Let’s begin with a reminder of why cash flow forecasts are often considered essential from an operational and strategic standpoint. It’s important to distinguish between an annual operating budget and a cash flow forecast.
An annual operating budget is an estimation of what the organization expects its income statement to look like at the end of its fiscal year. A cash flow forecast would typically start with the budget but convert it to the timing of sources and uses of cash. While the annual budget is considered a best practice for good governance and is generally approved by the board in a formal process. A cash flow forecast is typically developed by management to be used as an internal tool and is only shared with the Board when deemed necessary, such as justification of a substantial transaction or requesting a loan for working capital needs.
Many organizations find it difficult to justify the time spent on developing a cash flow forecast when their operating account is flush with cash coupled with time limitations and staffing constraints. Some organizations can simply dust off and update previous models that were developed for specific purposes such as feasibility studies, outside financing, revenue stream diversification considerations, etc.
Think about where we were two years ago. Many organizations had solid operations for the fiscal year ended December 31, 2019. Enter COVID-19 in March 2020 and organizations faced the beginning of a pandemic. Certainly, a pandemic isn’t the only thing that can cause major disruptions in the cash flow cycles of an organization. Think about the service interruptions, volume shifts, unexpected costs for disinfecting vs. cleaning, PPE, testing, and the various costs associated with working from home, such as technology and setting up offices, that were forced on organizations almost overnight. Then came the fears of a financial tsunami. Organizations wondered how they were going to make it? Many services were shut down for periods of time, without any expectation of knowing when they would be able to resume. We didn’t know whether it was going to last a matter of weeks or months. Some people thought it would be a matter of years. It turns out the latter were correct. Then along came the Federal Government and introduced 6 trillion dollars of stimulus funds into businesses and organizations in the United States. We had PPP1 and PPP2, Provider Relief Funds, SVOG, EIDL loans, Employee Retention Credits, a FICA deferral, unemployment cost relief for self-insured, Medicare advance payments, potential FEMA claims… among many other opportunities. It was virtually impossible to develop any type of cash flow forecast during such a period of extreme disruption. Most organizations only knew how much cash they had in their account on a day-to-day basis. However, some organizations did have their financial forecasts ready to project ahead when information became available and reliable. In essence, they were shifting from crisis and reactionary mode to more of a strategic mode.
Now, if we fast forward to today, we’re experiencing a COVID hangover, or put another way, financial long COVID. Dr. Fauci has already predicted a fall surge in 2022. New variants are popping up continuously. So, enough on why it’s important to have a cash flow forecast.
Now let’s focus on the “how” by discussing some of the considerations used when developing a practical cash flow model. Typically, a cash flow forecast uses longer-term thinking, with “longer-term” meaning more than one year. One year is good, but a longer period is better, keeping in mind that the further away we get from today, the less reliable it is. So, the further out we go, the more refining we need to do on a periodic basis.
When developing the cash flow forecast, it’s good to allow for a type of sensitivity analysis model, which can then be used for purposes of a stress test or, if needed, a cash burn rate, as many organizations experienced during the summer of 2020 and beyond. The most common models really boil down to two different types. The first is a strict use of a cash in and cash out model. The second, which tends to be more common and popular, starts with net income from the profit and loss statement. Then adjusts for timing differences, non-cash items such as depreciation, and lastly it factors in sources and uses of cash not affecting the income statement, such as loan activity and cash paid for capital purposes. One reason the second option is used more often is because it’s easier for a board or finance committee to understand when the starting point is similar to the operating results they’re used to seeing on a monthly or quarterly basis. It’s also helpful to develop a model that is fluid and will allow for real-time adjustments to inputs and outlier transactions as appropriate.
Once the forecast model is developed, adding relevant metrics such as days cash on hand and debt service coverage can be very useful when calculating the organizations future cash flow needs. These tools became vitally important once uncertainty was thrown into the picture with the disruption of COVID-19.
Most organizations would probably agree that expenses are much easier to forecast than revenue, particularly when you’re heavily reliant on State funding which has historically been uncertain and difficult to predict. Each year, the New York State budget becomes a major consideration in determining future funding. The January release of the Governor’s executive budget proposal frequently produces angst among service providers who have become accustomed to proposed rate cuts after applying spending caps, zero colas, across-the-board cuts, etc. The 2023 budget recently passed was around $220 billion. Depending on the services provided, many organizations were feeling pretty good about this budget while others were not. It’s interesting to point out that the 2023 budget is up from $170 billion five years ago which is a 30% increase and clearly not sustainable. Looking forward, how do you, as an organization, continue to adjust beyond one year and remain viable in your long-term strategic thinking?
When we think back to a year ago, most organizations were newly concerned about compensation rates and recruitment and retention. We became familiar with the term “The Great Resignation,” and now the focus is on finding available staff to provide services, compensating them adequately, and let’s throw in an annual inflation rate of over 8% as of March 2022. These factors become huge inputs in a cash flow forecast and the effects will be mostly permanent.
The last point worth mentioning is the ancillary benefit of having a well thought out cash flow forecast. You will impress your third-party stakeholders such as lending institutions and grantors, and let’s not forget your external auditors when you share a comprehensive cash flow forecast. It should also contribute to your annual budget process.
If the idea of developing and maintaining a cash flow forecast sounds overwhelming, we’re here to help. Reach out to one of the trusted professionals at Bonadio today. And please, most importantly, start thinking about this sooner than later to help better plan, rather than react during the next disruption in your cash flow cycle.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
