Part I: Linking Business Planning and Cash Flow Planning
Recently I was working with a client preparing projected Cash Flow statements for an IT business acquisition. He was concerned about a small negative net income number in the initial year of the pro forma income statement. He felt the bank that would be financing the deal might be concerned enough not to proceed with the funding. However what my client failed to remember is that Cash is King! Indeed, the first year of the projection showed a net cash surplus although net income was slightly negative. It was this exchange that made me realize that while he was rightly focused on profitability in thinking about his business plan for the newly acquired entity, he really had not paid equal attention to how his business planning linked to his cash flow plan.
Frequently, companies tend to overlook the linkage between business plans and cash flow. Not understanding how the business plan will generate or consume cash can produce a liquidity problem for a “profitable” company. For this reason it is essential to forecast cash flows as well as project likely profits.
Profit vs Cash Flow
The economic vitality of a business is seen mostly clearly through its ability to generate cash. Business profits – sales less costs – do not necessarily match the timing of their associated cash inflows and outflows. An obvious example of this cash timing difference is a customer paying for goods and services on credit. In this case, the costs of the sale (i.e., staff, order processing, raw materials) are borne in advance of the related payment being made by the customer. Additionally, cash must be invested replenish inventory, new equipment may have to be purchased etc.
Certainly in this example if the sales price exceeds the cost a profit was recorded. However the timing lag between cash expenditure and cash receipt results in net cash consumption – at least in the short term.
Deconstructing Cash Flow
Many business owners tend to just consider “financing” when thinking about sources of cash inflows. Other sources (or uses of cash) are operating activities (working capital, net income, depreciation and amortization; tax deferrals/payment) and investing activities such as capital expenditures and investments. So in short, cash can flow either in or out based on business decisions regarding payments to suppliers and staff, capital and interest repayments for loans, dividends, taxation and capital expenditure.
A business that generates cash has a positive net cash flow. Net cash flow is simply the difference between the inflows and outflows over time. A projected cumulative positive net cash flow over several periods highlights the capacity of a business to generate surplus cash and, conversely, a cumulative negative cash flow indicates the amount of additional cash required to sustain the business.
Cash Flow Planning/Forecasting
Cash flow planning determines whether the business generates or consumes cash over a given time period to determine. First cash identify inflows relating to sales, new loans, interest received etc. and then analyzing in detail the timing of expected payments relating to suppliers, wages, other expenses, capital expenditure, loan repayments, dividends, tax, interest payments etc. When this net cash flow is added to or subtracted from opening bank balances, any likely short-term bank funding requirements can be ascertained.
To create one, use your financial or income statement monthly forecast and a calendar year for financial reporting, and do the following:
• Outline the expected collections from your budgeted monthly invoicing. If your terms are net 30 and your clients typically pay in 45 days, use this fact as your basis for forecasts. For example, under that scenario, March’s invoices become May’s collections.
• For the first months of the year, add in when you expect to collect existing accounts receivable. If you have $20,000 in accounts receivable that were all invoiced in December of the prior year, then, based on the above assumption, the $20,000 should be added as projected cash inflow for the second month of your budget, which is February.
• Identify any other expected cash receipts. In your cash receipts forecast, include proceeds from bank loans or equity transactions, refunds, and customer deposits.
• Start looking at expenses and cash disbursements. Look at your expenses for the prior and current months and identify when they will be paid. Items such as payroll, rent, leases, travel, and entertainment are either recurring or paid out in the current budget month. Also, identify what fixed asset purchases and loan repayments you will make during the year.
• Review your accounts payable balance at the end of December for the prior year, and identify when these items will be paid. Add the amounts to your cash disbursements forecast.
• Do not include noncash expenses. Items such as monthly depreciation and amortization do not involve cash outlay but are included in your company’s financial statements.
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