It’s been said that “a goal without a plan is just a wish.” Needless to say, planning is vitally important and indispensable. Planning forces a consideration of the various factors, circumstances, and possible pitfalls that may determine the future course of a business. One risk that must be avoided at all costs is running out of cash and the best way to avoid that hazard is by looking ahead, i.e., cash planning, variously referred to as cash forecasting or cash projection. Consider your business’ future and how it will affect cash flow—receipts and expenditures of cash— and the cash balance.
Particularly for new businesses, “cash flow matters most… profit is secondary,” says famed management guru, Peter Drucker. Legendary investor, Warren Buffett, also focuses on cash, saying he assesses a company not by talking to security analysts, who look at profit, but credit analysts, because their focus is on cash flow.
In the long run, profit certainly matters. But for short term survival, cash rules the roost. And as has been said, the long term is simply a series of short terms strung together. In this brief, we’ll consider a number of operational factors that tend to have an effect on cash flow, as well as one tool that can prove useful in managing cash. But first, a quick word on the difference between cash flow and profit.
Cash Flow and Profit Are Not the Same
The purpose of business is profit, which really means that any business enterprise must add value. The market must place a higher value on the products and services the business provides than on the resources it employed to provide those products and services. The difference is the value the business adds by its operation.
But not all increases and decreases in value involve cash transactions which means that, generally, net profit and net cash will differ. For example, a manufacturing company certainly adds value when its products are sold. But if those products are sold on credit, it receives no cash at the time of sale. Later, when the customer pays, cash levels in the bank do increase, but, of course, there’s no change to revenue, since it’s already been recorded. Similarly, when a business is provided a product or service on credit, it incurs an expense, but there is no cash outlay, until the product or service is paid for. Again, depreciation, which reduces the value of assets, is a charge against profits (an expense) but involves no cash outlay.
In general, revenue, expenses and profit are measured using accounting rules, so that revenue (an accounting concept) is usually not the same as cash receipts, nor are expenses (an accounting concept) the same as cash expenditures. In the end, this means that a business’ bank balance bears very little or no relation to its net profit (earnings or income). Both are important and neglecting one because of a focus on the other may lead to trouble after a while.
Forecasting Cash Flow Is the Key to Successful Cash Management
The key to successful management of cash is forecasting future cash inflows and outflows, thereby mitigating unpleasant surprises. The objective is ensure that your enterprise is never caught in a cash crunch, which puts it at risk of cash flow insolvency, also known as commercial insolvency. Looking ahead allows you to shape the future to some extent by selecting a good time for discretionary expenditure. Forecasting also can identify cash deficits, giving you time to adjust or arrange short term financing.
The timing of cash receipts and payments can make a huge difference to your net cash position. Consider this example: ABC Ltd, which has average monthly receipts of $60,000 and payments of $40,000. This is an enterprise that should not have any cash flow problems, right? What happens, though, if debtors (companies that owe you money) take up to two months to pay you? Not so rosey a picture now, is it? This scenario is illustrated with a simplified cash flow forecast.
Assume that at the start of the year, the bank balance is zero, it will take half a year for the situation to be rectified and only if the company is able to obtain, at least, $80,000 in short term financing. Thus operational issues such as the timing of receipts from customers can have a serious impact on an enterprise’s cash flow and, consequently, its ability to stay in business. Receivables should be converted to cash in the shortest time possible through prompt billing and diligent follow up.
The same considerations apply to inventory. While it is important to have adequate amounts of inventory on hand, idle inventory represents resources that can be turned into cash.
One widely used tool for cash management is the cash flow forecast, not to be confused with the cash flow statement, with which it is similar in some respects. While a cash flow statement is one of the three financial statements—the other two being the income statement and balance sheet—that report past performance, the cash flow forecast or projection attempts to quantify future cash movements. The time interval—day, week, month—can be chosen to provide any level of detail. There might, for example, be one for a particular month that projects cash flows on a daily basis. (Figure 2). In addition, there may be another, for the six months ahead, that shows cash movements on a monthly basis, as in Figure 1.
The line items in a cash forecast can be named after the same account headings that appear in your cash book, such as cash sales, receipts from debtors, purchases, rent, office supplies, etc.
Cash Balance: Underestimate Rather than Overestimate
A few simple rules will make your forecast a reliable indicator of any possible cash calamity. While the numbers should reflect your best estimate, adopt a little pessimism as you introduce those for receipts, but include all payments likely to be made. A good cash forecast should always err on the side of caution, projecting a cash balance that comes in lower than actual cash balances as time unfolds. The daily cash forecast needs to be adjusted on a daily basis, replacing the estimated balance with the actual balance, so that the forecast is always grounded in reality.
No need to change the line items; simply adjust the opening balance of the cash forecast, using the cash book balance (not the balance at the bank). This adjustment is also necessary to reflect receipts and payments actually received. Check to make sure there are no duplicate entries. A receipt may have been received or a payment made, when an estimate for it appears at a later time on the cash projection. A variation on the calendar month cash forecast, which can prove especially helpful, is a rolling 30-day cash forecast. A rolling forecast adds future days as time passes, thus maintaining a forecast interval of 30 days.
Never Take Your Eyes Off Cash
Positive cash flow is essential to keeping your business operating and ensuring its survival. Thus, managing cash is a vital management responsibility. Good cash management requires a prudent approach but also accurate information on receipts and expenditure that is updated on a frequent basis. A cash forecast is an essential tool in cash management. We leave with some advice from serial entrepreneur, Sir Richard Branson, “Never take your eyes off the cash flow because it’s the lifeblood of business.”