Why is cash forecasting so important?
How many times have you heard someone say their business is doing fine because cash is growing? However, when you ask them whether the company is maximizing its potential cash flows, they cannot clearly articulate exactly the steps they are taking to ensure that it is. There are many factors that make a business successful, each of which have an impact on the cash flows generated. Understanding the expected impact of decisions made on the cash flows of the business can be the difference between success and failure. While this seems obvious it is an area that many business leaders may not fully understand potentially failing to ensure that their finance teams closely monitor.
A cash flow statement is not a business plan that attempts to predict future market changes, shifts in demand, changes in economic conditions, and factors that are outside the control of the company. Cash flow forecasting predicts the outcome of decisions made after the business plan is prepared. Companies who focus solely on income generation and not also on cash flow generation are not protecting themselves from the timing issues related to working capital and capital expenses required to generate that income or establishing the impact of unexpected deviations from the plan whether positive or negative.
Significant issues often arise when a cash forecast is not prepared simply due to the timing gap between collecting revenue from customers and paying suppliers. This timing gap can cause critical liquidity issues, especially for companies that are growing quickly.
When should you prepare a cash forecast?
The cash flow forecast is an outcome of the business plan and allows the company to determine liquidity requirements during the peaks and valleys of the business cycle. This forecast gives the company time to prepare investors, lenders, suppliers, and service providers about what to expect based on the cash cycle of the business. A simple example is matching the timing of cash receipts with cash disbursements. If you collect on a 30-day cycle, you can target to pay suppliers on a 30-day cycle.
Once the base financial forecast has been established, which traditionally means revenue and associated expenses, it is time to prepare a detailed cash forecast. The detailed cash forecast uses assumptions based primarily on prior experience to determine expected timing of cash receipts and cash outflows. While business plans can be updated annually, bi-annually, or quarterly much of what has been used in updating the assumptions in the business plan are already reflected in the future cash flows. Cash collections and disbursements have already been invoiced or committed to based, upon expectations baked into the existing plan.
To get the best business intelligence from a cash forecast it should be updated weekly and look forward a minimum of three quarters. This type of forecast has become known as the 13-week forecast and is critical to the management of the company.
What makes forecasting so difficult?
Forecasting of future cash flows brings a variety of challenges to almost all businesses. Challenges include:
- Gathering the information from various internal sources which can be fragment such as disparate accounting systems, geographic disbursement, and numerous bank accounts.
- Internal operating management teams who do not see cash flow management as part of their job description or do not understand the importance of cash flow management.
- Finance teams who lack experience in cash flow management or are not properly supported by the executive team as they try to instill financial discipline.
- Companies that are on the cash basis of accounting pose specific challenges to the forecasting process. Cash basis of accounting while good for preparing a tax return does not properly reflect the expected receipts and disbursements of the company. Critical information is not recorded on a timely basis making forecasting future expected receipts and related disbursements virtually impossible.
How is a 13-week cash forecast prepared?
Developing a good quality 13-week cash forecast is all about understanding the timing of receipts and disbursements. Steps include:
- Develop a Template
It is important to develop a template that reflects accurately the anticipated cash inflows and outflows of your business. This template should follow the basic structure of the business plan linking the key classifications of revenues and expenses which enables the company to tie the outcome to actual cash generated. As stated before, having great operating results does not automatically mean the company is generating positive cash. - Populate the Template
If possible, it is best practice to use historic data from the prior six to 12 months and populate the template on a weekly basis. This will help identify trends that can help model future periods. An example of this would be the average time taken to convert a sale into cash or how long on average it takes to pay suppliers. - Prepare the forecast
Break the forecast into two parts:
- Known Information
Revenue and expense outflows that have already been invoiced or committed to including accounts receivables and accounts payable which are reasonably certain inflows and outflows based upon information that can be obtained from a well-maintained and regularly updated accounting system. Examples of reasonably known expenses primarily include fixed expenses such as rent, insurance, loan payments, salaries, capital expenses etc. - Forecast information
This should be based on the latest update to the company business forecast and include revenue you expect to generate in the forecasted period and also any associated uncommitted variable expenses. These include items such as materials, wages, overheads, commissions etc.
What advantage can you expect from preparing a cash forecast
- Knowledge is Powerful
When you run scenarios around cash management you can make informed decisions to help manage the business. You can answer the questions regarding the impact of investment decisions, what happens when a company offers a discount to accelerate receivables, or the impact of taking early payment supplier discounts. While some decisions may seem intuitive, they may have long-term unanticipated negative consequences. - Identify Cash Flow Shortages
A reliable cash forecast gives advance warning of potential cash flow shortages and allows management time to mitigate the impact. Examples of actions that can be taken to postpone outflows are to stretch payables, postpone capital investments, reduce headcount, and adjust compensation structures. If the shortage is considered temporary early identification allows the company to work with its bank to increase short-term credit availability. - Manage Receivables
Identify when receivables are being stretched by customers and develop plans to accelerate collection. Cash collections often improve through targeted collection strategies. - Manage Outflows
Identify how much cash is available so that outflow targets can be set to ensure no unexpected liquidity events occur. - Communication with Lenders
Lenders and investors are more likely to assist in times of cash shortages when the company shows they have a good grasp of the reasons for any cash shortfall and can articulate the remediation actions being employed. - No Guarantee
A cash forecast is just that – a forecast. There is no guarantee that the outcome will be as expected. Running scenarios to identify worst-case events and establishing plans to remediate is prudent so remember to ask a variety of questions. What if there is a contract cancellation or delay in contract start-up? What happens if there is a short-term drop in demand? What happens if your supply chain is disrupted? What if there is a price increase on core materials that you cannot pass on to customers? How long will cash reserves last?
How do you know when you need help forecasting cash?
Many companies prepare annual business plans but once presented it is put on a shelf and only reviewed monthly or quarterly against actual performance. Reacting to the “bad” news at this point is too late and in most cases the company has used much of its cash reserves. If you answer “no” to any of the following questions, chances are you’re ready to get help from a professional advisor who can design a reliable cash forecast suitable for your business and train your team to prepare it accurately and consistently.
- Do you have a reliable cash forecast?
- Am I confident in the abilities of my finance/accounting department?
- Do you have a finance team that can answer all your questions when cash reserves are declining?
- Do I have cash reserves sufficient to withstand a crisis?
- Do I have cash reserves to fund anticipated growth?
- Am I confident that I don’t need help with the increasing complexity of my business?
- Is my company prepared if I decide to pursue a sale of the company?
- Do we have strong overall business processes?
- Am I ready to put the company in a better position for growth?
What can Windham Brannon do for you?
As with all processes, it is important that you take the time to understand what is wrong with your existing environment. This should be documented and shared with your advisor before you proceed to ensure you and your advisor are clear about the task. We have the experienced resources that can help you design and implement effective cash flow policies and processes, and then we can help train your staff to take the company forward. In addition, we will always be available to help should questions arise or improvements be requested.
Our team has significant hands-on experience in many industries which allows us to make the recommendations needed to help you and your business by providing the right guidance as your company matures. For more information, talk to your Windham Brannon advisor, or reach out to Laura Berry.
