Cash Is King: Mastering the Art of Cash Flow

Managing cash flow is the key to small-business success. Get a better grip on yours by doing a proper cash flow forecast and following these insightful do's and don'ts.
June 02, 2014

Every small-business owner knows that you need cash to survive and thrive, and without it, the future looks bleak. But how can you manage cash flow effectively? The key can be found in your cash flow forecast.

For many small-business owners, putting together an accurate forecast of the working capital needed is an arduous task. How can you predict sales, cash flow and expenses for the next 12 months in an uncertain economy? How can you spot red flags and warning signs ahead of the curve and be in a position to take action before it's too late? Better forecasting starts with a proper understanding of the term, followed by the implementation of the right infrastructure to keep you focused and on track to meet your goals.

What Is Cash Flow Forecasting? 

Forecasting in general is the art and science of peering into the future to get some degree of predictability based on your prior operating history as well as the historical and current trends in your industry.

Forecasting your cash flow helps manage the perils and risks of growing a business. Even "upside surprises" in a best case scenario can be hazardous. Some entrepreneurs will "lowball" or “sandbag” their sales forecast only to find themselves scrambling to deliver products and services, resulting in unhappy customers or celebrating fake or misleading successes. If your pipeline is robust, then your forecast must include the ability to scale, including affordable access to growth capital.

Sensitivity Analysis

The best approach to cash flow forecasting is to not create a single plan, but rather one plan with three possible scenarios. Your forecast should always include the worst case scenario, the best case scenario and something in between, often known as the “expected case” scenario. This process is also known as "sensitivity analysis." Be sure to identify and understand the dynamics of the key variables, which will influence your worst, expected and best case scenarios. 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 an important element in cash flow forecasting. Your goal is to be proactive and not reactive. Be a business news “junkie.” Pay careful attention to economic news, market updates and industry developments to determine how they may affect your cash flow.


Budgets and Cash Flow Forecasts

The well-drafted cash flow forecast should address how much money your company will need to implement its business plan over the next 12 to 18 months and why. 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 of the money on a lump sum basis.

The forecast should include what you're going to buy and why you believe that this expenditure is necessary for a company at your stage. Since it is unlikely that you'll be able to cover these costs from your internal cash flow or raise the exact amount of money you require, this section should be broken down into at least three different scenarios reflecting funding levels at the bottom, middle and upper ranges of the capital you seek to raise.

Tips and Common Mistakes to Avoid

The key to developing effective cash flow forecasts is to have clear and detailed footnotes that explain your underlying assumptions and the variables that affect these assumptions—and explain what key factors and sources of data you relied upon in arriving at these conclusions. The more accurate the forecast, the better you will know whether you will need credit cards, operating lines of credit, etc., to cover the gap between money in hand and money out the door.

Costs projections are often grossly underestimated by small and growing companies, especially in the area of personnel 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 are your chief revenue drivers, do your projections match up with your current personnel? Are you sure you will be able to attract and retain additional personnel as you grow? Your strategy must match the numbers.

It's also important to understand the financial and cash flow needs of the source of your “cash flow gap” lenders. Do 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 you'll be able to borrow the money.  

Know the numbers for your competitors and industry overall. Does your cash flow forecast fit with applicable and relevant key industry ratios? Why or why not? Where are you stronger than norm? Weaker? Why? Bankers and lenders who 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 the stated capital needs and projected cash flows. These are often called the “critical linkages” between the body of the business plan and the cash flow forecasts that must smoothly fit together. For example, the sales forecast should fit with the marketing budget. The new product development must fit with the research and development budget. A sophisticated reader will spot gaps between the words and the numbers early on, and then credibility is lost. There must also be consistency among the senior team members on the key milestones and capital needs; any major differences of opinion should be resolved well before anyone meets with the sources of capital.

Don’t rely too heavily on outside advisors or software programs when preparing cash flow forecasts. The prospective lenders want to know how you arrive 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 plenty of working capital as a cushion. It is 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.

In your cash flow projections and financial models, avoid some of the classic mistakes made by small and emerging growth businesses if at all possible. For example, many companies have experienced the classic “sideways V,” where sales go up but profits go down. Try to demonstrate that you and your team will stay focused on controlling costs during the growth phase, so that as sales increase, expenses increase at a slower rate.

The ability to measure costs and financial data is key to your ability to manage the company based on this data. The ability to contain and control costs, keep debt low on the balance sheet, experience 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 that are all critical drivers for continued business growth will all depend on the systems and procedures you put in place to measure and monitor performance. Once this data is analyzed, the team needs to be constantly tweaking and fine-tuning the operations to be managed toward maximum bouts of growth and profitability. It is important not to confuse effort and activity with actual results.

Andrew J. Sherman is a partner in the Washington, DC, office of Jones Day, with over 2,700 attorneys worldwide. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies, and is an adjunct professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University, where he has taught courses on business growth, capital formation and entrepreneurship for over 23 years. He is also the author of books on the legal and strategic aspects of business growth and capital formation. 

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