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In Today’s Email:

• 🔮 Forecasting Cashflow - Part 1

• 🔄 Direct vs Indirect Cashflows

• 💰 Easy money for KPMG

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THE DEEP DIVE

Cashflow Forecasting Part 1 - Direct vs Indirect Cashflows, and 13 Week Cashflow Forecasts

This is the fourth week in an 8 week season covering how to build a culture of cashflow obsession in your business.

“I need to understand exactly what the f*ck has happened here.”

I rarely get angry, but this had p*ssed me off.

Our 13 week cashflow forecast had worsened by $30m in two weeks.

The number was too big to be a ‘real’ variance. I.e. one explained by a genuine change in business performance. This was the correction of a forecasting error. And a big one.

But even worse, no-one could explain how the error had occurred. Not my VP of finance nor any of his direct reports.

They were in ass covering mode, and I was furious.

It wasn’t the mistake so much as the response to the mistake. This wasn’t how I worked. They were going to have to learn fast or learn on someone else’s payroll.

Meanwhile a young analyst had been working in the background during the discussion. She spoke up: “Take a look at this, I found a few issues in how we are actualizing the sales receipts.”

“Finally, someone has the courage and intellectual curiosity it will take to solve this problem. Thank you. Here’s what we’ll do. We are going to trash this model and start again.”

VP of Finance finally found his voice “Yes, we’ll do that. I’ll get the team together and we’ll present something back to you by the end of next week.”

Nice try.

“No, you misunderstood me. We are doing this now. Together. I’ll order the pizzas”

He pushed back: “Why don’t you leave it to us. Haven’t you got bigger and better things to be doing?”

“Are you f*cking kidding? No, I don’t have anything bigger than $30m to work on right now. We are doing this now.”

I was a few months into a new role. And there were two messages to land:

1. I do not accept sloppy sh*t like this anywhere in finance functions I lead.

2. We bring intensity to everything. But we reserve a special ‘volume 11’ intensity for cashflow matters.

I was also angry with myself. There’d been a few red flags on the forecasting process six weeks earlier. I should have acted sooner.

Over the next two days we broke down the 13 week cashflow process and rebuilt it. In one room we had a team decorating the walls with sticky notes; mapping and redesigning.

In the next room we had our two best Excel modelers (including the young analyst mentioned earlier) building the model from ground up.

We had the new model live inside a few days, and it worked a dream.

If something moved in our cashflow projections we could find and explain it easily. And then attribute it to an assumption or business owner.

My senior team engaged in weekly cashflow.

Clean and clear. As it should be. I could breathe again.

But better than that, they started to see things they hadn’t seen before.

By getting hands on in the weekly forecasting process, they started to feel the textures of the cashflows. The intra-week patterns. The monthly payment cadence. Which customers were paying erratically. Where inventory builds caused a pinch.

Inefficiencies that were hard to see before, now became obvious.

Within a few months we had list of hard opportunities to improve working capital by $60m. Real underlying improvements. (More on what they were and how we landed them later in the season).

And in the longer term the benefits were even bigger.

Cashflow moved up the agenda in monthly performance reviews.

The Long Range Planning process shifted focus to free cash flow return on net assets (rather than EBITDA.)

And even sales VPs started talking about working capital, and cash conversion, eventually ...

I’m getting a fuzzy feeling just writing about it.

This needed more than a good 13 week cashflow forecast. But it was the first step. No question.

So, it’s time for the single most important actionable advice in this whole season on cashflow.

A 13 week rolling cashflow forecast is the foundation of a strong cashflow culture.

If you aren’t running one, start now.

No nuance or exceptions here:

• The SMBs I own (one with sub $1m turnover) run a 13 week rolling cashflow forecasts.

• And so does the multi-billion $ corporation for which I’m CFO.

• Before long, I will run one for the finances of this newsletter.

The Cashflow Megaphone

When something changes in the economics of a business, the impact on cashflow is oftentimes bigger than the impact on profit.

Sometimes by an order of magnitude.

Whisper a profit impact in one end of a megaphone, and a cashflow impact will scream out the other side.

Here is why.

Imagine you have a business with $5m revenue. And $500k EBIT.

In round numbers, the business has:

• $100k of sales receipts per week

• $90k of supplier payments per week

• $10k of profit per week

I.e. transacting $190k of cash transactions per week, to make $10k.

A ratio of 19:1.

A small slippage of cashflows in the wrong direction adds up to a big number fast.

Business are hard wired to analyze through the profit lens. Finance teams need to change that wiring.

The 13 week rolling cashflow forecast brings to life the cashflow effects of daily operational micro decisions:

• Reducing settlement terms for a customer from 45 days to 30 days in exchange for another 5% growth.

• Resolving pricing disputes monthly instead of weekly to save an admin headcount.

• Increasing manufacturing run lengths to improve operational efficiency (but increase inventory)

These would all have a bigger -ve cashflow impact than their +ve profit impact.

In the short term at least.

That doesn’t mean they are the wrong thing to do. In fact, likely they are great ideas.

But they all have cashflow megaphone effects that need challenging and planning in.

Many businesses have died through driving for growth or more profit. But got suffocated by a consequential cashflow impact they didn’t see coming.

Get a hands on 13 week cashflow forecasting cycle running well in your business, and this will never happen to you.

The weekly rhythm pushes cashflow forwards on the agenda.

You will feel the fabric of the cashflows. And that familiarity will stop you committing cashflow self harm.

