Financial Planning & Analysis

How to Build a Cash Flow Forecast to Manage Liquidity Now

Many businesses are adversely impacted by the coronavirus pandemic. During a time of uncertainty, companies should more than ever reevaluate their operational strategy and profitability forecast. Most importantly, management must have good visibility into the company’s potential of liquidity difficulties and opportunities.

A well thought-out and dynamic cash flow analysis will provide stakeholders with such visibility. Cash is king, and cash flow is the bloodline of all companies. Without proper management of a company’s cash flow, a company will increase its exposure to unnecessary liquidity risks. Moreover, a company without a healthy and well-managed cash flow will face an uphill battle to remain profitable, secure favorable financing terms, attract potential inventors or be viable in the long run.

The long-term viability of a company is a function of three measures:

  • Liquidity, which can be gauged through the analysis of cash and working capital
  • Solvency, which can be assessed by an income statement and balance sheet, and
  • Cash flow, which can only be addressed by a cash flow analysis.

A cash flow analysis must address the following queries:

  • How can more detail and visibility be provided?
  • What are the company’s immediate obligations?
  • How can the company be run differently?
  • What can management do to preserve cash and beef up its bank balances?
  • How can the company best monitor performance?
  • Which strategy provides the most return?

Construction of a Cash Flow Analysis

3 Statement Projections

The most common cash flow construction that we are familiar with is the indirect method (i.e., starting with net income, plus or subtract adjustments, and ending with net cash flow) found in most IFRS filings.

A comprehensive approach of constructing this type of cash flow analysis uses three financial projections, which are commonly used by investment banking and private equity analysts. However, in the interest of time and for the purposes of cash flow analysis, management can simply project the company’s income statement and skip the tedious and time-consuming full balance sheet projection because changes in cash, debt and equity are all derived from the cash flow statement that can be projected independently.

Free cash flow is a popular metric in equity valuation and it also provides stakeholders with insight into the discretionary cash flow a company generates after it meets all its core business obligations. Discretionary (free) cash flow tells management the company’s recurring cash flow from its core operating businesses.

There are two main types of free cash flow:

  • Unlevered Free Cash Flow: [Earnings Before Interest and Taxes × (1 – Tax Rate)] + Non-Cash Adjustments +/- Changes in Working Capital – Capital Expenditure
  • Levered Free Cash Flow: Net Income + Non-Cash Adjustments +/- Changes in Working Capital – Capital Expenditure – Mandatory Debt Repayments

There are several differences between Unlevered and Levered free cash flow:

  • Unlevered free cash flow is capital structure neutral, while levered free cash flow includes interest expenses and mandatory debt repayments.
  • Unlevered free cash flow is discretionary cash flow available to all investors; however, levered free cash flow is discretionary cash flow only available to equity holders.
  • Enterprise value is paired with Unlevered free cash flow, while Equity value is paired with Levered free cash flow as valuation metrics.

Cash Loop

The cash loop method of cash flow construction is very similar to the direct method required under US GAAP, and it is also used in financial turnaround and restructuring situations. The cash loop cash flow construction is a source and use methodology that shows the receipts and disbursements.

A generalized cash loop format would include the following items:

(+) Opening Cash Balance

(+) Cash Receipts:

  • (+) Customer Collections from A/R
  • (+) Other Cash Receipt from Core Businesses
  • (+) Other Non-Core Cash Receipts
  • (+) Loan Proceeds

(-) Cash Disbursements:

  • (-) Salaries and Bonuses/Commissions
  • (-) Payroll-Related Expenses (e.g., Taxes and Insurance)
  • (-) Rent and Other Operating Leases
  • (-) Utilities
  • (-) Capital Expenditures
  • (-) General Selling and Administration Expenses
  • (-) Professional Fees
  • (-) Insurance
  • (-) Taxes
  • (-) Other Operating Expenses
  • (-) Interest and Loan Repayments
  • (-) Shareholder Disbursements/Dividends

(=) Ending Cash Balance

The cash loop cash flow analysis is often more intuitive and understandable for the stakeholders without a finance background. The cash receipts and disbursements forecast will easily assist management in answering the following key questions:

  • Are customers failing to pay according to terms?
  • Are higher than expected discounts being provided?
  • Is there a deterioration in the customer base?
  • Are competitive/pricing/position factors more influential than modeled?
  • Are vendors accelerating payments (reduced terms, COD, deposits)?
  • Are material or supplier costs increasing?
  • Is a system of addressing vendor payments necessary/functioning?
  • Is inventory being managed in the most cost-effective manner?
  • Are implemented cost reductions hitting the bottom line?

Conclusion

Regardless of how we construct a company’s cash flow, the cash flow analysis must be realistic, informational, allow visibility and execution of management’s plans. It must also justify the merits of business strategies and aid accountability.

If you don’t have the specialty or expertise in house to develop this type of modeling or analysis, we can help. Learn more about our business stability and contingency planning expertise and how we’re working with our clients through this challenging time:

business stabilization and contingency planning

About the Author

Prior to joining 8020 Consulting, Joe was an Investment Banker with experience in capital and debt markets, M&A, IPO, credit, distressed assets and financial assurance. His key responsibilities include buy-side and sell-side M&A, subsidiary spin-offs, capital raising through the debt and equity markets, structuring of hybrid securities, turnaround and restructuring and due diligence support. Over the years, Joe has advised and raised capital for REITs, property developers and major palm oil players. Joe has also lived and worked in a few of the world’s major financial cities such as Los Angeles, London, Singapore and Hong Kong. Joe graduated from the University of Southern California, and he is Chartered Accountant with the Institute of Chartered Accountants in England and Wales. Joe also holds the following FINRA licenses: Series 24, Series 63 and Series 79.

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