Multiple Cash Flow Scenarios That Help Adjust for Uncertainty
Accountants need to be thoughtful, conservative and flexible in light of COVID-19’s economic impacts by providing accurate cash flow forecasts that not only tell a story of a business’s past, but prepares it for the future.
Always the “gold standard” by which credit and investment decisions are made, cash flow analyses now also provide the means to monitor the health of your client’s business and provide immediate input necessary for critical management decision-making.
A balanced picture of the future health of a business not only benefits clients, but ultimately all stakeholders.
Everything Has Changed
COVID-19 and the associated shelter-in-place orders around the country have impacted business leaders enormously. Owners are challenged by immediate term liquidity issues, medium-term operational concerns and long-term business model viability. During this time, buyers and sellers have been reluctant to accept the risk associated with small business acquisition. Lenders and investors are on the sideline, too. Everyone is waiting for the dust to settle to see how deeply the economic downturn may go.
Post-COVID market realities will mean sources of credit and liquidity will require more, and better, company information. While challenging to the individual business owner, this can be expected to yield a greater consistency in small business financing or harvest strategies. The crucible of the post-COVID marketplace will ramp up urgency; business owners need to understand and respond with increasingly accurate and effective strategies.
Nothing Has Changed
This decade, 10,000 baby boomers will turn 65 every single day, according to the Pew Research Center, and they face the reality of slowing down and considering retirement. This demographic phenomenon first appeared about eight years ago and it is expected to last until 2029. COVID-19 has not changed this.
This demographic owns millions of US businesses, and a surge in transitions means more financial activity and capital demands will be coming to the market just as the effects of COVID-19 and the associated shelter-in-place requirements are being felt.
We know the level of liquidity in the marketplace is at unprecedented levels. The pressure to create investment in business assets can be expected to increase. The issue for business owners is “how can I learn to be more effective at raising capital or selling my business?” The pressure for investors and lenders will be “how do I get the information I need to put money to work while effectively managing risk?”
You Have to Tell the Story
This market pressure requires a consistent and predictable response from business owners. Lenders, investors or buyers will all demand the same accurate accounting and financial information. Constituents of a business want to know what has happened and what will happen.
Accounting and finance management are the key to how the story gets told. Accountants should look back at a client’s performance with precision and accuracy and provide the data that allows the folks in corporate finance to look forward and to create projections with wisdom and insight.
It seems simple: Start with available cash, add or subtract the results of company operations, add or subtract changes in balance sheet accounts and solve for ending cash. When done properly, it is telling a story with numbers.
The 13-Week Cash Flow (Rolling 13)
There is something magic about 13 weeks, it is one-quarter. It is a period of time long enough for trends to become apparent, but short enough to spot inconsistencies and correct course.
A quarter represents a familiar and comfortable period of time to evaluate assumptions and performance. The 13-week cash flow is the basic building block for a full set of projections.
To get started with preparing a 13-week cash flow, this checklist can be helpful:
Cash Flow Planning Checklist for Business Owners
- Historical Financials (three years preferable)
- Detailed Operating Data
- Estimates of Future Performance
- Identified Alternate Scenarios
- Detailed Inflows and Outflows
- Employee Information (Increases and Decreases)
- Other Balance Sheet Information
The three basic tools that provide the basis for looking forward are:
- Balance Sheet – provides a snapshot of a firm’s financial position at a given point in time
- Income Statement – summarizes a firm’s revenues and expenses over a given period of time (moving picture)
- Statement of Cash Flows – reports the cash impact of a firm’s inflows and outflows over a given period of time
Preparing a cash flow forecast begins with looking back. Historical financial information can provide valuable scale for making projections, but more importantly it provides the relationships between numbers that are essential when making estimates.
For example, understanding historical profit margins is critical for estimating future profitability. Likewise, collection and payable rates permit estimates about future uses of cash.
A thorough analysis of financial data is necessary, and insight into past financial performance influences the forecasting process. Future estimates rely on accurate historical information.
Cash flow forecasting also requires some estimates of future performance – both company-specific and the broader economy. When coupled with a firm understanding of historical relationships from the company’s financial data, the estimates can take shape into a forecast iteration. This makes even more sense when informed by detailed operating data and expected changes in operation.
The initial 13-week cash flow also serves as the basis of an important technique in financial management called the sensitivity analysis. A sensitivity analysis is a method for modifying inputs or assumptions in a financial model based on different expected economic outcomes or levels of performance. When an initial forecast is based on good historical information, these modifications, when entered into a model, provide alternative views of the future and help users to draw more educated conclusions.
Sensitivity analyses are generally conducted in groups and might look like: “best case,” “likely case” and “worst case.” These three iterations, when viewed together, will provide perspective and insight for users of the forecast.
This is an extremely valuable technique to sharpen the accuracy and relevance of financial projections, and it is particularly vital in a time of economic volatility and stress. This point cannot be over-emphasized.
Developing a set of projections using alternative inputs and assumptions will provide a more accurate and reliable forecast for lenders or investors, and ultimately it will tell a more accurate story. This might suggest that in order for financial projections to be accurate and effective, they should be prepared by trained professionals.
An outside third-party is able to recognize and digest information, review relevant data and communicate accurate findings. Experienced functional specialists are trained to view trends and recognize patterns in data. They can also provide the type of professional scrutiny and analysis that developing financial projections requires.
However, as a practical matter, cash flow forecasts cannot be prepared by professionals in a bubble. Input from business owners or company management provides the foundation for the analysis. And only a stakeholder in the company can provide a meaningful estimate of future performance.
But, no business owner can be expected to know everything about cash flow forecasting, and it is very unlikely they will have the detached perspective that forecasting requires. That is why the development of a good forecast is usually a collaboration of third-party professionals and company stakeholders.
“Due Diligence” is the Standard
Due diligence is widely known as the investigation of a business before signing a contract, or “an act with a certain standard of care.” Financial professionals are used to thinking about due diligence in the context of sales agreements or contracts, but the spirit of due diligence can reach deeper to address actions or activities that require investigation or acquiring knowledge prior to offering assurance or accepting responsibility. It speaks to actions that imply a conscious commitment to truth and accuracy. Philosophically, cash flow forecasting is such an activity.
The principle of due diligence is the heart of the developing financial projections. Developing a cash flow forecast, like conducting due diligence, creates a valuable tool for multiple constituencies.
For your business owner clients, cash flow forecasting can be a big undertaking. It is a process that educates and informs stakeholders and provides a tool for communicating the expected status of the business.
It is a process best devised and begun years before a crisis, but it needs to be done as soon as possible. For lenders and investors, a cash flow forecast is kind of an insurance policy against catastrophic oversight and a tool to help match the capital availability they offer with the true capital needs of the company. The smart business owner is wise to recognize and embrace the power of due diligence and the power of cash flow forecasting.
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Edward Webb is the Corporate Financing Consulting Partner at BPM LLP and has over 30 years of experience in consulting and financial management, including specific experience in business restructuring and leadership advisory services.