Failure to properly manage cash flows is the key reason for business liquidations and indeed within the first five years, most businesses will indeed cease to exist. Jeffrey Luckins of AMTIL corporate partner William Buck explains.
Speaking as a company auditor, one of the key procedures we perform to conclude our opinion on financial reports and address the going concern basis, is devoted to determining whether the company can pay their debts as and when they fall due, which is a key solvency requirement for businesses looking forward one year ahead. Indeed, we take the forecast cash flows and we flex them to address locked-in commitments, potential (new) sources of cash inflows and any other potential movements of cash over the next year. We want to know in a worst-case scenario, how it is possible for the business to survive? All business owners should adopt the same philosophy that we do to survive and to thrive.
Surprisingly, our observations are that cash flow management has a low priority in businesses or where it is implemented, the quality, timing and usefulness of the reporting is negligible at best.
Here’s the problem: forecasting is an inexact science and even when it is conducted, the quality of information supporting assumptions in the modelling can be weak or inconsistent with reality where insufficient research and due diligence is conducted. The result being that business owners place low reliance and faith in forecasting, preferring to address cash management issues on an ad hoc as needs or weekly basis.
Your first goal should be determining that the going concern basis is supportable to enable the business to survive in the short-term (ie the next year). This exercise may lead you to increase banking facilities, inject new equity, factor trade receivables, reduce short-term commitments or realise assets to enable sufficient working capital to be employed in the business.
Medium term thinking should be about investing in the business to build its critical mass and profitability – making a stronger business which is resilient to short-term term challenges. This forecasting may enable you to focus upon proactively implementing incentives and promotions which build a consistent loyal client base, improved decision-making around decisions to replace equipment or indeed to extend the life of existing equipment, acquiring a new business, negotiating with suppliers, and refinancing or communicating with your financiers.
Forecasting tools
There is now more choice than ever for cashflow forecasting tools. Some software programs appear quite impressive in terms of their visual outputs, however the pros and cons of each solution can be difficult to weigh up. Many software tools have limitations, so it is important to ask the right questions before buying. For example, some forecasting software does not interface with popular accounting systems or exports only hardcoded numbers to other programs such as Microsoft Excel.
When to use a spreadsheet for forecasting
Like other software programs, Microsoft Excel has limitations and potential issues when it comes to using it as your key forecasting tool. These issues include the risk of accidental errors and reusing templates that are no longer fit for purpose. However, the risk of errors can be minimised through well-designed spreadsheets with the appropriate checks and balances. Excel is still probably one of the best options for small-to-medium business in the following cases:
- Deciding on whether to finance a specific project. Starting a new product line or taking on a new contract that requires investment.
- Preparing for an acquisition. When preparing for an acquisition it is important to understand the cashflows of the target business to determine an appropriate offer price and to understand the combined value of your business and the target by modelling expected synergies.
- Preparing for sale or a partial divestment. As the value of a business is based on its future cashflows, both the potential buyers and you will want to see and understand the forecast cashflows to determine an appropriate price.
- Deciding whether to replace equipment or extend the life of existing equipment. Both scenarios can be modelled out over a specific period and compared based on net present value (NPV).
- Valuing your business. Forecast cash inflows and outflows are a key input for a valuation based on the discounted cashflows (DCF) method of valuation.
- Simple monthly, quarterly, or yearly forecasting. Spreadsheets are very useful for setting up forecasting at regular intervals regardless of what interval you choose. The chosen intervals can then be easily rolled up into a yearly overview.
Once a forecast is prepared in Excel, different scenarios can be built in to allow the end user to see and compare the result of these scenarios in the one table. One scenario may include what would happen to the profit and cashflow if the sales volume of a product line increased by say 10%.
When to avoid spreadsheets for forecasting
The more complex the forecasting becomes due to multiple locations, business units, foreign locations and currencies, and high levels of assumptions or sensitivities, the more it becomes apparent to implement a dedicated forecasting software solution.
Don’t give up on forecasting
Failure is not an option for forecasting cash flows; consider outsourcing this task if you lack the in-house skills to develop the modelling and interpret the results. Your survival as a business is on the line and assuming you have covered this risk, the opportunity to build your business and maximise profitability becomes the key objective. Whichever way you consider it, cash management forecasting is not negotiable for your business.
Jeffrey Luckins is a Director in the Audit & Assurance Division at William Buck – a leading firm of accountants and advisors. This article was co-authored with Lauren Morcom.