Create a Cash Flow Forecast
Once you have laid the foundations you can start to monitor your cash flow and to plan ahead. Monitoring your cash flow becomes extremely important when there is a liquidity problem, but it can also help you to take advantage of surplus cash and plan how to use excess liquidity. The best way is for sure is to automate the whole process, but as this is not always possible, we suggest some practical steps to manage it.
Decide the period of forecast: First step is to decide the period of forecast, while it would be nice to see 18 months, it may not make sense in many cases. Decide based on your company and the reliability of data, the more the business is stable and has reliable data, the more you can extend the length. Once you define the period that is reasonable for the business to forecast (3-6-12 months), you will then roll forward once actual data becomes available.
Focus on output: Outputs should provide key results to aid decision-making. The complexity of the forecast can vary based on your company’s needs and size, but it should contain 3 key elements:
- Operating cash: linking to balance sheet DSO (days sales outstanding), DPO (days payables outstanding) and DIO – days inventory on-hand
- Investing cash (capital expenditure, disinvestment)
- Financing cash (debt repayment)
The main goal of the cash flow forecast is to give actionable information, so it should be fit for purpose. Unless it is strictly necessary, do not build complex models that become prone to error and do not add more information. Keep inputs organized, processing simple and output clear.
Define a discipline for review: It could be monthly basis, but when conditions get tougher you may want to move to weekly review to improve visibility and reliability of information. Start focusing on monitoring the KPI (DIO, DSO, DPO). DSO shows how fast you’re getting paid and DPO shows how fast you’re spending money. So if your DPO is 30 days and your DSO is 60 days, you have space to improve. In an ideal situation you should have DSO<DPO, meaning your cash in inflow is coming faster than the outflow. Bring a structured approach of review to improve your ratios.
How to manage shortage and liquidity crisis: Stress test and scenario planning
Shortage and liquidity crises could derive from external factors (changing market conditions) or internal (operational inefficiencies). In both cases a key principle remains valid: you need to buy time. How long? Until you are able to implement the changes necessary or until market conditions return stable. Before tackling strategic or operational change you will need to understand how long is this time frame. Focus on solving the short term problem in order to be able to purse the long term goals.
Stress-test your forecast. Identify what are the drivers that can trigger a liquidity problem, define how this can impact your forecast and when/if the problem will arise (in one week, in one month..).
Create a scenario planning and course of actions for each scenario. Before you set your next course of action you should define a scenario planning. Identify the best case, medium case, worst case. For each case identify the period it will last and what measures should be put in place. Finding the balance is crucial, remember to pull all the levers and to pay particular attention on immediate actions that can create cash without affecting the business. Some practical examples include:
- Don’t buy assets but lease. Sell the non-strategic ones (or if strategic sell and leaseback)
- Reduce immediately non-strategic overheads
- Focus on products and services with a higher margin
- Prioritize less risky clients, where is more probable that payments will arrive on time
- Pay attention to cost-cutting that has direct implications on business performance and not add cash benefit in the short term. Balance the grade of severity based on the scenario.
Keep an open communication channel: It can happen that you don’t want to damage the reputation of the company, but it is worse to keep delaying payments. You will not only damage the reputation but also lose the trust of your vendors. In case of crisis it is extremely important to open communication. Let your vendors know what is happening, why they’re not getting paid, and when they can expect payment based on your most reliable plan.
Creating discipline in your organization is what is required to optimize your cash flow. Being in control is what is needed to boost resilience and capture opportunities.
Set the foundations for cash flow management, create a structured approach to planning and review. In stressful circumstances take control of the cash and correct the short term situation without losing view on the long term.