Cash flow forecasting for better cash management

Money talks in business. No matter what the business goals are, cash management has an essential effect on how quickly (or slowly) you can reach them. Adequacy of cash defines whether the business activity continues, often totally regardless of the profitability of the activity. Yet many companies do not compile cash flow forecasts, at least not regularly. It is often thought of as a difficult task; although converting accrual profit forecasts into a receipts-based cash flow forecast does include several different variables, they can all be modeled as calculation rules.

Every company would like to know how future cash flow looks like, and when can the goals be expected to be achieved. In a tight situation, a cash flow forecast is a necessity, but how is it done?

Cash flow statement often describes the past

Cash flow statement is one of the official financial statements, and partly because of this it describes past events well. It also has specific function as a part of official financial statements and financial analysis. However, many CPM software solutions use cash flow statements calculated from profit and balance forecasts to describe future monthly cash flow. This surely can help in noticing general trends, but for actual liquidity management, a month is a too long period. For compiling short term cash flow forecasts, better options than cash flow statement outline exist.

Optimum cash balance

Defining optimum cash balance helps to assess the cash situation. Often, a cash balance corresponding to 1-2 months’ expenses is considered optimum. In a successful business, this amount of cash should always be available. The line and nature of business may influence optimum cash balance. Similarly, for example a due payment of exceptional size or large changes in financing costs may raise or lower it, at least temporarily. When cash flow forecast indicates that cash balance will be below optimum in the forecast period, it provides a first signal indicating there is happening something that requires further analysis. It is the time to plan possible actions to be taken to raise the cash balance back to the optimum level.

Cash in, Cash out

A clear way to describe cash flow is to start from cash and equivalents, which refers to the balance on the bank account. Similarly, the description ends with the closing bank balance, after cash in and cash out payments, indicating the adequacy of the cash balance. The bank account balance may also be the amount available of the account credit limit. The most difficult part by far is to estimate future payments.

A realistic cash flow forecast requires compiling profit and balance forecasts. These I have covered in the previous article Profit Forecast. Usually, the payment terms of both sale and purchase for the company have been defined so that certain data on receivables and payables can be obtained from ERP- and financial systems for approximately two weeks into the future. Invoices due for that period are usually already in the systems, if only the financial system is up to date. Therefore, the two-week forecast is compiled from the system, and the following weeks are derived from the profit and balance forecasts.

Week-level forecast is adequate

The cash flow forecast should be compiled as a 12 weeks’ rolling forecast. Month is usually too long period for liquidity control, and day is usually a bit too short. In companies, payments are done at least weekly, maybe even daily, but usually payments cannot be done only monthly, since both 7- and 14-day payment terms are common. If business is very steady around the year, two weeks’ information may be adequate, but nowadays such steady progress can perhaps be considered a luxury. In any case, holidays, seasons, changes in the resource requirements for a part of the business, availability of raw materials etc. all affect cash flow.

The cash flow forecast for first two weeks is obtained from the ERP- or financial systems, and the forecast for weeks 3-12 is derived from the profit and balance forecasts. The starting point is evaluating the turnover payments. The average payment terms given for different business areas of the company, terms for factoring payments, possible separate cash flows from projects with their advance payments and the sales receivables turnover define on which weeks, and how much for each week, cash is expected in from the forecasted turnover. The same principles are used to estimate the payment date of accounts payable; average payment terms, separate cash flow forecasts of projects and accounts payable turnover.  The payment schedules for salaries, all taxes and different financing items are separately estimated and included. This provides a 12 weeks’ rolling cash flow forecast that is as realistic as possible. It can be used to guide operations, whether the cash balance is too low or too high.

Effects of cash planning

Based on the cash flow forecast, actions required by the cash position can be planned. If the cash position is very good, it is a good idea to invest the extra cash reserve in a risk-free way. Based on the cash flow forecast it is easy to see the possible size and length of the investment. Investment plans of fixed assets can be included in the cash flow forecast, and ensure the effect of the cash flow required by these investments on the cash position. A basis for investment financing is obtained at the same time; if the cash position does not enable direct payment of investments, other financing can be applied for the required period.

Cash flow forecast is a necessity for startups. Fast growth requires more working capital and strict cash position monitoring. Before cash flow reaches adequate level, the growth is financed either by credit or equity capital. External financing and capital investments into the company have to be agreed on in advance; when the cash balance is already negative, the negotiations are always more difficult.

In the later years of operation, the company will face new growth spurts or in the worst case, longer continuous periods of low activity. These have to be prepared for in advance, and a week-level cash flow forecast is an important source of information for this.

Taking control of a tight cash position

In a critical situation, strict cash management can help overcome a crisis. When the cash balance is close to zero, an operating plan for surviving the required time is needed. At the same time, it must be known how long these actions must be used. According to my own experience, a 12 weeks’ rolling cash flow forecast gives good guidelines for the actions required. When combined with week-level payment plans for suppliers, service providers and taxes, it enables strict continuous control of the cash, receivables and liabilities positions. Agreeing on payment schedules without a realistic week-level cash forecast is difficult, because you must be able to adhere to the agreed schedule.

Actions to be taken in a tight cash situation may include:

• accelerating invoicing
• intensifying debt collection
• using factoring possibilities
• checking pricing and margins
• cutting extra costs
• realizing extra fixed assets and inventory
• payment arrangements for short-term debts
• grace periods for loans
• agreeing on long-enough payment schedules

The fiscal authorities must be contacted before the taxes are due. This helps in achieving a positive attitude towards payment schedules. Both in the case of fiscal authorities and suppliers, the suggested payment schedule must be such that it can be adhered to. If for some reason, it proves to be difficult to adhere to the payment schedule, again it is important to make contact before any payments are overdue.

Payment schedules

Prioritization is needed when organizing payment schedules. If the total amount of invoices due from suppliers and service providers is much higher than the ability to pay, priority must be given to those suppliers whose products/services first accelerate the company’s own invoicing, and thus the cash flow in. This helps to generate cash for paying also the invoices from other parties. This principle holds for almost all suppliers, with the exceptions of fiscal authorities and the pension administration organization charging for occupational pension. In these cases, matters must be handled by adhering to strict payment schedules, since the alternative is receiving an “unclear” marking in a contractor liability report (or equivalent) and so at least the ability to participate in all public tenders is lost. When payment schedules are in order, sales work and submitting offers can be handled in a normal way, ensuring future cash flow.

During a restructuring, week-level cash flow forecast is obligatory. One of the most important things for an administrator to know is how much cash is available just now (or at any given moment) and how much cash will be available during the following weeks. The job of the administrator is to oversee that the debtor company does not create more debt during the restructuring process. On the contrary, providing a court with a realistic restructuring proposal requires that the debtor company has an adequately positive operational result and cash flow. This can be proven by a realistic three-month profit forecast and a week level cash flow forecast for the same period.

Summary

The 12-week rolling cash flow forecast provides a lot of, if not all, information on the operational level of the company. It cannot be ignored, especially if challenges in business have already been met. Unfortunately, at the moment no CPM software solution exists with the 12 weeks’ cash flow forecast. Therefore, the easy available option for now is Excel, where more complicated material often results in a complicated chart set.

During the Spring of 2017, Revise Oy will publish a model of CPM software which includes week-level cash flow forecasts. Contact us, if you would like to have help in making cash flow forecasts or prior information on the future CPM model.