Objectives
- Why is it important for an SME owner to get a grip on their cash flows through forecasting?
- What are the common definitions of cash flow?
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What is forecasting and how can it help an SME owner?
Why Get A Grip on Cash Flows?
If you are a business owner looking to exit in the next five to ten years, getting a grip on your cash flows (and being able to forecast them) is a critical step towards a successful exit. Why is this?
First, any prospective purchaser of your business will examine at least the last five fiscal years of your business and will sift through them with a fine-toothed comb to determine what is referred to as “normalized” cash flows (usually measured by something called EBITDA). EBITDA stands for earnings before interest, taxes, depreciation, and amortization and this is the usual measure of cash flow within an operating business. When businesses are being bought, sold, or valued, EBITDA is generally normalized. This refers to a process that eliminates one-off revenues and expenses, as well as adjusting certain expenses such as executive compensation to their fair market values. The objective of normalization is to derive the true economic profit of the business. Since EBITDA plays such an important role in valuations, by being able to forecast your EBITDA, you will have a better idea of how your business valuation (and overall economic health of the business) is trending.
Second, a growing business often times requires investments (or cash outflows) to later produce returns on those investments in the form of new revenues (cash inflows). Not all cash outflows are reflected in the income statement. For example, capital expenditures are important but are not directly reflected in the income statement. Other examples include paying down corporate debt, paying dividends, and changes in working capital. Forecasting cash flows helps you as an owner to adequately plan out the cash inflows and outflows that are not reflected in the income statement but if not managed, can result in unforeseen cash crunches that can impair a business (which can temporarily or permanently lower its value).
The third reason forecasting cash flows is important is that once you adopt a value creation mindset, your primary objective shifts from minimizing taxes to maximizing sustainable cash flows. Forecasting allows the owner who embraces a value creation mindset the ability to have both insight and foresight into the value creation activities of the business and provides objective ways to measure that value creation.
Lastly, as Alan Miltz popularized, “Revenue is vanity, profit is sanity, but cash is king.” This phrase emphasizes the fact that one can fool themselves into thinking they are creating value and growing by increasing revenue or profit, but at the end of the day, only cash is the true life blood of any company and it represents the reality of a company’s financial position. A company can increase revenues by taking on low-margin (and value destroying) business. Profit can be manipulated upwards by deferring expenses and using accounting tricks. Only cash is real. Ask your banker!
What is Cash Flow?
So how do we define cash flow? While EBITDA is the most known and used definition, it is deficient in many regards because it ignores other types of cash inflows and outflows that are analogous to corporate ownership. Net discretionary cash flow (sometimes referred to as “free cash flow”) is a better metric because it also takes into account the following:
- Changes in working capital;
- Changes in capital expenditures (net of tax shields);
- Normalized owner’s compensation; and
- Normalized expenses (including accounting for non-recurring expenses).
Net discretionary cash flows represents the amount of cash available for dividends, bonuses, or making reinvestments in the business. It is also commonly the metric of cash flow used to value many businesses by certified business valuators. By understanding, and regularly tracking this metric, you can better plan out discretionary expenditures such as bonuses, dividends, and business investments in growth-related activities (such as sales, marketing, infrastructure, operations, or capex for expansion purposes).
How Does Forecasting Help?
A forecast implies some vision into the future (usually at least 12 months) but can be broken down into whatever time period makes the most sense for the company’s managers. By forecasting discretionary net cash flows, you as a business owner can get the most true vision of how your cash flows are going to be trending in the next 12-18 months. This will allow you to foresee cash crunches well ahead of time (something the bank will certainly appreciate if you are borrowing money from them) along with getting a feel for the overall health of your company. If your cash flows are consistently trending upwards, the overall valuation of your business is most likely also trending upwards. By incorporating working capital and capital expenditures into the equation, you can better manage your operating lines of credit (used to fund the former) and term loans (funding the latter). Forecasting will also help you understand the drivers of various classes of expenses that may be of a fixed or variable nature and it is through that understanding that you can better manage those expenses in the future.
Think about it like this. If a substantial amount of your wealth is tied up in your business, and cash flows are a major determinant in any business valuation, doesn’t it just make sense you would want to better manage and predict your cash flows, especially if you have set a specific time goal on when to exit your business?
Another important aspect of forecasting is adding in a sensitivity analysis. A good forecast will usually be presented with three scenarios: a base case, pessimistic, and optimistic. The base case is the most likely scenario to happen based on the best knowledge the owner has at a given time. The optimistic scenario should be realistic (not a pie in the sky projection) and represent what is likely to happen if we make favourable assumptions with key variables. Similarly, the pessimistic scenario needs to be grounded in reality but representative of what might happen if unfavourable assumptions are made on key variables. A sensitivity analysis allows managers to better steer the business by foreseeing potential opportunities (or potholes) well in advance.
Conclusion
In conclusion, forecasts are only as good as the assumptions being made and it is important to monitor the accuracy of forecasts over time so that the company’s forecasting abilities continuously improve. Forecasts can never be perfectly accurate since the future is not fully under our control, but a reasonable forecast can help to steer an owner to increasing the value of their business over time leading to a successful exit.