Why focus on a cash flow analysis? Well, creating reliable, forward looking cash flow projections is getting more and more attention these days.
Many business owners are being advised to make at least a 13 week cash flow forecast. Startups going for investment often need up to 5 year cash flow projections!
Why though? What is the ultimate goal and what is the real value of doing this?
Aside from the obvious reason, to make sure you don’t run out of money, forecasting your cash flow is a powerful strategic planning tool.
Your true goal isn’t just to keep the bank account topped up (that definitely helps). It’s working out how you can make more cash. How you can grow your business.
A cash flow forecast (and cash flow analysis) isn’t just for short-term cash management. It’s useful for mid-term planning and long-term strategy too. Investors often require 5 year projections because they want to see a concrete plan for growing the business. Not just how you’ll scrabble around for enough money for next month’s rent.
The value in the cash flow forecasting process is really unlocked when you start modelling future business scenarios. When it comes to cash flow analysis, building different scenarios that help you understand and mitigate risk, but also help you work out when you can spend money on the activities that will accelerate your growth.
Running scenarios ultimately helps you figure out the right path to achieve your goals.
Understanding your short term cash situation can help you spot problems and tackle them early. You can work out how much of a cash buffer you need to maintain to survive worst-case scenarios. Or you can take steps like renegotiating the payment terms on your contracts for a bit more flexibility.
Looking at the mid and long-term cash scenarios will inform your goals, budgets and strategic decisions. You can get a bit more ‘aspirational’ and map out the projects, campaigns and expansions needed to hit your next important milestone.
Every business will have their own specific scenarios they need to think about. I’m going to run through 6 common scenarios relevant to almost any business. Looking at them should help you think of other scenarios you need to consider that are bespoke to your business.
Before we get started, if you’ve never conducted a cash flow analysis to make a cash flow forecast before then take a look at our beginners guide to forecasting cash flow forecasting. It’ll introduce you to the basics. Once you’re up and running you can then start to explore the scenarios I outline below.
1) What if everyone who owes you money pays you late?
One of the key components to short term cash management is the timing of payments. Perhaps you’re feeling safe because you know you have lots of money coming in on the horizon. But when is it actually going to hit your bank account? Will it be in time to pay your bills?
Hopefully, you’re using an accounting system that makes it easy to show a list of all outstanding invoices. Having this information in an accessible format is useful for looking at these scenarios.
If you are relying on these outstanding payments to pay upcoming bills then you should ask the worst-case question – ‘what if everyone pays late?’ (and the next question….’how late?’).
When you know how much you have in the bank and what you have to pay you’ll be able to see if you can cope. This is the ultimate challenge in short-term cash management for businesses running close to the edge. This worst-case scenario helps you understand how much risk there is to the business running out of money.
If you have a lot of past data to sift through then you could make your worst case more realistic. Find the worst month in your history for late payments. This shows that this bad situation is at least the worst that can happen. It could be worse than this, but this will help you judge what is likely or not.
Every scenario we look at here is dependent on how likely one outcome will occur versus another. You’ll often create a best case and a worst case scenario for any given risk or activity. It’s your past data and business knowledge that will inform your confidence levels when working out how likely these cases are to become a reality.
2) Do I have enough money in the bank to pay my tax bill?
In the UK, VAT is collected by the company when a customer makes a purchase. This amount is then periodically parcelled off to the Government from all transactions, often in 3 month batches.
This can be a dangerous process for small businesses. If all the cash from sales go into the same pot that bills are leaving from, you can get into trouble. After 3 months of transactions, this bill can be surprisingly big.
You’ve got to keep track of how much you owe to the Government so that you don’t spend it by mistake!
Again, having a good idea of how much is going in and out of your bank account will help you manage this critical issue.
This is less of an individual scenario and more a factor you should always consider when running other scenarios. If you are planning on spending money, you have to be aware of what you owe before you commit to it.
3) How sensitive is my business to changes in supplier costs?
We are now moving from short term issues to more mid-term questions. Supplier costs won’t be changing on a weekly basis so isn’t so critical for short term cash management.
So what do I mean by ‘sensitive’? Well, depending on the type of cost, a change might have a small or large impact on your business. Understanding what your business is ‘sensitive’ to helps you find risk and protect against it.
