By Brian Hartford, Managing Director
Business clichés are a dime a dozen but few provide value when integrated into the psyche of business professionals. None speaks more truth to power than my personal favorite: “Cash is King!” Yet, even with an understanding of the importance of cash, many small and middle-market business owners are naive when it comes to cash flow management and forecasting. It’s especially true for those who are facing troubled and uncertain times. While there are many methods to predict cash flow from financial statements, the 13 Week Cash Flow Model (TWCFM) is the most reliable and dynamic tool for cash flow management and forecasting. In fact, when cash is tight due to growth or distress, it’s the model toward which all professionals gravitate.
The TWCFM is a simple tool that accomplishes many goals, and not just for owners and managers. Banks, creditors, stockholders, and other business constituents all benefit from a functioning TWCFM. But disbelieving clients are often skeptical. What exactly is it? And how can it possibly help the growth potential of—or, on the other hand, how can it possibly save—the business?
The TWCFM is a dynamic, short-term method to forecast all sources and uses of cash. It’s long-term enough to predict immediate liquidity needs without being speculative. It improves transparency by ignoring the accounting conventions prescribed by GAAP that tend to obfuscate and confuse readers of financial statements on the true cash position of the company. When the liquidity position of the company is understood in plain terms, developing and implementing a turnaround plan for the business becomes not just attainable but accepted by stakeholders and decision makers.
A “Failed” Cash Flow Model
Despite its simplicity, those who attempt to implement the TWCFM are frustrated when it “fails.” The truth is, though, often when a TWCFM fails, it’s actually working exactly as it’s supposed to function. At Newpoint, we’ve found many TWCFM users develop models that predict healthy, break-even cash flow, yet are confused when cash flow turns negative. In most cases, the model is illustrating a lack of transparency. Unlike five-year pro forma models that rely on GAAP methods to predict aggregate account values and accommodate rounding and forecast errors in growth and discount rates (such as discounted cash flow valuation models), the TWCFM requires the user to be as granular as possible. Down-to-the-penny is all but impossible in a five-year forecast, but is achievable in a 13-week period. When the TWCFM accounts for cash costs, it forces the user to understand how the business produces and consumes cash, thereby providing transparency to the liquidity position of the company.
When Cash Flow Predications Fail to Materialize
A client once developed a cash flow model that predicted the company would run out of cash in six weeks. With its line of credit frozen and all other sources of cash tapped out, the company faced serious choices. Inventory management, or lack thereof, was at the top of the list. The nature of the business afforded the client the opportunity to move closer to a Just-in-Time (JIT) management system. Inventory had a virtually unlimited shelf life, lead-time on new orders was 48 hours, and there was no borrowing base dependent on inventory levels. However, the 45 year-old family business maintained a healthy (but now not helpful) inventory level and a the idea of a JIT system pushed the boundaries of management’s comfort zone. Our client made the difficult choice to reduce spending on inventory and conserve cash as they headed into a cash flow ebb. As a result, rather than a cash deficit, we emerged with an even larger cash balance than we’d had in robust times.
The TWCFM predicted doom and gloom if steps weren’t taken. They were, and the day was saved. Surprisingly, our client was more skeptical than ever before of the TWCFM! In his mind, the company should have gone out of business right then and there, not come out stronger than ever. In his words, “This model is useless. It was way off!” He failed to understand the model did exactly what it was supposed to do: it predicted intermediate-term liquidity needs and highlighted the actions required to address those needs. We had the opportunity to explain this to him and it was a genuine “aha!” moment resulting in a bona fide paradigm shift.
TWCFM = Dynamism
A final benefit of the TWCFM is its dynamism. Because the model’s timeline is short, it can essentially be updated in real-time. As weeks pass, a TWCFM user can compare what was predicted to happen with what actually happened. By analyzing these variances, users can evaluate their forecasting skills and determine if they are as granular as they need to be. Weekly variances enable users to fine-tune their assumptions and increase the accuracy of the model as it is updated and weeks accumulate. And as users are educated on the true cash costs of a particular disbursement, the increases in accuracy reflect the granularity of the model.
The TWCFM is a reality check for all stakeholders. A well-developed model forces users to confront their bias and reveals a level of detail and transparency in the liquidity position of the business. This simple tool, when completed with objectivity, offers increased stability for a struggling company.