Insights

Why is cash flow forecasting as important as your budget?


Sebastian Hyde

Director

Sebastian Hyde is a client director at Vantage Performance. He’s been a key player in many turnaround and restructuring engagements, assisting businesses to deal with the critical challenges they’re facing and get back on track.

Unlike revenue changes, the impact of cash flow movements is felt by your business almost immediately. Revenue goes up and down on a monthly basis but may not have any tangible impact on your business for weeks or months. Cash flow moves on a daily basis and it’s impacted by a broad array of variables within the business; supplier and customer contracts, tax legislation, employment agreements, and debt facilities, to name a few.

Given the high volatility of cash flow, businesses really need to be reviewing their cash flow forecasts on at least a weekly basis to ensure they don’t get caught short and become unable to meet their obligations on time.

How far should a cash flow forecast look ahead?

To be functional, a cash flow forecast needs to be at least as long as one cash cycle in your business. For a typical business, a cash cycle is roughly 13 weeks and this is why the standard cash flow is 13-weeks long. A cash cycle is the time period between when a business pays cash to its suppliers for inventory and receives cash from its customers.

An example for a manufacturing business would be as follows; buy raw materials in week one, receive raw materials in week three, convert raw materials to finished product in week five, store finished product in inventory until week eight, invoice customer and ship product in week eight, customer pays invoice five weeks later in week 13

Even in an uncertain world, most businesses have good visibility over the next 13 weeks of cash because the cash relates to sales that have already occurred.

Who should be responsible for cash flow forecasting?

The responsibility for cash flow forecasting should ideally sit in the finance team; usually with the leader of the finance team.

Depending on the size of the business that could be the CFO, a financial controller or finance manager. In a small business, the sole accountant or even the owner of the business will be doing everything and will also manage cash flow.

The reason that I believe that the finance team should manage cash flow forecasting is purely because a large part of managing cash flow is bringing together financial information from different parts of the business. The hub for financial information is always in the finance team, so that team is best placed to get the required information and keep it up to date.

What are some key warning signs of failing cash flow?

Key warning signs businesses should watch out for when cash flow forecasting are:

  1. Long customer payment terms: If your customers are asking for anything beyond 45-day payment terms that should be a big red flag.
  2. Late payments: If a customer hasn’t paid you for 60 plus days, that is a key warning sign that you are likely to experience cash flow issues. 
  3. Missing revenue or expense budgets: if your revenue is below budget or expenses are above for one or two months in a row there is a high probability cash flow will deteriorate in the next 13 weeks.

What are the dangers of incorrectly forecasting cash flow?

Transformation Office - business turnaround 1

The most obvious danger is running out of cash and not being able to make important payments for the business.

Running out of cash at a critical time can break businesses and at the very least, result in missing growth opportunities. For example: if you’re unable to renew your insurance on time, it could jeopardize your ability to win a new contract.

However, the dangers aren’t all a result of running out of cash. There is also the possibility of holding excess cash for working capital which could be returned to shareholders, used to pay down debt or invested in growth opportunities. By holding too much cash for working capital your business could be missing out on growth or paying unnecessary interest.

Is cash flow the reason rug stores are perpetually closing down?

Although cash is generally not the root cause of business liquidation, good cash flow forecasting can help business owners to navigate downturns and avoid liquidation.

Managing your cash flow tightly can help you get through a tough time and be ready to take advantage of new opportunities when conditions improve.

For example; if your business loses a major contract unexpectedly a good cash flow forecast will immediately give you an estimate of the amount of time you have to reduce your cost base to match your new lower revenue before you experience a cash shortfall.

Often businesses lose a big contract or customer, which on its own doesn’t create a cash flow issue. What creates the cash flow issue is the lag between that decline in revenue and a business downsizing.

Businesses are great at adding new costs as they grow, employing new people. It’s very simple to identify gaps in an organization as you grow, people within your organization literally point them out to you.

On the flip side, as your business shrinks you don’t have people pointing out: “I’ve got capacity, maybe you should make me redundant.” A good cash flow forecast helps a business to proactively identify when cost reductions are required.

What is the key to successful cash flow management?

The number one habit for good cash flow management is to be constantly reviewing, updating and challenging your assumptions.

Business conditions change daily and if you’re not reviewing your assumptions on a weekly basis, then the cash flow is going to become inaccurate within a week or two.

You also need to understand the net working capital position and profitability of your business. Understanding net working capital is critical to cash flow forecasting.

Your businesses’ net working capital impacts the cash required as the business grows and shrinks. In some businesses, as they grow, cash increases. In others, as they grow, cash decreases.

If you’re forecasting to grow a lot in the next year, your finance leader needs to forecast whether that’s going to mean you’ll need extra cash or whether you’re going to have a lot of surplus cash around.

What core reasons underlie a business’ cash flow issues?

Three core reasons for cash flow issues are; profitability, negative networking capital and high leverage.

Profitability is the most straightforward of the three issues. Simplistically, if you spend more than you earn then eventually, you will run out of cash.

Negative working capital and high leverage are less understood causes of cash flow issues and can both occur even though a business is profitable.

As mentioned previously, the negative net working capital issue refers to a contraction of cash caused by growth as a result of having short supplier payment terms and long customer payment terms.

Leverage refers to the proportion of debt vs. equity used to fund your business. High leverage becomes a cash flow issue when your business is not able to produce enough cash to cover the interest and debt repayments. Basically, if your business has too much debt all of the surplus cash may be used to pay the interest and debt repayments leaving no cash as a buffer against unexpected events.

How do you solve cash flow issues?

If it’s purely a leverage issue, then you can come up with solutions to restructure your debt which will reduce the cash flow burden. For example extend the term of the loan or sell assets and pay down debt to reduce the monthly repayments or refinance to a lower interest rate to reduce your monthly interest cost.

If it’s profitability you need to do a deep dive into your revenue and costs, consider price increases, productivity improvements, direct cost management and overhead reductions.

If it’s a net working capital issue, then debtor finance could offer a quick solution by bringing forward customer collections to match supplier payments and wages. Alternatively, you can negotiate with your customers to reduce their payment terms (ie. from 60 days to 30 days) and/or with your suppliers to increase theirs.

What systems work best for cash flow management?

Unfortunately, most basic accounting packages don’t include detailed cash flow management functionality. 

There is one cloud-based cash flow management tool which I’ve come across called Float. As far as I know, the software integrates with Xero, QuickBooks, and some other accounting packages. 

For small to medium-sized organizations (ten to a couple of hundred employees) a well-built cash flow model in Excel is the industry standard.

Building cash flow forecasts is a key part of what we do at Vantage. It’s not a common skill, and a good cash flow model is something that we find that the majority of clients don’t have in place.

 

*This article is general in nature and is not to be taken as financial or governance advice. You should consider seeking independent legal, financial, taxation or other advice to check how the information relates to your unique circumstances. Vantage Performance is not liable for any loss caused, whether due to negligence or otherwise arising from the use of, or reliance on, the information provided directly or indirectly.

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