How your cash flow forecast is misleading you

Your cash flow forecast might be hiding your true profitability issues

Cash flow problems kill startups, cash is king and cash flow problems are also the direct cause of global warming.

OK, that last one wasn’t true.

But you’ve probably heard the others before, or similarly dramatic proclamations. With how much is written on the importance of cash flow problems, you’d have thought it’s the cause of all the major issues in the world today! 

Ok, so I’m being a little overdramatic for effect. After all, at Brixx we’ve also done our fair share stressing the importance of cash flow forecasting.

The fact is, if you don’t have the cash in the bank, you can’t pay the bills so I’m not going to claim that isn’t important!

Your bank balance and future bank balance is the cold hard reality check that defines whether your business lives or dies. So it can be life or death for a business. 

If you’re having cash flow issues, forecasting is your early warning system that highlights problems in advance and helps you find solutions. It’s also the strategic tool for modelling scenarios and understanding the right time to spend and the right time to save.

But, it’s just one aspect of your business’ financial health.

If you are finding yourself close to the wire time and time again, if you are always reaching for that credit card, hitting your overdraft unplanned or seeking last minute funding, then there might be a different issue you’ve got to address. One that is not so easily highlighted by a cash flow forecast.

That’s right, some cash flow problems aren’t solved by more cash flow forecasting!

You need a more fundamental analysis of your business model and profitability. Despite all the glowing cash flow recommendations, you can’t clearly judge these issues from this financial report alone.

In this article, I’m going to show you how your cash flow analysis might be leading you astray and how you can correct it.

Muddying the flow

The flow of cash can be a great indicator of financial health. If it’s flowing in regularly, clearly that’s a good sign. 

However, your true business performance can be muddied because when a company completes a transaction, the cash can land in a different period. 

There are a surprising amount of ways this can happen, for example:

  • Cash owed for goods or services can be delayed or spread out over time
  • Cash can be received in advance of the provision of goods or services
  • Cash received can be inflated by the collection of taxes (which must be returned later)
  • Credit and funding can create an artificially positive cash position

These are just some of the ways that the purity of business performance can get lost on the cash flow.

Most of these examples are about the ‘manipulation’ of cash timing, adjusting when you pay or are paid. 

Improving cash terms and your available bank balance is all part of good treasury management.

A savvy finance team or business owner might use a host of techniques to ‘improve’ cash flow that have nothing to do with increasing sales performance or operating efficiency. 

It often means the timing of cash becomes detached from the activity that generated it. 

Every cash management technique employed moves your cash flow statement away from a true representation of financial performance. 

It’s because timing is incredibly important for attribution.

You need to be able to attribute financial results with the real-life actions that generated them.

How else will you know if what you’re working on is worth it?

What does business performance mean and how should we measure it?

What do I mean by ‘performance’? Surely a cash flow report shows your “performance” in terms of your ability to manage cash in and out?

That’s certainly one way of looking at it.

If you can perform the cash game well, you can be unprofitable for years (remember – being cash positive is different from being profitable)!

Take a look at Tesla, for example. Here is a company who has had very few profitable quarters (as of writing).

However, Tesla attracts so much investment that they never have cash flow issues. They “perform” well in regards to cash flow.

Are they performing well as a business though? With the amount of debate around Tesla’s past, present and future fortunes, this isn’t so clear!

Many high growth companies will forgo the opportunity for profit in order to keep spending high. 

Their goal is to achieve scale as quickly as possible, profit can come later. As long as investors still believe in the vision, this can be sustained for a very long time indeed. 

This isn’t the case for the majority of startups and small businesses though.

Most are charting the shortest path to breakeven in order to secure a stable business with a safe future. 

So the answer to this question can’t just be about cash flow performance.

Alright, but what about other measures of performance? Metrics like website visits, returning customers, number of orders etc are all KPIs many companies will track closely.

These metrics are important for understanding the detail of why you are yielding the revenues you’ve achieved.

You could use these in tandem with a cash flow statement to get a solid impression of how you’re doing. 

However, ultimately you want the financial performance for the bottom line judgement to see if your business model works.

This is best analysed through an accrual-basis profit & loss report

Every cash management technique employed moves your cash flow statement away from a true representation of financial performance. It’s because timing is incredibly important for attribution. You need to be able to attribute financial results with the real-life actions that generated them.Click To Tweet

Performance earned, not borrowed

Now, you might be thinking is the profit & loss report really so different from a cash flow statement?

Will I learn that much more about my business?

It all comes back to that timing difference explained earlier. An accrual-basis profit & loss report recognises revenues and expenses when they are earned

The accountants reading this will likely be very familiar with this process. Accrual-basis and cash-basis accounting are two methods for documenting your finances.

For the uninitiated, accrual-basis broadly means that the monetary value for an activity is lined up as closely as it can be to when the good or service was provided in the real world.

