This is CFO Secrets. The weekly newsletter that loves nothing more than to sit with a hot cup of cocoa and an ice cold balance sheet.

10 Minute Read Time

In Today’s Email:

• 🔮 Forecasting Cashflow - Part 2

• ☠️ Fraudsters Upping their Game

• 🤬 A Sweary Review

A WORD FROM THIS SEASON’S SPONSOR…

THE DEEP DIVE

Connecting the Dots - Indirect Cashflow Forecasts & Downside Planning.

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

I am lucky to have had some outstanding mentors.

CFOs who have done much bigger jobs than I’ve ever done. And maybe will ever do. CFOs who went on to be CEOs and Chairs of large public companies.

Old boys and girls who have seen it all.

Despite their decades of wisdom, there’s often only one thing they would share of real value. The one thing I wouldn’t hear elsewhere.

This was one such conversation with a particularly wise old figure. Let’s call him Gandalf.

It went something like this …

Gandalf: “What is the worst thing that can happen to a CFO?”

Me: “Getting fired, I guess …”

Gandalf: “Haha. You are kidding, right? I got fired four times, and I’m still breathing. If getting fired is the worst thing that happens to you in your career, you should thank the stars. Think harder.”

Me: “I guess the worst thing would be to f*ck up so badly that I lose my reputation. My name, face and resume became toxic.”

Gandalf: “Bingo. And how would that happen?”

Me: “Two ways. One: A major integrity or fraud issue. Two: A good business goes bust unexpectedly on my watch.”

Gandalf: “Correct. I’ll assume number 1 won’t be an issue, so let’s talk about 2. Your first duty as CFO is to make sure you don’t run out of cash. To be precise; at any moment you need to be 95% confident you have enough available cash for the next 18 months.”

Me: “Why 95%?”

Gandalf: “100% confidence is impossible, and 99% confidence is expensive. Liquidity costs. At 95% it means you’ll get it wrong once every two decades. That’s an acceptable level of risk.”

Me: “Makes sense. And why 18 months?”

Gandalf: “Because that is enough time to react if things go bad.”

Me: “What if it isn’t fixable? And 18 months isn’t enough”

Gandalf: “For most problems it will be. It’s enough time to shoot adrenaline into business performance. Slash costs. Close loss making businesses. Then get 6 months evidence of better numbers. And still have time to raise money if needed.”

Me: “And if it’s not enough time?”

Gandalf: “If you’ve done those things, and it’s still not solvable, it was likely not solvable in the first place. Your job is to marshal a ‘crash landing’. Operational restructuring. Financial restructuring. Chapter 11. Maybe worse.”

Me: “OK, but that still sounds kinda sh*t.”

Gandalf: “It is. But your reputation will be in tact if you see the problem coming, and manage it well. It will be experience for you. A badge of honor. But if the problem creeps up on you, it will be a turd with your name on it. Forever.”

This message was clear; forewarned is forearmed. But the real value from Gandalf, were the parameters. 95% and 18 months. I still use these today.

Every month I review an 18 month Indirect Cashflow Forecast with two scenarios:

1. Base Case - What I expect to happen - A median outcome

2. Sh*t Case - Reasonable worst case - A 5th percentile outcome. (100 being best and 0 worst)

I then plan balance sheet and liquidity needs. Ensuring that we are ‘default alive’ on the sh*t case.

This is the best method I have seen for balancing capital efficiency with liquidity.

Today we will break it down.

Last week we talked about the two different methods of building cashflow forecasts. Direct and Indirect. This post will assume you have first read that post.

Direct is well suited for short range forecasting (13 weeks).

Indirect cashflow forecasting is perfect for mid range forecasting; 18 months and beyond.

As a reminder. The Indirect Method relies on double entry bookkeeping. It imputes a cashflow analysis from the Income Statement and Balance Sheet.

It’s more technical than the direct method, but also much more versatile.

You can use indirect cashflow forecasts for any period for which you have a P&L and Balance Sheet forecast.

But today we are going to focus on using Indirect Cashflow Forecasts for a rolling 18 month period. Here’s an example:

Just like the 13 week rolling forecast, getting the right headings and structure for your business, makes it 10x easier. So customize your template accordingly.

Here are some notes against each row that will help:

Process Notes

• Remember; GAAP is unimportant here. This is for internal stakeholders, and a forecast. Use a template that suits your business.

• You should cycle the forecast monthly. The biggest challenge will be actualizing each period. The same challenge we talked about last week in the weekly forecast.

• This is easier if you have a robust monthly commentary of actual vs budget / forecast cashflow. This should help identify any timing considerations for actualizing.

Scenarios

You should maintain two scenarios that are run monthly; The Base Case and The Sh*t Case. There is a third scenario needed in special circumstances (more on that in a moment)

Building a Base Case

This should be your ‘median expectation’. What is your most likely outcome? The assumptions used should connect to your wider FP&A cycle. Use the budget or latest forecast.

If you want stakeholders to recognize the output, they need to recognize the assumptions.

Building a Sh*t Case.

This is more judgmental. You are looking for a 5th percentile outcome.

Treat this like a thought experiment.

What would a ‘reasonable worst case’ actually look like? What would a 1 in 20 poor performance look like (in numbers)? 10% worse than budget? 50% worse? Depends on the volatility in your business. You should risk adjust downwards from your base case line by line.

Make sure you can verbalize these assumptions. If there is a problem, it’s important you can explain it to your Exec and Board in a straight forward, fact based way.

Example:

“Our downside cash modeling shows if we miss EBITDA by more than 30% over the next 12 months, then next years working capital outflow will sink us by Easter. We can mitigate this by increasing our overdraft limit, or cutting headcount by 10%. We have 3 months to act.”