Cashflow Forecasting Methods

There are two methods for forecasting cashflow; Direct and Indirect.

They are different. Chalk and cheese, in fact.

Both valuable. But each used for different things.

Direct Cashflow Method

The Direct Method uses cash receipts and cash payments as they would appear on the bank statements. This is the same method you would use to plan your household cashflow:

• Start with the opening balance

• Add on cash receipts

• Deduct cash payments

• Finish with the closing balance

Indirect Cashflow Method

The Indirect Method relies on double entry bookkeeping to impute a cashflow analysis from the Income Statement and Balance Sheet.

It more conceptual. Starting with Net Income or EBIT and then using movements in the balance sheet to reconcile back to the closing cash balance.

Both valid methods.

The direct method:

• is simple to understand

• is easier to reconcile vs bank statements

• can get prepared by anyone with rigor and a few braincells

• is better over short time horizons (weekly)

• does not talk to the wider financial statements

The indirect method:

• needs a finance pro to prepare it

• is harder to understand for non-finance; more conceptual

• is more versatile

• is better over longer periods of time

• talks to the financial statements.

Indirect method cashflows get calculated from balance sheets. So you can only build them on whatever frequency you close your financials.

For most businesses this is monthly. So the indirect method cannot get used for a 13 week rolling forecast.

So by default:

You’ll be using a Direct Method cashflow for your 13 week cashflow forecast.

We’ll return to how to use indirect cashflows next week.

Building a 13 Week Direct Method Cashflow Forecast

An Example:

Whilst this only shows 3 weeks (1 week of actuals + 2 weeks of forecast), this is just to help readability of the image. You should prepare this with 1 week of actuals and 13 weeks of forecast, each week. It’s a landscape document rather than portrait.

Notes:

• Each row in the spreadsheet is an individual forecasting unit. These should be specified to fit the cashflows of your business.

• Behind each row you should have a forecasting method (even if its very simple).

• Each row should also have an agreed reforecasting frequency. Not everything needs to be re-forecasted every week. But be systemic about this.

• As you better understand your cashflows better with each passing week, that could mean adding more rows. To strip individual customers or payments out of general buckets.

• You could have a separate tab that forecasts every customer receipt date individually. This works well in small businesses where the volume is manageable.

• Complete the forecast by the end of Tuesday each week latest. Monday should be reconciling the previous weeks bank and actualizing last week's forecast. Tuesday rolling forward the forecast and reviewing.

• This should get completed by the treasury team, or the controlling team. Depending on the size of business.

• We will cover the ‘daily cash management provision’ and ‘effective cash balance’ (see bottom of the image) later in the season.

The senior finance team should review this together each week in 3 directions:

• Actual v Forecast. (Prior Week Actuals vs Last Weeks Forecast)

• Latest Forecast. (Full 13 Week Forecast Review)

• Latest Forecast v Previous Forecast (Variance analysis by row by week)

With a weekly routine, forecasting errors will have nowhere to hide. The forecast quality will improve by orders of magnitude.

And once you have suffocated the forecasting errors, the real value starts:

• Cashflow inefficiencies will become obvious.

• Working capital will become top of mind for the senior finance team.

• A cashflow mindset infects the rest of the business.

Two Common Pitfalls

There are two common mistakes systemic in most 13 week cashflow forecast processes, I see.

These two pitfalls also caused 90% of the $30m forecast issue I started this post with:

Error 1 - Transaction to Trading Handoff

In the near term weeks (weeks 1-4) you will be largely able to rely on what you see on the receivables and payable ledgers. I.e. you are forecasting cash settlement of transactions that have already occurred.

But this won't work for the more distant weeks (upto week 13). You will need to overlay forecast cash impacts of sales and purchases that haven’t occurred yet.

This is a weakness of the direct method for cashflows.

For example. If you have average customer settlement terms of 4 weeks, then at week 0 you have a high degree of certainty over customer receipts in weeks 1-4. But the sales receipts in week 13 will depend on sales in week 9, which are not yet certain.

This presents two challenges:

1. You need to make reasonable assumptions about sales or purchases to fill the gaps

2. The handoff from one method to the other needs to work well. The risk of double count or omission is high here.

Error 2 - Actualization

This takes us back to the cashflow megaphone point.

Gross cashflows are large, and are subject to big timing swings. Things move between weeks all the time.

Let’s assume you are in Week 0, and forecast to receive $100 in each of week 1 and week 2.

But roll forward a week and you have received $120, because one customer paid $20 early (that was due in week 2). You would ‘actualize’ the $120 receipt into the opening balance for Week 2. So as you reforecast cashflows for Week 2, you need to reduce week 2 receipts down to $80 to avoid a double count of that $20.

Simple enough?

Now try doing that at scale, for a business with thousands of suppliers and customers.

You can’t. So you need a systemic approach to timing differences. And a strong process to identify, estimate and adjust for big timing swings.

Weekly reviews and a disciplined process fixes this, but it takes a few cycles.

Homework

The most important homework of the season. But also the most straight forward:

1. Get a 13 week cashflow forecast live for your business.

2. Review at the highest level of the finance team each week

3. Challenge to improve accuracy, avoiding the two pitfalls

Do this religiously for long enough and good things will happen. We’ll cover where specifically to look for those good things later in the season.

Next week we’ll jump right into indirect cashflow forecasts, and how & when to use them.

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Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need]p