Managing Cash Flow Complexities – Part 2: More than just Math

Many times CEOs and business owners have concerns or anxieties over future cash flows.  They have usually seen the rough times when cash levels were so low, they weren’t quite sure how they were going to make payroll.  Or, they’ve been hit with an unexpected cash flow surprise that they weren’t counting on… making it difficult to pay vendors timely.

In one sense, the cash flow projection is just a simple mathematical formula.  In a balance sheet, total assets (A) always should equal the sum of liabilities (L) plus equity (E).  So A=L+E.  The reason this is so is because of the accounting principle that in a balance sheet, all of the debits have to equal the credits (the reason it was originally called a balance sheet, is because when the sheet was properly completed, the debits balanced with the credits).

The assets on a balance sheet consist of all your cash, plus all of you non-cash assets.  So the sum of cash (C) and all of your non-cash assets (NC) should always equal the sum of liabilities (L) plus equity (E).  So C+NC=A.  And A=L+E. Simple!

So, in order to properly predict future cash flows, you need to be able to properly estimate the changes in the following areas:

  1. Your non-cash assets – e.g. increases or decreases in inventories, fixed assets, prepaid assets, etc.
  2. Your liabilities – e.g. increases or decreases in accounts payable, long-term debt, credit lines, etc.
  3. Your company’s equity – e.g. increases or decreases in net income, distributions to owners, sales of stock, etc.

In this mathematical formula, if you were able to accurately predict changes in non-cash assets (NC), liabilities (L), and equity (E), then the amount of cash is just derived from the formula.  Liabilities plus equity, minus non-cash assets would always equal cash (L+E-NC=C).

By now you probably realize that even though this is just a simple mathematical formula, the complexity comes in the accurate (or materially accurate) prediction of liabilities, non-cash assets and equity.  In order to properly estimate the change in equity, you’ll need to be able to properly predict revenues and expenses, in addition to other equity changes.

Many times companies focus only on accurately predicting revenue and expenses in doing a cash flow forecast.  While this is critically important, this only works if your customers always pay on time and accounts receivable levels remained constant, and where your company’s inventory levels, fixed assets, debts, etc. never change.  Many times the unexpected surprises happen when there is an unexpected need elsewhere (e.g. buying equipment that you did not plan for, or an increase in inventory that was funded by cash purchases that you didn’t count on, or when a significant customer goes bankrupt or decides they can’t pay you for 90 days).

In order to accurately predict the changes in all of these areas, you need a person who understands you business, including its cyclical trends, capital expenditure needs, inventory build up requirements, debt covenants, etc.  Anyone can build an Excel model to take care of the simple mathematical equation.  In fact there are several great tools that have already taken into consideration these mathematical formulas applied to the balance sheet that will save you the immense amount of time it may take to build an Excel spread schedule from scratch.

While cash flow modeling tools are important, it still comes down to the fact that garbage put into a cash flow modeling tool or into Excel, will only produce garbage (unless you get lucky).

Are you concerned about your company’s cash flow?  Are you getting understandable cash flow projections on a regular basis that are reasonably accurate?  Stepping back from the mathematics… do you have someone who is not only able to do cash flow projections, but in addition, is able to help you manage critical areas of your business including inventory levels, accounts receivable levels, collections, capital expenditure financing, cost controls, and revenue generation?

If you would like some help with the complexities of cash flow, contact one of our 200+ partners nationwide who can assist you with this and other CFO related services for your business.

photo credit: Cash Flow via photopin (license)

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