Clear. Measurable.

This Sh*t Case is your safety net as a CFO. It’s not just the insurance policy on the Company. It’s the insurance policy on your reputation.

If you blindly sensitize every assumption, its useless.

And if you don’t risk adjust enough, you will get blind sided too often.

There is a skill to this, which needs to get combined with good business knowledge. Art and Science.

The Third Scenario

In some circumstances you may need to run a Third scenario. In situations of high growth with high positive working capital you will need an ‘upside case’. In this scenario, when sales and profit go up, cashflow weakens fast. It creates a J Curve.

In an extreme case, this could mean cashflow in your upside cash is weaker in the short term than even in your sh*t case.

This is also known as ‘overtrading.’

This is a first world problem, as long as it is foreseen and gets managed well.

A good 18 month rolling forecast scenario is what ensures it is foreseen.

Plenty of otherwise great businesses have been killed by this phenomenom. Most commonly; ecom startups.

We will cover this in more detail later in the series.

You have Forecast Scenarios, What Now?

Once you have forecast scenario. You can plot your Available Cash by month. Here’s a plot for the example used earlier (with a Sh*t Case included)

In this example, it shows a base case is very positive, but the sh*t case shows a negative available cash balance in a years’ time. This is driven by a need to repay $1,000 of debt in month 15:

Here is the beauty of 18 month cashflow modeling. And where it differs to 13 week cash forecasting. If there is a hole in your 13 week cashflow cash balance, it’s panic stations. That is an immediate survival threat, and you need to orient every decision around short term cashflow. That damages businesses.

But here there is no cause for panic. And why an 18 months horizon is so important. There is time to course correct.

And the base case is fine, so we are talking about contingency planning. Not an existential crisis.

Next question is this. Are there levers to pull? You see that there are a bunch of heavy capex investments scheduled for Months 13, 14, & 15.

By pausing these investments, you can keep the available cash balance in your sh*t case above water. Even after making the debt repayments:

You can quickly draw the following conclusions and messages to your Board and Exec:

1. You expect cashflow to be positive based on the base case

2. You do, however, have $1,000 of debt to repay in a years time, so need to keep an eye on this

3. In the downside scenario, without mitigation the debt repayment will take you underwater

4. But, there are discretionary capex investments that can be deferred if necessary

5. If you track closer to the sh*t case than the base case, you can then decide whether it is better to cancel the investment plans. Or raise new funds. Capital allocation question. To review monthly.

6. Meanwhile, even in the sh*t case you expect a minimum of $500 surplus cash for the next 12 months. So you can lock $500 into 12 month treasuries. The rest you should cycle through 1,3 or 6 month treasuries, once it is generated, based on the forecasts at that time.

Your level of panic in these situations should be directly correlated to the level of control you have.

Specifically, the control over recovering the shit case to a position of positive available cash. If your level of control is <100% you should have some level of concern. Until its 100% again.

In the example, the level of control is 100%, because of the ability to reschedule investments. Maybe this has other consequences, but that is a separate point.

A Couple of Pro Moves:

• Tie your treasury management policy directly to your 18 month cashflow forecast. How you hold cash is dependent on how much surplus you have vs base case, and sh*t case.

• Extra points If you can align your 18 month cashflow forecast to measure Maintainable Free Cashflow. I didn’t do that today, to keep the example simple.

Capital Inefficient CFOs

One of your atomic duties as CFO is to optimize capital allocation.

So many CFOs are inefficient here. They either:

a) hoard cash they don’t need ‘just in case.’ This is expensive for the business and shareholders. It often leads to laziness in forecasting and cost management.

b) run too fast and loose with liquidity, and need money at short notice. Money at short notice is always expensive.

Both are a function of a weak finance team.

And a weak understanding of the medium term cashflow outlook of their business and scenario ranges.

Follow this week’s homework and you won’t fall into the same trap:

Homework

1. Build an 18 month rolling cashflow forecast model fit for your business

2. Feed it with ‘base case’ assumptions from your latest budget / forecast outlook

3. Give deep consideration to what a 5th percentile outcome would look like. What would that do to your base case assumptions

4. Model the sh*t case

5. If the sh*t case says you do not have enough cash, model the internal levers you could pull to fix it if required.

6. If there are not enough levers you need to work on a specific contingency funding plan. A plan to make sure you are ready to move to secure the balance sheet if you have to. What is your plan if the 5th percentile comes true?

7. Draw a treasury policy for how you handle cash, and manage debt that fits your profile.

Next week we tackle the real secret of cashflow management. Working Capital.

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THIS WEEK ON SOCIAL MEDIA

Girds is always on point…

On a serious note though. I heard from a Big 4 partner recently of examples they’d seen of fraudsters leveraging AI to produce bogus callbacks (using a model trained on the voice of the CEO / CFO). Be on guard.

A great piece from President of the Twitter CFO Sneakerhead Communit; Robert M Sterling:

Preparing a P&L is not the same as understanding a P&L. And you cannot be a great CFO is you don’t understand how a P&L works. This is not a skill you will learn in an accounting or audit function. You need to get closer to where the sausage is made.

FEEDBACK CORNER

A review of the last post:

I’m glad the content is helping you muddle through, Alex. Unfortunately, titles are cheap in finance. Anyone can call themselves a CFO. Over time I intend to use CFO Secrets to set the bar for what businesses and their owners should be able to expect from a CFO.

PS - Alex found the sweet spot for a guaranteed mention in this newsletter; profanity and praise. 👩‍🍳👌

AND FINALLY…

Next time, we’ll dive into indirect cashflow forecasting (aka cash forecasting for grown ups).

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Stay Crispy,

The Secret CFO

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