How credit terms affect cash flow timings

Credit terms refer to the period given to customers to pay for goods or services after the purchase agreement. These terms influence when money enters the business, directly impacting cash flow patterns.

Effects of credit terms on business cash flow

• Immediate payment - Cash inflows occur at the time of sale, aligning receipts with the sales period and minimising delays.
• Extended credit - Payments are received after a set period (e.g., 30 or 60 days), creating a lag that can result in negative cash flow during high-sales months if outflows exceed inflows.
• Overall impact - Businesses offering credit may need to arrange short-term finance to cover gaps, but it can attract more customers by providing flexibility.

The components of cash flow forecasting

Cash flow forecasting involves predicting the movement of money into and out of a business over time. This helps identify potential shortfalls and ensures the business can meet its financial obligations.

Key elements in a cash flow forecast

Formula for net cash flow

$\text{Net cash flow}=\text{total receipts}-\text{total payments}$

Formula for closing balance

$\text{Closing balance}=\text{opening balance}+\text{net cash flow}$

The impact of immediate payment on cash flow

When customers pay at the point of purchase, cash inflows match the timing of sales, providing a steady and predictable cash flow.

Cash flow patterns with immediate payment

• Alignment with sales - High sales months, such as peak seasons, result in matching high receipts, supporting positive cash flow.
• Potential challenges - Even with immediate payments, there might be brief periods of negative cash flow due to upfront costs, requiring short-term finance for perhaps one month.

The impact of credit terms on cash flow

Offering credit terms, such as allowing payment three months after purchase, delays cash inflows and can create mismatches with outflows. This often leads to negative cash flow in the short term, especially during peak sales periods, as the business waits for payments.

Cash flow patterns with credit terms

• Lag in receipts - Sales made in one month generate inflows later (e.g., June sales paid in September), potentially causing cash shortages in the interim.
• Negative cash flow risks - During busy sales periods, outflows for production or stock may exceed inflows, leading to the need for short-term finance over multiple months.

Worked example - Calculating net cash flow and closing balance with credit terms

A business starts May with an opening balance of £3,800. During May, total receipts are £7,500 (including delayed payments from February sales), and total payments are £8,900. Calculate the net cash flow and closing balance for May.

Step 1: Identify the values

• Opening balance = £3,800
• Total receipts = £7,500
• Total payments = £8,900

Step 2: Calculate net cash flow

$\text{Net cash flow}=\pounds \mathrm{7,500}-\pounds \mathrm{8,900}=-\pounds \mathrm{1,400}$

Step 3: Calculate closing balance

$\text{Closing balance}=\pounds \mathrm{3,800}+(-\pounds \mathrm{1,400})=\pounds \mathrm{2,400}$

Key differences between immediate payment and credit terms

The choice between immediate payment and credit terms significantly affects cash flow management, particularly in terms of timing and financing needs.

Comparing the effects on cash flow

• Immediate payment:
  • Receipts align directly with sales periods.
  • Typically requires short-term finance for only one month during minor shortfalls.
• Three-month credit terms:
  • Creates a three-month delay in receipts, leading to potential negative cash flow in peak months.
  • Often requires short-term finance for four months to cover extended gaps.