Written by Sarah Martin & Ken Kaplan of Kaplan CFO Solutions, LLC
Sarah Martin is a Partner and Ken Kaplan is CEO/Managing Partner at Asheville’s Kaplan CFO Solutions, LLC.
Why reliable cash flow projections are important for any business…
One of the most important tasks of managing your business is making sure you have enough money to pay vendors and employees. Cash flow analysis and projections are the vital tasks that will help manage your cash outlays and cash inflows, making sure your business operations continue uninterrupted. Having a profitable business is great, but profit and cash are not the same.
A profitable business without cash could become insolvent. Depending on your business size and industry, weekly or even daily cash flow analysis is a must.
The best part of a cash flow projection may be the scariest part. Why? Because it gives an early warning sign and enables the business to make critical changes to ward off the impending shortfall. While working with a solar development company recently, the weekly cash flow report we used was far more important than the monthly financial statements that we generated, because the cash flow report told us what was going to happen. Compare that to the monthly financial statement, which was a summary of what had already happened.
The cash flow report enabled us to figure out what vendors we should call in advance to advise when they would get paid. It showed us how far along we needed to be in construction so that we could properly draw on our construction line to cover overhead costs. And sometimes, it showed us that we had to wait several months to start a new project in order to get cash flow aligned properly.
So these early warning signs are critical, especially in the early years of a new business, because the entrepreneur must develop credibility. He or she must earn the trust of customers, suppliers, employees, and bankers.
In another instance one distribution client we had was very adept at the cash flow report. She used it to set a goal for her receivables collection team and her sales team, as well as to better time inventory purchases. This particular business imports product from overseas, and payments to suppliers cannot be delayed, so those inventory purchases had to be very precise.
What do we do if we have a situation where a payment is coming due, but do not have sufficient cash? We will need to borrow funds against a credit line to pay those bills; however, this shortfall can only be determined by having a reliable cash flow analysis and projections. Knowing the gap in advance allows us to make an arrangement with our bank or creditor before the payments are due. Conversely, asking for a loan or line of credit too late will be evidence of bad cash management and will likely result in rejection. Of course, there are other options besides drawing on a credit line to be able to afford that next big payment.
The cash flow projection is a tool we use to help business owners de-stress and be proactive.
How do we prepare a cash flow projection? We start by creating a spreadsheet that projects cash over a thirteen-week period; thus, thirteen columns. We analyze the accounts receivable to learn how much of a typical month’s sales is paid in the month of sale, the first month after sale, the second month after sale, etc. For example, I can look at a certain medical supply company and calculate that on average, 15 percent of sales are collected in the month of sale, 45 percent are collected in the first month after sale, 20 percent are collected in the second month after sale, and the balance (minus a write off percentage) is collected in the third month after sale. These percentages vary significantly from business to business.
The next step is to project inventory needs. Inventory needs are a function of sales forecast and inventory turn. Typically, in a thirteen week forecast, we already know the amount of purchase orders outstanding and when we expect that product to arrive. So the cash outlay is a function of the dollar amount of inventory that we will receive and the payment terms we have with our vendors.
Next, we need to list our operating expenses such as sales and marketing, payroll, rent, and other predictable operating expenses. Yes, we also include a line for miscellaneous expenses that are difficult to forecast.
Finally, we have to include lease payments and debt service. These are the easiest to project because they are constant from month to month.
Now it is time to sum every column and include the overage or shortage from the previous week. When a given week’s cash balance is negative, it’s time to take a deep breath and smile, because we now know about a problem in advance and can figure out how to resolve it. Maybe we delay the delivery of a purchase order from a vendor. Maybe we look at a large customer order and talk to the customer about placing a deposit. Maybe we ask our banker (four weeks in advance) to increase the credit line and now we can show him when we think we can pay off the balance completely.
Our distribution client discussed above got so good at this, that she turned the thirteen-week cash forecast into a 52 week forecast! You can imagine that it made her feel much more comfortable about finally taking money out of the business for some important personal reason.
Perhaps the best thing about preparing this is, once we do it the first time, we simply add a week every time the current week ends. So it becomes a rolling forecast.
What are the difficulties in this approach? Clearly, the ability to forecast sales and collections. Using a spreadsheet, we can insert a variety of different projections and see the effect that good or bad sales would have on the ending cash balance. While it might sound counterintuitive, sales above your projection can have a short term negative effect on cash flow. This happens if the time it takes to collect on those sales is very long or—even worse—very unpredictable. We call this a “good problem” to have because banks and vendors are usually more supportive when our sales exceed our projections.
The cash flow projection is a tool we use to help business owners de-stress and be proactive. It is easier to understand than standard financial statements because it only considers Cash-In and Cash-Out. Still, standard financial statements are also important because they can tell us, in quantifiable terms, about what happened last month, last quarter, or last year.
If you want to run your business like a “tight ship,” the cash flow projection is certainly an arrow to have in your quiver.
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