The Cash Flow Forecast

Planning for Profit and Sustainability:

Most businesses operate on a budget; a road map that sets financial objectives and waypoints for a fiscal period, like a year.

The document we call a budget is actually a summary of many sub-budgets, forecasts and tactical plans.  To derive a budget line like “Sales” a whole year’s marketing and sales plan might be developed, leading to the sales targets for each month in the year.  The sales estimates will demand a level of goods or services to be available, appearing as purchases or cost of sales, to support the sales estimates.  The overall strategy will require a certain level of manpower giving rise to wage and salary costs appearing on the budget as operating expenses.

No business can avoid unpredictable challenges. Smart businesses plan in great detail, leaving as little as possible to chance.

The objective is to develop a business plan for the year which will produce a profit.  In developing the estimates of income and expense, we use experience of past years as a guide, along with new strategies or products.  In the case of a new business, we obtain expense estimates from service providers or research operating costs of similar businesses. 

Estimating income for a new business is always a challenge because there is no history.  There are many approaches to estimating revenue for a new business.  Suffice it to say that income estimates for new business should be on the conservative side.  For an existing business, we rely more on history.  A mature business might only realize an inflationary increase in income, year over year.  A younger business often grows at a faster rate in its early years at rates of 10% or more.  Income is difficult to predict yet, it must be sufficient to cover expenses.

Once we’re happy with our budget estimates, we’ll plot the income and expense for each month, through the year.  Some months might see a surplus of revenue over expense.  Other months will result in a deficit.  At the end of the year, the positive months should outweigh the negative months resulting in a profit.

The completed budget might look like this:

Operating Budget.png

Note that we have estimated cash sales and sales “on terms”.  The latter are sales to customers who have arranged credit terms, typically 30 days, with a discount for payment within 10 days.  This collectible customer debt is called “Accounts Receivable”.  Receivables represent an expectation of cash receipts in the near future. Depending on how expertly receivables are managed, this asset can become a pool of unavailable cash, urgently needed to meet expenses and obligations.  With the widespread acceptance of credit cards, may businesses have moved away from Accounts Receivable, preferring the certainty of cash.

Forecasting Cash Requirements

Having completed the budget, we’re only half done.  Even though the budget balances and we are projecting a profit, we need to make sure that we have cash available, when we need it, to meet our obligations.  The budget alone does not address cash flow requirements.

Cash is the lifeblood of any business or organization.

Cash is generated by sales, disposal of assets, loans and customer payments

Cash is depleted by operating expenses, acquisition of assets or inventory, paying down loans and supplier payments

What's the Difference?

The difference between a budget and a cash flow forecast, even through both are plotted monthly, through the year, is that the generation and the spending of cash often does not match the periods in which we recognize revenue and expense.

In a profit and loss statement, not all items represent cash flow.  For example, if you sell to customers on credit, the sale might be reflected in December but you may not receive the cash from the sale until January, February or later, when the cash proceeds of the sale will be available to pay for operating expenses or reduce debt.

A Profit and Loss Statement recognizes income and expense in a specific accounting period.

A Cash Flow Forecast captures cash received and paid out in a specific period.

Because the availability of cash is critical to the health of a business, a budget may look workable on paper but, if the business is not generating a healthy stream of cash, the business will die.

If you have created an annual budget, you plan your anticipated sales and expenses, typically for each month.  A cash flow forecast is developed for the same periods and generally follows the same format as a budget or Profit and Loss Statement with the exception that accounting treatments like “accruals”, “deferred items” and “depreciation” are excluded. 

If you are able to borrow operating cash for your business, that becomes a source of cash, just like income from sales.  If you carry accounts receivable, in addition to making cash sales, only cash received from customer payments is recognized in an operating period.

If your business is seasonal, some periods may produce strong sales and cash income while other periods may be average or below average, while expenses remain constant.  While some months are positive and some are negative cash flow, your expectation is that over the course of the year, the end result will be positive.  Good cash flow management is critical to a good outcome.

If your business makes a profit, you will be required to pay taxes.  Based on a year ending December 31st, you may pay taxes on that year in April of the following year.  So, in addition to the normal cash expenses for, you must have sufficient cash on hand to cover the tax bill.

If you collect HST on your sales, reporting and remitting quarterly, you actually have the use of the HST funds for up to three months, before you have to turn it over to Revenue Canada.  In a cash flow sense, it is a short-term, interest-free loan.  On the down side, you pay the tax collected on the sale, regardless of whether you have been paid by your customer.

If your business buys and sells goods, like a wholesale supply or a retail business, management of your inventory is critical to healthy cash flow.  If you have a large quantity of obsolete or slow-moving inventory, this can be a heavy drag on cash flow.  Inventory only generates cash when it is sold.  You can only replace obsolete inventory with cash.  If your inventory is obsolete, your customers will go elsewhere and your business will slowly die.

In a seasonal business, you may begin to receive fall and winter goods in June and your supplier may expect payment by the end of July or August.  You may only hit the peak of your fall-winter sales in the pre-Christmas period.  Early in the new year, you have to be thinking about turning the remainder of fall-winter merchandise into the cash you will need for spring-summer merchandise, which will begin arriving in March.

