When studying finance, it's helpful to
stop talking about just money and start talking about the three different
types of money - cash, profit & capital.
Cash refers to any money the business has to hand immediately
(e.g. sitting in a bank account or in the office safe) that can
be spent right away on paying bills and debts etc)
Profit refers to the income of the business after it
has paid its costs. It's what the business 'makes.' We will look
more at this when we consider the profit & loss account.
Capital is the money that owners invest in the business.
You could say that they 'lend' the business money. This will be
looked at further in the balance sheet.
Cash
Perhaps the most important type of money
is cash. Without it, the business cannot pay its debts and could be
forced into insolvency.
Sole traders and partnerships can be declared bankrupt.
The owners may have to sell the assets of the business. Because
they have unlimited liability they are personally responsible
for the debts of the business and may have to use more of their
own money to pay off the debts.
Limited companies can go into liquidation. The assets of
the company can be sold to pay debts and the shareholders may lose
their investments. Because they have limited liability, shareholders
will not lose any more than the money they used to buy shares.
During the 1992 recession about 60,000 businesses failed
(over 1,000 a week). This figure is usually lower as businesses
find it harder to operate in a recession, a time when consumer demand
for goods and services is low.
Lack of cash or liquidity is a common cause of business failure
The Cash Cycle
A good way of understanding why businesses
fail is to consider the way cash flows in a business.
If you were to start making a product, you would have to spend
money on the raw materials, wages, rent etc before you sold
the product. Your payments would come before you received money.
There are plenty of strategies that a business could follow such
as selling shares, borrowing money etc, but you can see that this
cash cycle could leave a business weak for a period of time.
Imagine your business owed money to the bank for a loan it took
out to buy a van. What would happen if the bank demanded payment
whilst you were making your product and you hadn't been able to
sell it yet? It's possible that your business could be declared
insolvent and would fail. Your product could have been the most
impressive thing since sliced bread, it could have been an invention
that would have been a top-seller for years and made you a millionaire
but if you can't pay your debts, you risk failure.
Cash Flow Forecasting
Businesses need liquidity. They
need to know that they have cash available at any point in time to
handle debt-payment and emergencies. A common method of achieving
this is to create a cash flow forecast. This will predict how
much cash a business will have each month. It can use this to ensure
it does not run the risk of having too little cash available and failing.
Although a cash flow forecast isn't a formal accounting document,
it is often produced as a method of financial planning. It can be
shown to banks and potential shareholders. If the business can demonstrate
that it has anticipated future problems and has made plans to deal
with them, it is more likely to persuade people to lend it money
or invest in it. Would you want to invest in a business that was
likely to fail next month?
Too Much Cash?
Is it possible to have too much cash? Yes. It is very important
to have enough cash but large amounts of cash simply sitting in
a bank account could be put to good use. Interest earned from bank
accounts is at usually quite a low rate. Investing in new technology,
employing more staff or an advertising campaign could produce more
profit for the business.
We shall look at this idea of 'how much is too much and
how much is not enough?' when we look at the current and
acid test ratios in our work on the balance sheet.
