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Study notes

Causes of cash flow problems

  • Levels: AS, A Level
  • Exam boards: AQA, Edexcel, OCR, IB

What is a cash flow problem and what do they happen so often in all types of business?

A cash flow problem can be defined as:

When a business does not have enough cash to be able to pay its liabilities

The main causes of cash flow problems are:

  • Low profits or (worse) losses
  • Over-investment in capacity
  • Too much stock
  • Allowing customers too much credit
  • Overtrading
  • Unexpected changes
  • Seasonal demand

Let's look at these in a little more detail.

Factor

Why It Causes a Cash Flow Problem

Low profits or (worse) losses

The profit a business makes from trading is the most important source of cash.

There is a direct link between low profits or losses and cash flow problems

Remember - most loss-making businesses eventually run out of cash

Over-investment in capacity

This happens when a business spends too much on fixed assets

Problem is made worse if short-term finance is used (e.g. bank overdraft)

Fixed assets are hard to turn back into cash in the short-run

Too much stock

Holding too much stock ties up cash

+ Increased risk that stocks become obsolete

On the other hand...

There needs to be enough stock to meet demand

Bulk buying may mean lower purchase prices

Allowing customers too much credit

Customers who buy on credit are called "trade debtors"

Offer credit = good way of building sales

On the other hand...

Late payment is a common problem – and slow-paying customers often put a strain on cash flow

Worse still, the debt may go "bad" – i.e. it is not paid at all

Overtrading

Occurs where a business expands too quickly, putting pressure on short-term finance

Classic example – retail chains

  • Keen to open new outlets
  • Have to pay rent in advance, pay for shop-fitting, pay for stocks
  • Large outlay before sales begin in new store

Businesses that rely on long-term contracts are also at high risk of overtrading

Unexpected changes

These are items or events that are not included in the cash flow forecast – they are unforeseen. Examples include:

  • Internal change (e.g. machinery breakdown, loss of key staff)
  • External change (e.g. economic downturn, accidents, change in legislation that requires a business to invest in new facilities)

Seasonal demand

Where there are predictable changes in demand & cash flow

Production or purchasing usually in advance of seasonal peak in demand = cash outflows before inflows

This can be managed – cash flow forecast should allow for seasonal changes

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