Every small-business owner knows that cash flow management is critical, but it's likely to be even more important in 2015.
As we gear up for managing our businesses this year, a wide variety of factors will drive the importance of effective cash flow management, including the volatility of the capital markets, tightening commercial lending standards, the political uncertainty in Washington and the pockets of global unrest around the world. Customers who sense this level of volatility may hold on to their money for longer periods of time, which means your ability to get paid and have cash in hand will be delayed.
Learn By Example
So what can you do to improve your business's cash flow? This hypothetical example offers some key insights.
Let's imagine you own a small, well-established catering company. You get a call one day to provide the food and beverages for a very large, high-profile wedding. The client gives you a 10 percent deposit, and you and your team immediately start planning the menu (the overhead costs for your time and effort are already chipping away at the deposit). Your projected revenue on the event is $100,000 (nice!), and your target profit after labor, food and other costs have been paid will be almost $25,000 (even nicer!).
Then the big day arrives, and you're already thinking about all the things you'll do with that $25,000 profit. But as the reception is winding down, the bride’s father pulls you aside and tells you that he just lost his job and will need some extra time to pay the catering bills. He apologizes profusely, but you're furious. Your staff all expects to be paid this evening, and your food vendors will be clamoring for their payments by Monday.
On an accrual basis, you look great on paper: revenue of $100,000, $75,000 in costs and a very healthy $25,000 profit. But on a cash basis, this situation could cripple or even destroy your company.
So what could you have done differently to avoid this mess?
- Have an operating line of credit in place with a local bank in anticipation of these cash-flow gaps
- Have working capital in place to anticipate the “delta” between revenues booked and cash received so costs can be covered
- Get your clients to pay you progress payments and/or a larger deposit in anticipation of this contingency
- Get your clients to sign a promissory note and assign/factor it with a third party to “liberate” some cash as soon as possible
- Build business models and cash-flow forecasts to avoid being blindsided by your customer’s miseries
The first four ideas are pretty straightforward, but if you've never done any cash flow forecasting, learning how will help you improve your cash flow management.
Cash Flow Forecasting 101
Business forecasting in general involves peering into the future to get some degree of predictability based on the norms of your industry, your business model and your prior operating history as well as the historical and current trends in the economy. Forecasting your cash flow can help you better manage the risks of growing a business.
For small-business owners, putting together an accurate forecast of the working capital you'll need to survive and thrive can be an arduous task. How can you predict sales, cash flow and expenses for the next 12 months in an uncertain, rollercoaster-type economy? How can you spot red flags and warning signs ahead of the curve and be in a position to take remedial action before it's too late? Forecasting starts with a proper definition of the term as well as creating an infrastructure to keep you focused and on track to meet your goals.
The best approach to cash flow forecasting isn't to create a single plan but rather one plan with three possible scenarios: worst-case scenario, best-case scenario and something in between, often known as “expected case” scenario. To create these three scenarios, you need to identify and understand the dynamics of the key variables that will influence your business. These variables may include your typical sales cycle, degrees of customer satisfaction, the entry of new competitors or the reliability of your products or services. Keeping your finger on the pulse of what’s happening in the marketplace is also key to successful cash flow forecasting—your goal is to be proactive and not reactive. Be a business news “junkie,” and pay careful attention to economic news, market updates and industry developments to determine how it may affect your cash flow.
A well-drafted cash flow forecast should also address how much money your company will need to implement its business plan over the next 12 to 18 months and why. It should carefully anticipate when you need to pay your bills and compare it to how and when your customers typically pay you. It should also demonstrate when the various capital levels will be required, since many investors and lenders will prefer to invest or lend in stages as milestones are met rather than giving your company all the money on a lump sum basis.
The forecast should also include any major expenditures you're planning and why you believe they're necessary for a company at your stage. This section should be broken down into at least three different scenarios reflecting differing funding levels at the bottom, middle and upper ranges of the capital you're seeking since it's unlikely you'll be able to raise the exact amount of money you require or cover these costs from your internal cash flow.
Getting Down to Work
The key to preparing effective cash flow forecasts is to have clear and detailed footnotes that explain your underlying assumptions and the variables—the key factors and sources of data you relied upon in arriving at these conclusions—that affect these assumptions. The more accurate your forecast, the better you'll know whether you'll need credit cards, operating lines of credit or other sources of funding to cover the gap between money in hand and money out the door.
These tips to take away and common mistakes to avoid can help you create a cash flow forecast that helps your business thrive:
- Don't underestimate your cost projections, especially in the area of personnel expenses. Small and growing companies often grossly underestimate these expenses. Be sure to include all costs associated with human resources such as headhunter fees, benefits, technology, resources and office space, not just salaries and projected bonuses.
- Understand your key reserve drivers and the variables that affect actual performances. If people/time is your chief revenue driver, make sure your projections match up with your current personnel. Are you sure you'll be able to attract and retain additional personnel as you grow? Your strategy must match the numbers.
- Understand the financial and cash flow needs of the source of your “cash flow gap” lenders. For commercial banks, make sure your projections and cash flows match up with the schedule of debt service payments. Don’t force fit your projections into a third party’s perceived cash flow needs or their expected rates of return. Your numbers will either meet their needs or they won’t. A little bit of tweaking is fine, but don’t do a major overhaul or get too aggressive just because you think that's the only way they'll lend you money.
- Know the numbers for your competitors and your industry overall. Does your cash flow forecast fit with applicable and relevant key industry ratios? Why or why not? Where are you stronger than the norm? Weaker? Why? Bankers and lenders that regularly provide capital to your industry will be very familiar with these numbers, and you need to be as well.
- The focus on your business plan must match up consistently with your stated capital needs and projected cash flow. These are often called the “critical linkages” between the body of the business plan and the cash flow forecasts, and they must smoothly fit together. For example, your sales forecast should fit with your marketing budget. Your new product development plans must fit your research and development budget. A sophisticated reader will spot gaps between the words and the numbers early on, and when they do, you'll lose your credibility.
- Don’t rely too heavily on outside advisors or software programs when preparing your cash flow forecasts. Prospective lenders want to know how you arrived at these conclusions, not how some consultant or software program got you there. Use your advisors as editors and sounding boards but not as primary draftsmen.
- Give yourself enough of a working capital cushion. It's very costly to go back to the source of capital for additional funds prematurely or in between expected rounds. Leave room for error in your projections so you don't run out of cash too soon.
Your ability to measure costs and financial data directly affects your ability to manage your company based on this data. To create a growing, thriving business, you must be able to contain and control costs, keep debt low on the balance sheet, manage rapid sales growth, increase profit margins, build multiple reserve streams and strong earnings, and position your company for additional rounds of capital at higher valuations.
These critical drivers for continued business growth will all depend on the systems and procedures you put in place to measure and monitor performance. Learning to create realistic cash flow forecasts is a critical step on the road to business success.
Andrew J. Sherman, a partner in the Washington, DC, law office of Jones Day, is a recognized international authority on the legal and strategic issues affecting small and growing companies. Sherman is also an adjunct professor in the MBA program at both the University of Maryland and Georgetown University as well as the author of 26 books on the legal and strategic aspects of business growth and capital formation. Email Sherman at email@example.com.
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