The main problem with cash is that it’s fickle – here today, gone tomorrow. Many businesses have run into difficulty when they couldn’t get a loan to cover the difference between cash and profits. That is, they’ve got paper profits, but the expenses need to be paid, and the cash hasn’t come in yet. Businesses like this use cash flow forecasting for two main reasons: 1) to make sure they grow their sales only as fast as that their working capital can match, and 2) to ensure they’ve actually lined up enough working capital, often in the form of a long term line of credit, to be able to pay all their expenses without embarrassment.
A less well known problem faces the business that has a positive cash cycle – the kind of firm that receives the money before they have to pay the expenses. Companies in this desirable position may think they don’t need cash flow forecasting – as long as they keep trading profitably, the cash will always be there. This type of cash flow can also be a killer, and can take business leaders completely by surprise.
The main pitfall for positive cash cycles occurs when a business uses its cash to finance its operations. Why? Even a business with very thin profits, but growing rapidly, could find itself apparently swimming in cash. Surely it makes sense to use the cash productively, to invest in business improvements and growth? But what if the cash inflows subside, even just for a few months?
Imagine a (highly simplified) business turning over £1m per month. It has a positive cash cycle of 1 month, and razor thin margins. So although profits are essentially non-existent, it sits on £1m of cash at any one time, which has been paid into the bank, but won’t need to be paid out until next month. By that month, another £1m will have come in, so the company will look appreciatively on that money, which always seems to be there, and may think of investing it in something more productive than savings.
Now, imagine that after a couple of months they’ve invested £1m in new equipment, with the intention of growing the business. This is shown as “Month3” in the table to the right – you can see that after a couple of months of sitting on £1m in the bank, they wanted to do something with it, even though their profits are actually zero. Unfortunately bad weather plays havoc on their market (or some other unexpected event occurs) and sales vanish to nothing the next month – “Month4”. Imagine, too, that they feel safe, because they can reduce their expenses by £1m – they have the ultimate in flexible operations, so their margins will stay the same (zero, but at least they’re not losing money).
Unfortunately their cash position is terrible. The £1m buffer that they used to have is now invested in equipment. The expenses from last month - £1m – were going to be paid for with the £1m in cash coming in this month. Regrettably it’s not there, and they need an emergency loan of £1m from the bank in order to pay their debts. The equipment probably cannot be liquidated for £1m, and this is not a profitable firm, so the bank may ask some very difficult questions about this loan request. Promise of positive cash flow returning next month may sound to the bank like "jam tomorrow", no matter how justified. They will want to know why you didn't see this coming.
The best way to head off this sort of problem is to incorporate cash flow reporting into the monthly accounts, and to use scenarios to test cash flow forecasts on a regular basis. This will highlight any risks to future cash flows, and should prevent all but the most extreme of unexpected events from taking business leaders by surprise.
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