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What is Cash Flow?

See also:
Free Cash Flow Definition
How Growth Affects Cash Flow
Why Use a 13-Week Cash Flow Report as a Management Tool?
Why You Need to Have a 13-Week Cash Flow Report

What is Cash Flow?

Cash flow is a term describing the money into and out of a business. This includes all transactions that transfer cash. Furthermore, the business’s sources of cash are separated into three areas in the company’s cash flow statements. Some of the different categories for money spent or earned to fit into the following:

Cash flow in vital to your business. It is the blood or oxygen for your company. Without it, there is no company.

What is Net Income?

Net income is a measure of revenue after subtracting all expenses. This means you take the total revenue for a period and subtract cost of goods/services as well as overhead. This gives a rough idea of whether a business made ‘money’ during the period. However, net income is not a good way to determine the cash usage in a business.

Key Differences Between Cash Flow & Net Income

Some of the key differences between cash flow and net income include the following:

  1. A business can be profitable and go out of business from lack of cash.
  2. A business can have cash flow but remain unprofitable.
  3. Cash flow is reflected on the cash flow statement and not the income statement or balance sheet.
  4. Analyzing cash flow is a way of planning for future cash needs.
  5. Investors can tell where the cash comes from and where it goes from statement of cash flows.
  6. Loans show up as cash on an income statement; Loans are shown as positive financing activities in the statement of cash flows.
  7. Watching cash flow helps notify a business of cash shortages and shows when to borrow money to keep operations going.

Click here to read more about Cash Flow vs Net Income.

What is Cash Flow?

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What is Cash Flow?

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Transfer Pricing

See Also:
Service Department Costs
Responsibility Center
Profit Center
Cost Center
Cost Driver

Transfer Pricing

Transfer prices are the prices used for transactions within a company. A transfer price is an internal price. When one division of a company sells a product to another division of the same company, the price charged is called a transfer price. This is in contrast to external prices, or market prices, which are charged to customers outside the company.

In large multi-divisional corporations, where divisions are responsible for their own profits, divisions often transact with each other as if transacting with an outside customer. While internal transactions don’t affect the overall profit of the corporation, they do affect the profits of the relevant internal divisions. A high transfer price benefits the selling division to the detriment of the buying division. A low transfer price benefits the buying division to the detriment of the selling division.

The goal of the corporation is to establish transfer prices that provide incentives for divisional managers to act in the best interest of the corporation as a whole.

Transfer Price Calculation

A transfer price generally has two parts: the outlay costs and the opportunity cost. The cost of making or obtaining the product is known as the outlay cost. The opportunity cost is the profit the division could make by selling the product in the marketplace, as opposed to selling the product internally.

Transfer Price = Outlay Cost + Opportunity Cost

For example, consider a division that makes hats. The cost of making one hat is $2. That division can sell the hat in the marketplace for the market price of $5. Therefore, the opportunity cost of selling the hat internally instead of externally is $3. The transfer price would then be $5.

$5 = $2 + $3

In this simple example the transfer price is the same as the market price. In more complex examples this might not be the case. However, transfer prices are frequently based on or similar to market prices.

To learn how to price for profit, download our Pricing for Profit Inspection Guide.

transfer pricing

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Trade Finance

See Also:
Trade Credit
Trade Account
Exchange Traded Funds
Currency Exchange Rates
Currency Swap

Trade Finance Definition

Trade Finance is the movement of assets, transactions, or investments overseas into other markets. To ensure the safety of a purchaser or seller trade finance, banks often provide a needed service to make the transactions as meaningful and as safe as possible.

Trade Finance Meaning

Many transactions among a buyer and a seller result in a prepayment or purchase on credit. This, of course, depends on the terms of the sale. These activities are often more risky for a buyer (importer) or a seller (exporter) because of the international arena in which they operate.

Finance methods often include a bank in transactions to reduce the risk. For example, if a buyer purchases goods on credit, then the seller may want to reduce its overall risk in the receipt of payment by using a trade finance bank. The bank would take part in the transaction by putting up a contract. Whereas, the bank will pay the seller and leave the buyer to pay the bank for the transaction of the goods. If a prepayment occurs, banks can assist in the documentation of the goods to be shipped. This ensures that the buyer is actually purchasing the goods it has paid for.

trade finance

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Trade Credit

See Also:
5 Cs of Credit
Credit Sales
Standard Chart of Accounts
Income Statement
Free Cash Flow

Trade Credit Definition

The trade credit definition refers to postponing payment for goods or services received. Another trade credit definition is buying goods on credit, or extending credit to customers. It is also receiving goods now and paying for them later. And trade credit is delivering goods to a customer now and agreeing to receive payment for those goods at a later date. Trade credit terms often require payment within one month of the invoice date, but may also be for longer periods. Most of the commercial transactions between businesses involve trade credit. This type of credit facilitates business to business transactions and is a vital component of any commercial industry.

