Workbook 5 – How not to run out of cash
Contents
Highlights ................................................................................................................................................ 2
Quick practice session on not running out of cash ................................................................................. 3
Financial Quiz 5 – How not to run out of cash ........................................................................................ 4
Learning Zone – How not to run out of cash .......................................................................................... 4
Gearing and Capital employed............................................................................................................ 4
Liquidity and Insolvency ...................................................................................................................... 5
Working Capital................................................................................................................................... 5
Cash flow planning .............................................................................................................................. 5
Talk the talk......................................................................................................................................... 6
Reflection and Discussion Zone – How not to run out of cash ............................................................... 6
Progress test – How not to run out of cash ............................................................................................ 7
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Workbook 5 – How not to run out of cash
Highlights
1. Understand financial gearing (the balance between equity and borrowed funding) and how it
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can be critical to the survival of a business
Explore the advantages and disadvantages of borrowing rather than seeking funds from
equity investors
See the need to use long term funds for capital expenditure
Be able to coherently explain the funding structure of your business to investors, lenders
and advisers
Meet the key ratios used to the assess the dependency of a business on borrowings
Understand why lenders often use two different ways to measure liquidity
See how profit and stability can sometimes be in conflict
Be able to explain the difference between a business which is insolvent and one which is
experiencing a liquidity crisis
Learn how to avoid getting into financial difficulty
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Workbook 5 – How not to run out of cash
Quick practice session on not running out of cash
Explore the type of policies and decisions that can if
untested undermine the stability and even survival of a
new business
Recreate the strategies explored in the
video:
 Increase the price of the new
equipment from€ 6000 to€8000
 Buy an extra 100 units on credit for
stock
 Increase our debtor collection
times from 60 to 90 days
As illustrated in column one.
And then explore strategies that might
protect the cash position e.g.
Explore the impact of:
 Reducing the number of bikes
bought on credit by 50 units
 Increasing the days taken to pay
creditors to 90
 Reducing the days taken to collect
cash to 45
 Paying only 90% of the overheads
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Workbook 5 – How not to run out of cash
Financial Quiz 5 – How not to run out of cash*
#
Questions
1
What would Billy's closing cash position be If he agreed with his bank
that he should invest his €15000 in a pension fund and borrow all the
capital i.e. take a loan of €18000 with repayments in year one of
€3600 principal and 2000 interest?
2
What would the closing cash position be if following the scenario
described in question one Billy found that credit sales fell from 300
to 200 units?
3
What creditor days would Billy now have to take to return the closing
bank balance to a positive position?
4
Billy uses FaBLinker so he sees the danger in the funding strategy
described in question one so he restores his original business model
(Net Profit €12950 Closing Cash €16831) and tests his exposure to
potential cash flow problems. At what Debtor Days would his closing
cash first slip into a negative figure?
5
With Debtor days at 168 and sales volume and cost assumptions
remaining the same: what is the lowest Selling Price (in euro without
cents) Billy would need to obtain to get his closing cash position
above €16000 again?
Your
answer
Correct
answer
*Answer based on Billy's business model as it was after section four "How to Generate
Profit". That is with a Net profit of €12950 and closing cash balance of €16831
Learning Zone – How not to run out of cash
The primary source of cash in business should be profitable sales. But even if you follow all the tips
and hit your sales and margin targets you can still run out of cash if you don’t:
1. Get enough long term capital into the business at the beginning to cover investment in fixed
assets and the cash flow gap that is common until the business reaches critical mass in terms
of sales and receipts
2. Rely too much on borrowings for your capital
3. Install effective working capital policies (credit terms and stock control) from the start and
maintain them
Gearing and Capital employed
Gearing refers to the mix of the constituents of long term funding in a business – Owners’ Funds and
Long Term Loans.
Where:
 Long Term loans < Owners Funds the business is aid to have low gearing
 Long Term loans => Owners Funds the business is aid to have high gearing
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Workbook 5 – How not to run out of cash
The advantage of borrowing is that it allows an entrepreneur to set up and grow a business without
having to relinquish ownership. A highly geared company would be exposed to more risk (from
increased interest rates or ability to make repayments if profits and cash flow fall) and would find
further borrowing difficult if it hits its expected targets more slowly than planned.
Liquidity and Insolvency
A company is said to have liquidity problems when it struggles to pay day to day debts as they arise.
A company is insolvent when its liabilities exceed the value of its assets.
Liquidity problems are often referred to as a “cash crisis” with all the urgency that this suggests
whereas a company can sometimes survive for months even years juggling creditors before a deficit
in assets is recognised.
Working Capital
The Cash flow cycle image in module 3 and the sequence of stock to debtor to cash illustrated in the
video introducing this module make it clear that the composition of current assets can be as
important as the aggregate value.
For this and other reasons financial analysts use two measures of liquidity:
1. The Current ratio
2. The Quick or “Acid Test” ratio which excludes stock from the equation.
We will examine these ratios in detail in Module 6 – Ratios.
Cash flow planning
Detailed cash flow planning involves projecting all the main sources of cash in and cash out to ensure
that the bank account stays within the agreed limit. The forecast would usually be monthly for
twelve months but could be weekly or even daily when cash flow is tight. ProfitScout in Step Three
is designed to provide twelve month detailed projections.
