Use this tool to develop a point of view on sources and insight into your company’s cash requirements

Key Takeaways: 
  • If you don’t have a good handle on the ins and outs of cash, your business can be in a constant cash-starved state. 
  • Cash flow modeling helps determine how to build and maintain a strong cash position. 
  • Cash flow modeling is a bit like budgeting, but you have to expand it into scenario-based modeling.  
  • A cash flow model is a “living” document that must be updated regularly. 

Cash flow modeling is an important strategy that helps create a significant indicator of a company’s financial performance, regardless of the size of a business. 

Owners of small and medium-sized businesses often complain that, even though sales are strong, they are always short of cash to pay bills and make payroll.  

Cash flow modeling is essential to analyzing where the cash is – and isn’t – and determining how to build and maintain a strong cash position. It can help a business owner look ahead to see what the cash position will be for the next two quarters or more. Most importantly, if you were negative on cash flow for a month, it can provide insight into what went awry. 

What is Cash Flow Modeling? 

A cash flow model can inject some perspective into your financial management. If you have a variation in cash flow, the model can help explain what happened. Was the forecast off? Or did the variation happen because of an unforeseen external issue? 

Cash flow modeling is a bit like budgeting, but it is important to have the flexibility to expand into probability adjusted scenario-based modeling. For example, the model should include a “base case” on how you expect the company to perform and what you expect the cash flow to be. It is also helpful to then you look at the low end or “worst-case scenario.” Finally, you should consider the “best-case” scenario. It’s not likely you’ll experience the worst-case or best-case scenario, but understanding what those bookends look like can help you make adjustments as you go through the year.  

While there are certain steps common to building a cash flow model in any business, it’s important to understand that every business is different. A construction company could be working on a single project for two years or more with revenue coming in periodically over the life of the contract, whereas a company selling software as a service may incur recurring revenue in very short cycles. The two companies will have very different looking cash flow models. 

How to Build Cash Flow Model 

Cash flow modeling starts with a set of assumptions and steps based on prior performance: 

  • First, establish a time frame for your model. It could be a short-term period like the next quarter or the next two quarters, or longer term such as one to five years. 
  • Look at revenues over the past few months and consider what levels of revenues you expect over the time frame. What does your pipeline look like? Do you have contracts in place? Adjust for probability. 
  • Look at cash flow for the past month or two to understand inflows and outflows. This helps to capture projections. The numbers don’t have to be perfect – they just get you started. 
  • Take into account other factors such as payroll, maintenance, utilities and other expenses. 
  • What capital expenditures are on the horizon for the time frame you are looking at? Will you be investing in your business by purchasing equipment or expanding to a new location? What will the property, plant and equipment costs be? 

Your model should be sophisticated enough to give you reliable information, but simple enough that you can understand it and stick with it over time. A cash flow model is a “living” document that must be updated regularly. 

An often-overlooked factor in cash flow modeling is working capital, which is a particularly sensitive factor for startups and young businesses. Issues impacting working capital can sometimes be easy to spot and correct on a cash flow model. For example, you invoice customers and give them 30 days to pay. But you receive bills from vendors with payment terms of 15 days. If your collection terms are longer than your bill payment terms, you will have ongoing cash shortfalls. Remedies can include changing the payment terms on your invoices or offering clients a discount for early payment. 

“CASH IS LIKE OXYGEN – IF IT DISAPPEARS FOR A FEW MINUTES, IT’S ALL OVER.” – WARREN BUFFETT

 “Cash is like oxygen” doesn’t just apply to retail businesses and other cash-heavy entities. All businesses need a healthy cash flow to operate, and if you don’t have a good handle on the ins and outs of cash, your business can be in a constant cash-starved state.  

Moreover, some lenders require cash flow models for higher-risk loans. It’s never a bad idea to include a cash flow model when seeking financing, as it’s a document that speaks to the financial astuteness of your business. This can be particularly helpful when you are seeking a large loan, such as $1 million for a new piece of farm equipment. 

Business owners often become focused on more complex metrics such as net income after tax. While that’s a very important metric, seeing what’s happening in your bank account really clicks when you’re looking at your first cash flow model. 

If you would like assistance in building an effective cash flow model for your business, contact an Adams Brown advisor.