So the monetary value for an activity is accounted for when it is earned by work the business has undertaken, uninfluenced by credit and payment terms or any other manipulation of cash

This is important because, as I was describing earlier, the cash flow statement can become very detached from the reality of “doing work”.

Whilst the cash flow gives you a pure view of what is actually in your bank account at any one time, the profit & loss gives you a pure view of the value of the activities you undertake as a business – when you undertake them.

So how does this help?

Well, with revenues and expenses correctly attributed to work done or products provided it becomes far easier to analyse whether what you are doing makes monetary sense or not.

It cuts through some of the timing confusion caused by a cash flow statement.

If you agree to a 3-month consultancy project that is paid upfront, the profit & loss will show that cash amount spread out over the 3 month period.

Consultancy paid upfront Month 1 Month 2 Month 3
Cash flow £3000
Profit & Loss £1000 £1000 £1000

You might have been paid in advance, but the money hasn’t been earned yet.

Only once you’ve done your hours will the profit & loss recognise your monetary contribution to the businesses performance.

Another example would be making a purchase on credit – where you’ve received the item in full already but you’ve delayed the cash payment until later. Again, the profit & loss recognises the activity as it happens ignoring your cash terms.

Paying on credit card Month 1 Month 2
Cash flow £100
Profit & Loss £100

 

This is critically important. If that expense was for the petrol required to drive you to your client’s offices for consultancy – you want to tie that together with the period the consultancy revenue was earned.

Just because you paid it on a credit card, which doesn’t need to be paid off for a month, doesn’t mean it isn’t related!

Credit cards can really mask a lot of activity as they can lump together a range of different costs that all go out later than the original transactions.

The point is, you want to line up the monetary value of real-world actions in the periods those actions occur, not when they happen to be paid for

With all the revenues and expenses being lined up in the same way, you can clearly see whether what your spending time on as a business adds up to a profit.

Again, I have to emphasise that a cash flow report is only serving to detach you from what is actually happening in your business.

Sounds crazy if you have read the flood of cash flow articles around the internet! 

Of course, you do need to be careful.

Never look at the bottom line of a profit & loss and expect to see how much money you have in the bank to pay your bills. That really is what the cash flow statement is for (or better yet, just go directly to the source, your bank account!) 

Here’s another example from our own business here at Brixx.

Example – Recording Subscription Service Cash & Revenue

At Brixx, we run a SAAS business model (software as a service). Meaning we sell subscription-based software for a recurring cost either monthly or an upfront annual amount. 

For any SAAS company looking to judge their business performance it’s crucial that SAAS revenue is accounted for correctly. 

Now, if you aren’t a SAAS company this example is still relevant to you! Most companies buy from SAAS companies these days to run their business. This example will be exactly the same but from an expense and cash spent point of view, rather than revenue received (less impact of course, since it will just be one category of your costs rather than your lifeblood of sales).

A 12-month subscription purchased upfront should have the revenue spread out over the course of the billing cycle, similar to the earlier examples.

M1 M2 M3 M4 M5 M6 M7 M8 M9 M10 M11 M12
CF  £120
PL £10 £10 £10 £10 £10 £10 £10 £10 £10 £10 £10 £10

A customer may have paid the cash in a lump sum but they are now owed 12 months of service. 

After a month of their subscription passes, we can recognise 1/12th of the revenue on our Profit & Loss. The portion that has so far been earned. 

This makes sense. Not only does it recognise our continuing requirement to provide this service (actually recorded as a liability on the Balance Sheet if you were interested) but it then lines up the revenue to the costs associated with providing that service.

For a SAAS business like Brixx, that’ll be costs like servers and customer service salaries – costs that are paid monthly.

If we want to analyse our profitability, we’ve got to line up those income and costs correctly or it would be impossible to judge.

Many physical products are sold on a subscription basis too and it gets even more important (and complicated!) to track. You’ll have to factor in stock levels that are perhaps paid in advance which then reduce over time as they are delivered.

There is a lot to model there! (You might need some financial modelling software to help at that point *wink* *wink*)

Know what type of performance you are analysing

Ultimately, you need to analyse both cash flow and profitability to have a true handle on your business financial performance. 

Your profit margins (gross, operating, net) reveal how efficiently you are running. They show if the revenue you are making covers the direct costs of sale associated with it as well as the indirect cost of operating your business. 

You can get an impression of this on your cash flow statement, especially if it’s formatted so that funding sources are split out.

However, it’s all too easy for the timing of cash to become disassociated with the event that generated it.

Spending a bit of time generating accrual-based reports and forecasts can yield some key insights about your business important for your decision making.

Interested in modelling your future cash flow, profit & loss and balance sheet without needing a background in finance?

Start a free trial of Brixx financial forecasting software today to begin modelling your future.

Brixx financial modelling and forecasting software

James Beer 22nd September 2020 By
 

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