If a consumer receives goods now and agrees to pay for them later, then the consumer purchased the goods with trade credit. Likewise, if a supplier delivers goods now and agrees to receive payment later, then the sale was made with trade credit. There are two types of trade credit: trade receivables and trade payables. Trade credit payables and receivables can become complex. It is important to manage trade credit properly and accurately.


Download The 25 Ways to Improve Cash Flow


Accounting Trade Credit

For accounting trade credit, the value of goods bought on credit is recorded on the balance sheet in an account called accounts payable, representing money the company owes for goods it already received. These are trade payables.

While the value of goods sold on credit is recorded on the balance sheet in an account called accounts receivable, representing the money owed to a company for goods it already delivered to customers. These are trade receivables.

Trade credit is essentially a short-term indirect loan. When a supplier delivers goods to a buyer and agrees to accept payment later, the supplier is essentially financing the purchase for the buyer. Trade credit is an interest-free loan. As long as the buyer postpones payment, the buyer is saving the money that would have been spent on interest to finance the purchase with a loan. At the same time, the supplier is losing the interest it would have earned had it received the payment and invested the cash. Therefore, the buyer wants to postpone payment as long as possible and the supplier wants to collect payment as soon as possible. That is why suppliers often offer discount credit terms to buyers who pay sooner rather than later.

Trade Receivables Definition

Trade receivables represent the money owed but not yet paid to a company for goods or services already delivered or provided to the customer. The goods were delivered. Then the company recorded the sale. But the cash was not yet received. Record trade receivables as an asset on the balance sheet in an account called accounts receivable.

Trade Payables Definition

Trade payables represent the money a company owes but has not yet paid for goods or services that have already been delivered or provided from a supplier. The goods were received, the expense was recorded, but the cash was not yet paid. Trade payables are recorded as a liability on the balance sheet in an account called accounts payable.

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

trade credit, Accounting Trade Credit, trade credit definition
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Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

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Segmenting Customers for Profit

Segmenting Customers for Profit Process

Market segmentation is the process of dividing up the total market based on identifiable characteristics, which have common needs. You can also apply the concept of market segmentation to your customers. For example, you can segment your customers based on the cost to service, the size of the average sale or the number of transactions.

Though segmenting customers for profit or customer segmentation is a simple concept, it is not simple to implement in any meaningful way. The difficult part is identifying the various segments so that you can identify profitable customers versus those that can cost you time and money.

Customer Segmentation – Vertical or Horizontal

Customers may be segmented either horizontally or vertically.

Horizontal segmentation is where you divide customers by industry, geographic location or revenue size.

Vertical segmentation is where you might sell numerous services or products to just one particular type of customer.

For example, you might sell to customers in the construction industry numerous products, such as, steel, lumber and doors to that customer. Though segmenting customers based on market characteristics is useful, you might also segment your customers based on servicing characteristics (i.e.: size of order number of transactions or total sales volume).

Profitability Analysis By Customer

Once you have identified the various segments that apply to your customers you then perform a profitability analysis by customer. Take your annual sales by customer and break it out into various segments. Identify any patterns or relationships which might indicate opportunities for improvement. For example: a large number of small customers or concentration of large ones.

Customer Profitability Analysis

Next, perform a customer profitability analysis by subtracting your estimated relative cost to service from the revenue for the various segments. Estimating the cost to service may be done in general terms on a scale of one to five or in specific terms using activity-based costing. By relating your cost to service to your revenue streams, you can often identify “profit drains” that can be restructured. This restructuring might involve raising prices on select customers, implementing price discounts, sales incentives or firing customers.

If you want to learn how to price for profit, then download our Pricing for Profit Inspection Guide.

segmenting customers for profit

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Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

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segmenting customers for profit

 

Recommended reading: The Strategy and Tactics of Pricing, Fourth Edition, by Thomas T. Nagle and John E. Hogan

See Also:
Segment Margin
Activity Based Costing vs Traditional Costing
Implementing Activity Based Costing
Profitability Index Method
Net Profit Margin Analysis
Gross Profit Margin Ratio Analysis

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Nominal Interest Rate

See Also:
What is Compound Interest
Effective Rate of Interest Calculation
Interest Expense
When is Interest Rate Not as Important in Selecting a Loan?
Interest Rate Swaps

Nominal Interest Rate Definition

A nominal interest rate is the interest rate rate quoted on lending and borrowing transactions. Nominal rates represent the rate of exchange between current and future dollars. It is unadjusted for the effects of inflation. Since nominal rates are not adjusted for inflation, they do not convey the prices of lending and borrowing transactions as accurately as real interest rates. In comparison, real interest rates are adjusted for inflation.

