depreciation is an accounting journal that recognises an expense in the period (so reducing operating profit), but there is no actual payment of cash (so cash doesn’t actually fall). This means that simply using operating profit would understate the actual cash position of the business. To remove the impact of depreciation we need to add the expense back to operating profit to restate it to a more accurate ‘cash profit’.
Another non-cash item that would need to be adjusted for is any profit or loss on disposal of non-current assets as these affect operating profit but aren’t actual cash movements. To remove their impact on operating profit we would:
• Add back any loss on disposal.
• Deduct any profit on disposal.

Dealing with cash items that are not included in operating profit
As well as adjusting for non-cash items that are included in operating profit, we also need to adjust for cash items that are not included in operating profit. This tends to relate to items on the balance sheet but would also include payments for tax (as operating profit is the profit before tax is dealt with). One thing to watch for with tax is that we must deduct the tax actually paid in the period which may not be the same as the tax charge in the P&L for the period.

Movements in balance sheet items
The other significant adjustments required are for movements in balances of assets and liabilities on the balance sheet.
Consider a simple example: imagine that we made one sale for £100 in the period and that there was no cost of making the sale. This would give a profit figure of £100. But does this mean that the cash balance would have increased by the same £100? Well, what if the sale was on credit and the customer has not paid us yet? This would mean that trade receivables had increased by £100 and that there was no increase in cash at all. The profit earned on the sale has been ‘soaked up’ by the increase in trade receivables.
Another way to think about this is that an increase in trade receivables is ‘bad for cash’ as it means we haven’t been paid yet so we would deduct the increase from our operating profit when reconciling to actual cashflow. If trade receivables were to decrease in a period this is ‘good for cash’ as it means credit customers are paying faster so we add the decrease to operating profit.
• We deduct increases in inventory as these are ‘bad for cash’ as we have to pay for the stock.
• We add increases in trade payables as this is ‘good for cash’ as we are paying suppliers slower and keeping the money.
• We deduct increases in non-current assets (when we have made acquisitions) as this is ‘bad for cash’.
• We add any proceeds from asset disposals as this is ‘good for cash’.
So we end up with a reconciliation that might look something like:
Operating profit (our starting point) 50,000
Add back depreciation +4,000
Deduct profit on disposal of NCAs (2,000)
Deduct tax paid (12,000)
Deduct increase in trade receivables (3,500)
Add decrease in inventories +1,000
Add increase in trade payables +4,000
Deduct acquisition of NCAs (6,500)
Add proceeds from disposals of NCAs +5,000
Net change in cash position +40,000

• Gareth John is a tutor/director with First Intuition and helps to manage their AAT distance learning programme. He was PQ’s Accountancy Lecturer of the Year in 2011

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