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If you are concerned about your business cash flow, then you should be using a cash flow forecast.*** Indeed, I urge you to use a daily cash flow forecast to run your business, to set out the basic principles and prerequisites for implementing and using a forecast and then address specific issues that constrain your ability to make a useful forecast.

Your Intuition is Right 80% of the Time

You intuitively know that you need cash to run your business. Plainly, there are specific situations when debt and equity financing of your business makes absolute, wonderful sense. We’ll get to those below.

Nevertheless, the modern financial system has invented many, sexy ways to go broke by paying your bills with other people’s money. Add in your lost time and money spent pitching for seed capital, angel capital, expansion capital, mezzanine capital, venture capital, get-out-of-debt free capital, etc., and you can very easily and quickly find yourself operating on negative cash flow.

Yep. At three o’clock in the morning, when all the finery is stripped away, you need cash to run your business. If you already have debt or equity partners, they undoubtedly remind you about this every day — every single day.

In the game of chess, the player that imagines the possibilities furthest into the future tends to win. In sports, the team that anticipates – forecasts – the opponent’s actions most effectively tends to win. In daily traffic, taking in the entire flow of traffic around us tends to help us get through the traffic faster, avoiding both fender-benders and fatalities.

Likewise, in business, forecasting the most likely scenarios and the most devastating scenarios tends to help us avoid nasty events like bankruptcy. Cash flow forecasting is one of the simplest, most useful tools you can use to improve your business. All else equal, businesses that forecast do better than those that don’t.

Model Your Cash Conversion Cycle by Date

To illustrate, consider the cash conversion cycle. Let’s begin with a company at the Start of Operations. Cash comes into your business through founder capital. You, as the business owner, may have had to take a personal loan or line of credit to get these funds. Nevertheless, with regards to the business, the funds go on the books as Start-up Capital. (You may decide to loan the business these funds, but that is another matter.) At any rate, With these funds, you buy assets and pay expenses. You sell goods and services to customers and customers, ultimately, pay their bills. The time it takes for cash to go through the business operation cycle and be converted back to cash again is known as the cash conversion cycle.

A Statement of Cash Flows shows how cash has moved through this cycle through units of time. The basis unit ranges from an hour to a year, with days, weeks, months and quarters in between. A cash flow forecast then shows how cash may move through this cycle in the future based on the assumptions you’ve used to derive the forecast.

A Statement of Cash Flows and the cash flow forecast are usually part of a larger financial model. The financial model includes the three key financial statements: balance sheet, income statement and cash flow statement. These statements should show the current results reported on each statement as well as multiple, historical points in time to show trends in your business. Though public companies report their numbers on a quarterly basis, the most common unit of time in use for financial statements, including a Statement of Cash Flows, is a month. Some companies use weekly units for their internal use because the week more naturally fits the life of the business.

A financial model helps you see clearly when these actual, historical events have occurred and when forecast events are likely to occur in the future. By when, I mean the date. If you know the date of each actual and forecast transactional event, you can sum these events by week, month, quarter, and year. Thus, you can change your level of analysis across these levels seamlessly, without having to do major reconstruction to your financial model.

Since actual historical transactions happen on a date, that date is part of the transactional record. So, switching between days, weeks, months, quarters and years is typically not an issue. Many forecast models fail because the forecast events don’t have a date as part of their record. Instead, in an apparent effort to save time and avoid complexity, the forecast is based on some abstracted level of analysis, such as monthly or weekly. When this is the case, it is very cumbersome and expensive to switch to a more granular level of analysis, such as daily.

If you have a weekly or bi-weekly payroll and you have a variety of monthly vendor payments, you begin to sense the difficulties involved with building a forecast that can easily flip between both units of analysis. For example, if your model has your payroll expense on a particular date, then it doesn’t matter whether, say, payroll Friday is the 27th of June or July 2nd, the expense hits the same week and it would it hit the right month. (Remember, I’m referring here to the cash forecast: the cash leaves your payroll checking account that day. Whether you choose to accrue payroll expense or not is a different, albeit important, matter with respect to the Income Statement not the Statement of Cash Flows.) Likewise, your monthly expenses are typically due around the same day of the month such as the 20th or the third Friday, or something like that. It’s difficult trying to figure out in which weeks to forecast these monthly expenses. Those difficulties disappear when you forecast the dates going forward based on their inherent logic – e.g., the 20th of each month, the third Friday, etc.

Do the Math

These statements must reconcile, tie-out, foot, add-up, and otherwise honor the logic of how changes on one statement flow from and to the other financial statements.

For instance, when a sale is invoiced, income goes up on the income statement and your accounts receivable asset goes up on the balance sheet. In our example, no cash has yet changed hands so there is no effect on the cash statement. When the customer does pay the bill a day, a week, a month, or 90 days later, the receivables asset goes down on the balance sheet and the cash account goes down. There is no net increase in assets, the asset of the receivable has simply been converted to cash. There is no effect on the income statement since the sale has already been booked.

There is, however, an effect on the cash statement.

You’ve got Cash!

And, of course, cash is king. You typically can’t pay bills, wages or dividends using your accounts receivable account. You need to issue funds electronically, via wire or old-fashioned check using funds from your checking account or pay from actual petty cash.

Yes, just like with households, businesses can pay bills through a simple line of credit or bank card. Further, sometimes the loan basis for these lines of credit are calculations using receivables valuations and / or inventory valuations. We’ll come back to these issues at another time.

For now though, the important idea is that the numbers on the statements must honor, again, the logic of how changes on one statement flow from and to the other statements.

“Past performance does not guarantee future results”

True indeed.

Nevertheless, it’s at this point that most business owners check their email, Facebook, Amazon, Linkedin, CNN, or do whatever they call it when they chose do nothing effective when it comes to financial forecasting. That’s okay. Actually, that’s good for you because at least one of those business owners is your competitor. By forecasting, you make a choice to take up a critical, competitive advantage.

So, congratulations on choosing to forecast. I’ll leave you with what I see as the five most critical issues your model should address. Get these five things right and you’re a long way ahead of your competitors (and their FaceBook pals):

  1. Seamless integration between actual and forecast as the future rolls into the past.
    1. Forecast derived from three layers of data:
    2. Actual assets and liabilities –
    3. Current sales, purchase, and related orders –
  2. Pure forecast orders –
  3. The date (day) as the base unit of time.
  4. Up-to-the-date data – which requires computing systems, organizational processes, staff buy-in all focused on eliminating paper backlog.
  5. Dashboard controls to run various what-if scenarios.

One last point about Dashboard controls. Often, the thinking you do about which controls you need leads you to make explicit the core assumptions you have about your business. In doing so, you can test the validity of these assumptions, building performance metrics to track these, and management plans to improve these assumptions.

Good luck with your forecasting efforts. Let me know what works and doesn’t work for you. If you have any questions or would like some help – please contact me.

***To avoid cash flow worries in your business, you should be in the right business – a Star business. What’s a Star business? Read Richard Koch’s The Star Principle. That’s Koch as in kosh as in “By gosh, Koch’s ideas are a delightful nosh!” Or, contact me about Star Restructuring your existing business.