Nominal Interest Rate, Real Interest Rate

Nominal interest rates are not adjusted for inflation. Adjust real interest rates for inflation. Make the adjustment with current or projected inflation rates. Furthermore, real interest rates offer a more accurate representation of the prices of lending and borrowing transactions. Use the following formula to calculate real interest rates:

Real Interest Rate = Nominal Interest Rate – Inflation Rate

For example, if a lender offers a loan with a nominal rate of 5% and the inflation rate is 3%, then the lender will earn real interest of 2%. If, however, the inflation rate is 7%, then the lender will essentially be losing value on the loan.

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Nominal Interest Rate

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LIBOR (London Interbank Offered Rate)

See Also:
Interest Rate Swaps
Prime Lending Rate
Libor versus Prime Rate
Federal Funds Rate

LIBOR Definition

The LIBOR definition is a benchmark interest rate derived from the rates at which banks are able to borrow funds from one another in the London inter-bank market, is the foundation of all lending rates. Furthermore, this term is a common reference rate for short-term lending transactions around the world. The British Bankers‘ Association publishes this rate daily at approximately 11:30am GMT.

LIBOR Explanation

LIBOR, explained below, is one of the most pivotal lending rates for the entire world. LIBOR rates are based on a filtered average of the market rates at which banks are willing to offer deposits to other banks for certain currencies, maturities, and fixing dates. In addition, LIBOR publishes rates for Australian Dollars, Euros, Japanese Yen, Sterling, US Dollars, and other currencies. Maturities can range from overnight to one year. LIBOR commonly quotes the rates for 1 month, 3 months, 6 months, and 1 year. The fixing date is the date on which the rate is relevant. While actual market rates fluctuate throughout the day, LIBOR remains fixed for 24 hours.

LIBOR as a Reference Rate

LIBOR is used as a reference interest rate for loans to borrowers with good credit as well as loans to borrowers with poor credit.

Example

For example, a borrower with good credit might secure a loan at LIBOR, the reference rate, plus a narrow quoted margin, or the percentage point spread above the reference rate. Meanwhile, a borrower with poor credit might secure a loan at LIBOR plus a wider quoted margin. LIBOR swap rates are also used as a reference rate for currencies, mortgages, interest rate swaps and other financial instruments.

LIBOR Quotes

Overnight LIBOR-Rate

1-month LIBOR-Rate

3-month LIBOR-Rate

6-month LIBOR-Rate

1-year LIBOR-Rate

LIBOR Calculation

LIBOR, calculated daily by the British Bankers’ Association (BBA), is based on a filtered average of inter-bank deposit offer quotes submitted from certain contributor banks.

The BBA selects a panel of at least 8 Contributor Banks for each relevant currency. For example, the Australian Dollar panel consists of 8 banks. The Canadian Dollar panel consists of 12 banks. And the Japanese Yen panel consists of 16 banks. The Contributor Panel selections are based on the banks’ credit standing, reputation, participation in the London inter-bank market, and other relevant factors. The compositions of the Contributor Bank Panels are reviewed annually.

Each day, between 11:00am GMT and 11:10am GMT, each Contributor Bank submits to the BBA the actual rate at which it could borrow funds just before 11:00am GMT on that day in the London inter-bank market for particular currencies, maturities, and fixing dates.

Then the submitted rates are ranked. Then they calculate the mean using only the two middle quartiles of the ranking. For example, if 16 rates are submitted, then calculate the mean using the middle 8 rates. Whereas if 12 rates are submitted, then use the middle 6 rates. And if 8 rates are submitted, then use the middle 4. The calculated mean becomes the London Inter-bank Offered Rate for that particular currency, maturity, and fixing date. The BBA then publishes this rate at approximately 11:30am GMT.

History of LIBOR

LIBOR was established between 1984 and 1985. It provides a standardized rate to facilitate the increasing usage of new financial instruments, such as interest rate swaps, foreign currency options, and forward rate agreements.

LIBOR Historical Rates and Current Rates

For LIBOR rates, see:

bba.org.uk

bankrate.com

bloomberg.com

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LIBOR Definition

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