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Workbook 5 – How not to run out of cash
Talk the talk
Look up the following terms in the Glossary
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Gearing
Insolvent
Liquidity
Long to long
Over trading
Owners' funds
Venture Capital
Working Capital
Reflection and Discussion Zone – How not to run out of cash
Prompt
Key learning points
What term is used for the relationship
between owners’ funds and borrowed
funds?
Gearing is the most common term but Financial Leverage is often
used as well
What are the advantages and
disadvantages of borrowing rather than
seeking funding from investors?
Understand the advantages of borrowing to retain ownership but
also show an awareness of the dangers if profits are lower than
forecast and interest cover drops.
What impact would an increase in
profitability have on stability
It would reduce gearing by increasing the Reserves and boost
working capital by increasing the difference between current
assets and current liabilities.
The most common are:
Debt to equity %
And
Equity to Total assets
What ratios are used to measure the
level of dependence of a business on
borrowed funds?
What is the meaning of the following
rule of thumb in funding “Long to long
and long to short but there is danger in
short to long”
Why would a salesperson be likely to
want much higher inventory levels and
generous credit terms for customers
than would a financial controller.
It emphasises the need for adequate long term capital.
Essentially it means to fund fixed assets from long term capital to
avoid using short term capital which could precipate a liquidity
crisis in the event of expected cash flows from debtors is delayed
or fails to materialise.
Understand the natural tension between offering maximum
customer service i.e. carrying high stock levels and stretching the
credit allowed and the consequences in terms of liquidity risk and
ineffective use of capital.
Under what circumstances might it be
smart for a business to maintain high
inventory levels?
Where delays in delivery or other interruptions to supply are
likely.
Where prices rises are expected.
When might it be smart business to
When the business has the funding to carry the additional
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Workbook 5 – How not to run out of cash
Prompt
Key learning points
allow more generous credit terms to a
customer?
working capital required and the customer is important in
strategic or profit terms.
What does the term liquidity mean in
business finance and what ratios are
used to measure it?
The ability to meet your day to day financial obligations i.e. to
have enough cash to pay your immediate debts.
Why do lenders use two ratios
(Current and Quick) to assess liquidity
Because it may take a long time to convert stock to cash.
Stock valuations may be inflated by failing to allow for loss and
damage.
It might be difficult to secure a fair price for stock in a “fire sale”.
Progress test – How not to run out of cash
Question 1: Which of the following best describes the term "Owners' Equity"?
a) The amount of money which would remain after all liabilities were paid in full
b) The money invested in the business by the owners
c) The profits retained in the business
d) The right to vote at Annual General Meetings
Question 2: Which one of the following is included in the calculation of "Owners' Funds"?
a) Bank loans outstanding
b) Creditors (Accounts payable)
c) Retained profits
d) Money owed by debtors
Question 3: Which of the following best defines the meaning of the term "Liquidity"?
a) The surplus of current assets over current liabilities in a business
b) The amount of cash held in the business
c) The relationship between Owners' Funds and Borrowing
d) The extent to which current assets are composed of cash rather than debtors and stock
Question 4: Which of the following best determines the term "Working Capital"?
a) The capital applied to acquire stock for resale
b) The difference between current assets and current liabilities
c) The difference between Total Assets and Total Liabilities
d) The capital lodged to interest earning deposit accounts
Question 5: Which one of the following best defines the term "Gearing"?
a) The relationship between current assets and current liabilities
b) The leverage offered by a high gross profit margin
c) The ratio of total assets to current assets
d) The ratio between Owners' Funds and borrowed funds invested in the business
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Workbook 5 – How not to run out of cash
Question 6: Which one of the following best defines the term "Capital Employed"?
a) The net value of fixed assets employed in the business
b) All the funding used in the business i.e. owners', long term loans and current liabilities
c) The total long term funding i.e. Owners' Funds and Long Term Liabilities"
d) The Owners' Funds
Question 7: Which one of the following best defines the term "Insolvent"?
a) The inability to satisfy creditors either because liabilities exceed assets or inability to pay
debts as they mature
b) Failure to make a profit for three years
c) Incurring a "Judgement" from a creditor
d) Having too much capital tied up in inventory rather than cash
Question 8: What one of the following best defines the term "Venture Capital"?
a) Money provided by the owners for a new project
b) Capital advanced by investors to start-ups and early stage ventures with a view to early
exit and capital appreciation
c) Capital provided by individuals for a long term project
d) Low interest funding for start-up businesses
Question 9: Which of the following would offer the lowest risk funding to the viability of a
business?
a) A cash injection of €50000 through the issue of new ordinary shares
b) Drawing down a new long term loan of €50000 from a bank
c) Indefinitely deferring €50000 payments to short term creditors
d) Pledging a marketable asset in return for an overdraft facility of €50000
Question 10: Which one of the following best describes the term "Over trading"?
a) Selling more than the previous period
b) Selling goods to loyal customers knowing that they don't need that amount and it will
cause a drop in demand in subsequent periods
c) Pushing sales to the point where the business won't get the cash in from debtors in time
to pay suppliers when the business has not provided to meet that situation
d) Bartering goods with other businesses with no cash changing hands
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