The importance of developing and maintaining an up-to-date cash flow model should not be underestimated. It should be an essential tool in every financial executive’s toolbox to help the business manage its cash flow and liquidity. It is especially valuable when a business faces various financial challenges and may also be required by financial institutions to support a company’s liquidity position, loan extensions, facility increase requests, and covenant waiver requests.

Cash flow modeling can forecast future cash flows by using a combination of historical information, estimates of future results, and educated assumptions about cash inflows and outflows. A good cash flow model will allow the user to look at various scenarios by changing assumptions and data inputs to provide “what if” scenarios. This can allow your business to prepare for potential changes in revenue streams, material costs, payroll, and other items.

Cash flow forecasts should be updated regularly, as frequently as weekly but no less than monthly. Forecast time periods can extend out as short as 18 months but are more commonly three to five years.

Cash Inflows

Key items impacting cash inflows include operational revenues, investment income, and rental income.

To forecast operational revenue, management needs to have a thorough understanding of monthly collection trends (i.e., number of days to collect receivables), an estimate of revenue growth based on anticipated new customers, volume increases from existing customers, and expected price increases.

Investment income can include dividends and interest, and capital gains. Dividends and interest cash inflow streams can be somewhat predictable, but capital gains and losses are often excluded due to their more unpredictable nature.

Rental income streams are usually much easier to predict since they are supported by lease agreements, presuming there is limited turnover.

Cash Outflows

Key items affecting cash outflows include raw materials and supplies, payroll and related costs, general and administrative expenses, debt service payments, and others.

Raw material and supply costs have a significant impact on a manufacturer’s business, for example, and have been especially impacted by supply chain issues and high inflation over the past few years. For manufacturers, it is critical to understand inventory turnover and the ability to incorporate price increases incurred on critical materials and supplies. Moreover, management should analyze the business’ ability to pass increases on to customers and maintain gross margins.

Payroll and related costs are predictable for the most part, but your cash flow model needs to incorporate any anticipated increases or decreases in headcount, bonuses, raises, etc.

General and administrative costs can be analyzed and estimated. Similar to understanding your customer collections, you need to know the number of days accounts payable are outstanding and the impact of paying early discounts when available.

Debt service payments include financing with banks and other lenders, as well as capital and operating leases. Cash flow model forecasts may be utilized to support borrowing needs and increases to credit facilities to support your company’s growth.

Cash flow forecast models can be complex and do take time and understanding to develop. The cash flow model is a working document that can be continuously improved and updated. It is a tool that assists management in its decision-making process by understanding short- and long-term liquidity needs, its impact on operations, and the business’ potential borrowing requirements.

If you would like to discuss how developing a cash flow model can benefit your business, please contact Rich Snyder at Email.

Richard Snyder, CPA

Richard Snyder is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email or 215.441.4600.    

 

 

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