13-week cash forecast – insights lead to action

October 2020 | SPOTLIGHT | FINANCE & ACCOUNTING

Financier Worldwide Magazine

October 2020 Issue

Cash is king. When the economy slows down and companies begin to experience the effect of lower revenues, thoughtful management of a company’s liquidity becomes critical. The 13-week cash forecast is a fundamental tool for managing liquidity in good times and in challenging times.

At the most basic level, analysis starts with a book-based cash balance at the beginning of a week, then adds expected collections, deducts expected payments and estimates a cash balance at the end of the week. The cash balance is then rolled forward to the following week and the analysis is repeated. Thirteen weeks is the most common forecast period.

This period is a good balance between the certainty of early week collections and payments and a longer view that provides management time to develop responses to any shortfalls. Longer forecasts are often prepared but can become less reliable in the later weeks as the timing and magnitude of future sales and collections become less certain.

Preparing a 13-week forecast can be an extremely complex process, but the forecast loses utility if the results are not clear and easy to read. Management and lenders need to quickly understand the analysis so that the insights can be used to develop solutions. As an example, forecasting collections can be complicated by having multiple product or service offerings with varying customer payment cycles. Best practice is to prepare detailed analytical schedules that support a high-level summary.

Lenders will often require companies to provide pro forma financial projections on a quarterly or other basis. These pro forma income statements or profit and loss projections can provide insights into the future prospects and profitability of a company. The 13-week forecast does not replace those projections; it is a supplement that provides insights into future liquidity. Put another way, pro forma profits are not the same as cash and cannot be used to repay a loan (or meet payroll).

When companies begin to experience financial stress or distress, liquidity management is essential. Lenders want to understand where cash is being spent, how it is collected and if there will be enough to keep operating while management develops a response. Lenders want to understand that management is being diligent and practical in these circumstances. Lenders may also require budget to actual variance reports on a weekly, bi-weekly or monthly basis as a check on how reasonable the forecast was. Overly optimistic analyses are hard to disguise when collections lag and expenses exceed forecasts.

Lenders will often ask about collections. Conducting the detailed analysis required to prepare a weekly cash forecast can lead to a deep dive into the value of certain customer relationships. These forecasts should be based on actual experience, not on standard terms that may not be enforced. A common insight from this exercise is that low-margin, slow-paying customers require a significant amount of working capital.

Management could respond by redirecting sales and marketing efforts toward faster paying customers or change pricing strategies for slow payers. Offering prompt-pay discounts to low margin customers may increase revenues, but negatively affect liquidity.

Lenders will also ask about funds being spent on inventory. The detailed analysis required to forecast inventory needs may lead to insights into purchases that can be deferred or avoided. As an example, management should evaluate if replenishing stock of slow-moving inventory during a liquidity crisis is the best use of limited resources. Conducting this analysis, developing a strategy to manage inventory during a liquidity crisis and sharing those insights with lenders will enhance management’s credibility.

Evaluating a 13-week cash forecast requires a dive into the assumptions underlying each line item.

Collections can be forecast on a top-down or a bottoms-up basis. With either approach, questions to consider include the reasonableness of applying historical or average days-to-collect experience to the current market and whether the customer base is homogenous with consistent payment histories. Sales forecasts drive collections during later periods. Evaluating these forecasts is critical to assessing the reasonableness of the cash collection forecast.

When evaluating expenditure forecasts there are several points to consider. Management may have more control over expenditures than is appreciated. Inventory purchases can be deferred, or payment terms revised. Depending on the strength of the customer relationships, for project-specific materials it may be possible to require a deposit to cover the cost of materials.

An analysis of historical general and administrative expenses will inform an assessment of projected expenditures.

For example, annual payroll costs may include holiday bonuses or incentive compensation. When preparing a cash forecast, management should carefully consider the timing of these payments. Expense accruals are not the same as pre-funding expenses. Another example is property taxes that are typically paid once per year. The expense is recognised over the course of a year, but the cash transfer occurs at a single moment.

The importance of the 13-week forecast comes from the early warning management gets about impending liquidity crises. The worst-case scenario occurs when management discovers the company is out of cash when payroll comes due. Early adoption and implementation of a 13-week cash forecast analysis is essential to managing liquidity. An early warning that a company will run out of cash in 10 weeks provides management time to develop and implement solutions.

John D. Baumgartner is a managing director at Stout. He can be contacted on +1 (713) 221 5149 or by email: jbaumgartner@stout.com.

John D. Baumgartner

Stout