If you carry accounts receivable, where some or all of your sales are invoiced to customers, with payment expected within 30 days, management of your accounts receivable is vital to your cash flow and the financial health of your business.  Remember, your customer is playing the cash flow game too.  That’s why you offer a discount if an invoice is paid within ten days.  However, if your customer is chronically short of cash, instead of taking the discount, she may drag out payment to the full 30 days and beyond.  That’s why it is important to you to be in constant touch with customers who are late with payments.  Many customers who are tight for cash or who are using you as an ATM, will respond to the persistent supplier first.  While you don’t want to lose the business, some business is just too costly to service.

You may pay your employees every second Friday. On that day, you need to have sufficient cash on hand to cover their gross pay, less deductions.  On the 15th of the following month, you will need enough cash to remit the deductions, plus your employer’s contribution to Employment Insurance and Canada Pension.

These are just a few examples to show that the timing of inflow and outflow of cash does not match the budget or the Profit and Loss Statement for the same period. The cash flow forecast anticipates demands on cash for which you must be prepared.  If you are using borrowed cash to smooth out seasonal fluctuations, you need to manage your borrowing.  Using what banks call a “revolving line of credit” you are expected to remain within your limit and ideally, drive the balance down to zero at least once a year, if even just for a short period.  Unless you can demonstrate to the lender that you can accomplish this, you may find your line of credit reduced, further crippling your business.  If you are borrowing, interest on the outstanding balance will be charged against your account each month.  Your Cash Flow Forecast must include this cash expense.

From time to time, we hear stories of large businesses which have operated successfully for generations, then collapsed because they ran out of cash. Sears is a recent example.  Their earnings produced insufficient cash, they were no longer able to attract cash from investors and financial institutions were no longer willing to lend cash.

By now, you realize the importance of predicting and managing cash flow.  You want to avoid unpleasant surprises and you want to have a tool that helps you to anticipate trouble and plan remedial action while you still have options.

So how do we plan and manage cash flow?  Using Excel and some simple math, we can track cash flow over time – in the case of our examples, over a calendar year. 

Here is a sample Cash Flow Projection, based on the Budget we created earlier:

Cash Flow Forecast.png

The cash flow projection for the year begins with $1,500. cash on hand.  In each month we can track cash received through sales, collections of accounts receivable, borrowing and HST collected.  Cash is disbursed in operating expenses, payments to vendors, payroll withholdings and interest on the operating loan.  HST remittances are made quarterly and annual income tax is paid in April.  On the “Borrowing” line, we can see where cash was borrowed to make sure there is a positive balance at the end of the month.  In some months, when extra cash is available, the loan balance is reduced. 

Assuming we began the year with a loan balance of $1,000, borrowing activity through the year resulted in a year-end loan balance of $3,000.  In effect, cash was increased over the operating period by taking on debt.  Details of the transactions can be seen in the following chart:

Operating Loan.png

Operating a line of credit is a good back-up tool in managing short-term cash shortages.  This resource must be carefully managed to remain within the lender’s terms and minimize interest costs.

The level of Accounts Receivable is affected by sales on credit and payments received on customer accounts.  If Receivables payments are not collected promptly, cash flow is adversely affected and cash must be found from other sources, like a line of credit, to make up the shortfall.  Accounts Receivable transactions can be seen in the following table:

Accounts Receivable.png

Note that we began the year with an Accounts Receivable balance of $1,500.  In several months of the year, charges to customer accounts exceeded collections, resulting in outstanding balances at year-end of $7,942.  More effort is needed to collect accounts within 30 days.

Inventory must be available to support estimated sales.  If goods are purchased on credit, cash must be available to pay suppliers.  Otherwise, goods may not be available or, they may only be available on a cash basis and possibly, at higher prices.

Inventory Transactions.png

The year begins with accounts payable to vendors amounting to $6,000.  In some months, purchases of inventory exceeded those required to replace goods sold, with the result that inventory increased by $2,842. at year-end, with a corresponding reduction in cash available to pay vendors.   Inventory must be managed so that suppliers’ credit terms are met, without running short of cash and having to resort to borrowing.

A shortfall in cash is evident in the activity in Accounts Payable over the course of the year where the total amount owing to suppliers increased by $3,162. In effect, cash “borrowed” from suppliers by allowing Accounts Payable to increase.  Much of the increase can be attributed to the increase in inventory levels.

Accounts Payable Detail.png

The takeaway:

Just as we make a budget for an operating period, the companion piece is the cash flow forecast which anticipates the availability of cash to meet the obligations of the business.

If the business is generating profits, it should be cash flow positive.  But, if it is servicing heavy debt, and/or if inventory and accounts receivable are not turning over, a cash flow crisis may be looming.

When we anticipate a cash crunch down the road, we can react and prepare.  We can talk to our friendly banker about an operating loan.  We can work harder at collecting receivables and blow out excess/obsolete inventory. 

The cash flow analysis can predict cash shortfalls caused by improper management of Accounts Receivable, Inventory levels and Accounts Payable.

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