In times of uncertainty, the capability of an organization to navigate through significant instability can be the catalyst for long-term financial health. A cash-flow forecast model serves as an early warning sign to a company’s future business health by putting a forensic lens on cash balances under a variety of future circumstances.

Having a model that is dynamic, easily updated for changing conditions, and able to support iterative scenario analysis isn’t a luxury; it’s a necessity — as vital as a fire extinguisher in a furnace room. Moreover, a cash-flow forecast model should be simple enough to be operated and communicated across an organization’s entire leadership team.

Why Needed?

Cash flow is the lifeblood of any business. If a company runs out of cash and cannot secure additional financing, it becomes insolvent. So, the need to view accurate forecasted cash positions always is critical. This is particularly important in times of market disruption, where unprecedented events, such as a global health pandemic, changing supplier/customer landscapes, or employment volatility, can lead to business failure if not properly planned. In particular, cash-flow forecasting can provide the following insights:

  • How long can the business continue to meet payroll obligations?
  • Are there any potential problems with customer payments? Has debt payment slowed?
  • Can the business afford to pay suppliers? Receipts tend to lag revenues and suppliers may require immediate payment during difficult economic conditions.
  • Are there adjustments that need to be made (i.e., cutting expenses)?

Additionally, external stakeholders, including  lenders, will require a cash flow forecast to gain visibility to potential risks.

Determine An Approach

Depending on the depth of the information needed, a cash-flow forecast can be viewed monthly, weekly, or even daily. Daily cash forecasts can be important for some businesses, particularly when a cash shortage is probable. There are two optimal ways to forecast cash flow:

  • Direct method — Schedules cash receipts less disbursements (payroll, purchases, etc.). Best suited for the short term where actual data is known.
  • Indirect method – Starts with net income and adds or subtracts changes in the balance sheet accounts (e.g., accounts receivable or accounts payable). This is best for a medium to long-term view.

Long-term forecasting allows for future strategic planning but is susceptible to greater variability in outer time periods. Short-term forecasting provides greater granularity and accuracy of upcoming cash positions. Struggling businesses should utilize short-term forecasting to ensure survival through a potential cash-flow crisis. Ideally, all organizations should engage in both short- and long-term forecasting.

Build a Robust Forecast

An organization’s cash-flow forecast should be straightforward and uncomplicated for use across the leadership team, providing key insights quickly. There are many software tools that specialize in cash-flow modeling, but Excel can be used effectively as well. The process for determining a business’s projected cash flow should include the following steps:

  1. Review history. Gather historical accounting data. This data needs to detail income and expenses from the organization’s accounting books or software. Review the data to get a benchmark indication of expected future cash flows by line item. This will provide insights such as sales trends (and associated lag time until cash is received) as well as timing and amount of expected recurring expenses. It will also be useful to review bank account activity to understand the timing of historical receipts and disbursements.
  2. Document cash on hand. At the beginning of each period, start with your opening cash balance. This will be equal to the ending balance of the prior period.
  3. Project receipts for upcoming periods. Predict how much cash will come into the business for the upcoming periods, including potential risks to future inflows. Don’t confuse cash flow with revenue. This step is a measure of what will be collected in payment for goods or services. Be sure to include other inflows outside of operating activities, such as interest income, sale of assets, debt management, and others.
  4. Estimate cash outflows. Estimate all payments expected to be made by period. This includes supplier payments, rent, utilities, payroll, and other bills, as well as any upcoming changes or new cash outflows. It would be wise to separate disbursements into different buckets for management visibility:
  5. Operational. Payments related to the organization’s goods or services. Includes raw materials, freight/distribution and royalty payments (if any).
  6. Non-Operational. Rent, utilities, marketing or advertising, capex payments, repairs & maintenance, and other overhead.
  7. People. Expected payroll obligations including benefits and taxes.
  8. Financing/Other. Interest payments, fees, and legal/financial payments.
  9. Calculate Net Cash. Add opening balance to projected receipts less cash outflows to estimate ending net cash for each period. This amount will be next month’s opening cash balance.

Create Multiple Iterations

A cash-flow forecast should be modeled with multiple “what-if” scenarios for planning. This allows an organization to see various results of their forecasted cash position based on potential unknowns. Creating a variety of models will allow a business to see its cash flow position under a range of different future circumstances. This allows an organization to quickly adapt processes and build contingency planning protocols as needed. Scenario planning should be simple enough to produce a quick view, particularly when timing of decisions is critical. With multiple, dynamic scenarios, management teams can monitor company results and adjust plans.

Publish Key Insights

Because an effective cash flow forecast will cascade throughout an organization, operability and understanding of the model by non-finance professionals is key. Insights within the model need to be understood by all key leaders, and an effective forecast often requires input from a variety of non-finance individuals throughout the company. An intuitive cash flow forecast will help drive ownership, as well as accuracy, through incorporation of operational knowledge.

Cash forecasting provides a clearer picture of where the company is headed as well as visibility into where improvements or adjustments need to be made. Many organizations don’t have the financial strength to survive short-term crisis or business disruptions. Having a cash-flow forecasting model on hand is vital for evaluating a company’s liquidity over a specific timeframe. An organization’s understanding of its cash position in the short and long term can help it make better decisions and avoid facing the unfortunate position of insolvency in the event of unforeseen circumstances.

David Lewis is CEO of 8020 Consulting, an accounting and finance project consulting firm providing solutions for clients ranging from Fortune 50 companies to middle-market and venture-backed firms.

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