Financial analysts call this process ‘Sensitivity analysis’. Sensitivity analysis is a discipline that can be used for analysing a broad range of market and economic factors. It’s about stress testing your business to ensure it can cope with external changes in the market out of your control.
So, if your internet bill goes up by £5 a month, it’s unlikely to break the bank.
If your T-shirt supplier (for your fashionable internet T-shirt business) increases their cost from £2 to £2.50 per unit, you need to pay attention. That’s a 25% increase on every unit you sell! It could have large ramifications on your profit margins and ultimately how much cash you bring home each month.
Your business is far more sensitive to changes in the material cost of t-shirts than changes to internet bills. It’s important to identify these risks in advance and understand the impact that they could have over a long period of time. You might run a number of sensitivity scenarios in isolation. You could also apply a number of these factors together in one cash flow forecast to create a worst case scenario.
Overall, this is another factor that influences your cash planning and working out how much of a cash buffer you want to leave in your account at any one time. At the same time, if you identify high risk areas you can begin to create back up plans (like researching alternative suppliers) should the worst happen.
4) How much do I need to spend on marketing to grow my revenue?
As businesses grow and become more disciplined around planning then it’s common for companies to establish budgets for all cost categories. These encompass everything, including marketing, and help keep cash spend under control and within acceptable boundaries.
For small or early stage businesses, spending (especially around marketing) can be more…fluid.
That’s because you’re still busy discovering and experimenting with marketing activities, trying to work out what is effective.
You want that flexibility to ramp up spending on activities that can prove their return on investment, whilst weeding out the activities that don’t pull their weight.
Whilst you’re experimenting, it’s really useful to have one eye on your cash flow model. You can forecast the potential sales and the marketing costs needed to drive them. There is a lot of complex cash in, cash out going on which needs to be planned around other cash-based concerns we’ve already identified.
5) When can I afford to expand my team?
Building the right team is critical to success and if sales are on the rise, you might be itching to expand.
Employing people is one of the most expensive costs to any business. It’s really critical to get the timing right and employ people when you can truly afford them.
The real cost of employing one person can often be hidden. It’s not just their base salary. There are recruitment costs, taxes and benefit costs, not to mention new equipment or software you might need to buy them.
It’s really important to look at this in the context of all your business costs. If you’re looking to double your team then you should start modelling a realistic time frame for this. Perhaps you can identify some sales milestones you need to hit that make it safe to take on each new employee.
If you’re really interested in strategically growing your business then looking at how you’ll expand your team over the next few years is a key set of scenarios.
6) When can I afford to make large capital purchases?
How many of you out there are making your team battle day to day with 5 year old laptops? It’s really tempting to just ‘make do’ with what you’ve got. Save some money.
Upgrading old equipment and infrastructure seems like a painful process because they often involve biting away large chunks of cash from your bank account.
This is a serious ‘false economy’ though. Inadequate equipment that wastes your employees time will cost you more in the long run.
As we just saw, salaries are one of the biggest costs to any business, you need to get the most out of your employees time. Forecasting your cash and understanding when you’re safe to spend a large chunk of business savings can help ease the anxiety around these large purchases.
It can also help you plan how you can spread out these purchases over time to ease the hit on your bank account. Look strategically at your future cash flow is key to making sensible decisions right now.
Modelling your business financials with scenarios
As you can see, there are a lot of ‘what-if’ questions you can ask to explore the future of your business. Running scenarios helps to answer them and give you a better appreciation of what you need to do to achieve your goals. A good cash flow analysis can help you get a better idea of where your company could improve.
Broadly, they help to:
- Ensure you won’t run out of money
- Identify and take steps to reduce risk in the business
- Understand what you need to spend to grow your business
- Understand when you are safe to spend that money
Overall, forecasting cash flow in the short, mid and long term will help you make good strategic decisions. It’ll save you money and help grow your business faster.
If you’re just getting started with cash flow analysis – you might want to keep it simple with our free cash flow forecast spreadsheet template.
If you’re intrigued by the word ‘modelling’ and wondering if it has any place in the hectic world of small business, try our Beginner’s guide to financial modelling techniques for small business.