How to spot cash crunches ahead of time

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Profits are nice but cash flow is what really counts. If there isn't enough money coming in to meet payroll and debt payments, a business may not be around for long.

Cash-flow modelling can help ensure that unexpected cash crunches don't crop up. All that's needed is a recent set of financial statements and a spreadsheet. It's easy enough for a business owner to do on their own. But an accountant can save time and make sure it's done right.

"Cash-flow modelling is one of the most useful tools a small- to medium-sized business can use. It allows the business to forecast how certain decisions or events will affect their business," says Colleen Gibb, a fellow of the Institute of Chartered Accountants and head of Gibb Widdis Chartered Accountants Professional Corp. in Ancaster, Ont.

"Basically, a business can begin with their most recent year of actual financial reporting and prepare a cash-flow analysis to show where the funds have gone," she adds. "Once you have the past year's cash flow prepared you can build in the changes you expect to incur and understand the impact to cash flow before it becomes a huge operational issue."

Cash-flow modelling is often done when a firm is thinking about expanding, making an acquisition and/or applying for a line of credit, says John Wright, a chartered accountant and director of assurance services at McLarty & Co. in Ottawa. Lenders, in particular, like to see an analysis that provides some assurance that loans and interest can be repaid.

To illustrate how the technique can be used, consider a simplified example using a table provided by Mr. Wright for hypothetical company ABC Co. As can be seen from the "Equipment acquisitions" line, ABC Co. is thinking about buying equipment in Periods 1 and 2. How will these acquisitions affect cash flow? Will they require special measures?

ABC Co. cash flows

In Period 1, cash flow from operations (CFFO) falls short of tax, debt and equipment payments by $20-million. But the line of credit (LOC) covers the deficiency and leaves $10-million to spare. No problems here.

In Period 2, CFFO leaves a shortfall of $35-million after deducting tax, debt, equipment and the cash deficiency from the previous period. The line of credit will cover $30-million of this, leaving a shortfall of $5-million.

The company will therefore need to consider delaying the purchase of equipment in Period 2. Alternatively, it will need to find cash from sources such as inventory liquidation, collecting receivables or new sources of credit.

In Period 3, there is still a cash shortfall of $2-million after the line of credit is applied, even though no more equipment is bought and CFFO has risen to $75-million. Again, either the equipment purchase should be postponed or cash needs to be drummed up.

In Period 4, there is excess cash of $1-million after inflows and outflows are balanced. So the equipment purchases could perhaps be justified over a longer term, but interim financing would still be needed in Periods 2 and 3.

Actual cash-flow modelling is, of course, more complicated than this simplified example. To provide one small indication, consider the calculation of cash obtained from accounts receivable. A formula may be needed to reflect the percentages of customers that pay after 30, 60, 90 and 120 days.

Cash-flow modelling can also be done on a monthly basis using the monthly budget as a starting point, continues Mr. Wright. Cash deficiencies can show up in selected months of the year, so it's important to anticipate them and take action.

Ms. Gibb provided some examples of applications. In one case, a small business operating without an operating line of credit had the opportunity to expand its customer base by selling into the United States.

"Cash flow modelling was used to project an increase in sales and an increase in accounts receivable." Also factored in were increases in purchases of goods for resale, inventory levels and shipping costs to the United States.

"These changes are built into their prior year's cash flow to determine if the company is still able to operate without a line of credit, or whether they will experience a month or more of negative cash that will require a line of credit."

The model allows the company to test assumptions and project different scenarios. "Say they had initially predicted sales would increase by 50 per cent. The modelling program allows them to reduce the sales growth … and to assess the risk," she adds.