3 June, 2014, by Gemma Morgan-Jones
Stealing From The Bottom Line
Speaker: Professor Bob Berry, Nottingham University Business School.
Understanding the ‘cash’ in cash flow forecasting
Bob begins today’s seminar with a simple four letter word: cash.
Understanding cash is the key to effective cash flow forecasting, but what is a forecast and why do we forecast? That is what Bob will be unpacking in today’s presentation.
Every year within companies there is a panic to produce ‘The Budget’. Once the document has achieved its intended function of persuading the bank manager or investor to hand over some cash, it is promptly stuck in a cupboard and never referred to again. Yet a forecast should first and foremost be a management tool.
What is the bottom line?
People often think that ‘the bottom line’ = profit. Profit is actually what’s left after everything else has been taken into account, including interest and tax – Profit After Interest and Tax (PAIT).
A new interpretation is that the bottom line is the most important thing, but it’s important to bear in mind that when we do our accounts, revenue includes promises to pay as well as cash payments.
Bob cites an example of two school children selling junk food in the schoolyard. One sells to children his own age and size who pay him there and then in cash. The other sells to older, bigger children who promise to pay tomorrow. Theoretically, from an accounting point of view, both generate the same profit, but whose position is stronger? The truth is that the bottom line for most businesses is cash.
A bathtub is a useful analogy for cash flow. We picture a bath with a certain amount of water in that represents our starting cash. The water flowing in via the tap represents our cash inflow. The water flowing out via the plughole represents our cash outflow.
Starting cash + Cash inflow – Cash outflow = Cash remaining
Forecasting cash flow
The real value of forecasting is to reveal when our stock of cash is dwindling; when there’s not going to be enough cash to pay the bills at the end of the month. This empowers us with the knowledge to respond by either reducing our internal claims on cash flow or sourcing external cash.
What about commercial cash flow forecasting systems?
If you have a copy of Excel and even the most basic spreadsheet skills, you don’t need a commercial forecasting system. Some commercial forecasting systems add statistical tools, but how many of us really understand them, asks Bob. The most important thing is to understand what you are forecasting and why.
99% of business forecasting is not objective; it’s subjective. People create forecasts that “feel right” based on what they “think is going to happen”. When consulting with a business, one of Bob’s first priorities is to get to the bottom of why. If you cannot explain why you think something will happen, the chances are your forecast is not objective.
All forecasts are the consequences of assumptions. The word ‘if’ is key.
Some ‘automatic’ forecasts are easy, like how much tax you will have to pay the taxman ‘if’ the business makes a certain amount of profit. But other, non-automatic forecasts prove much more difficult.
“If I get that new customer then sales will increase by £10,000”………but only if.
So how do we do this well?
- Start by deciding what to forecast. What are the most important items?
- Decide what is the right level of detail. For example, do you forecast total sales or sales by customer? Is the time unit in days, weeks, months or years?
- Accept that a forecast isn’t an end in itself. It is information for a manager and if the manager can’t make sense of it, then what use is it?
Certainty, risk and uncertainty
So what should a forecast look like? That depends on how you view the future.
Most text books assume the world is certain; that only one thing can happen and that it will happen.
A more advanced text book will say the world is risky; that several things can potentially happen, but again that only one will happen.
The third alternative is that the world is uncertain; that there are too many outcomes to even list. This requires the acknowledgement that we simply don’t know all the things that might happen.
Forecasts and explanations
There’s a danger in assuming that when people use the word forecast, they interpret it in the same way that you do. There’s a difference between the “most likely” outcome and “expected value”.
People labour under the misconception that a good forecast will tell them exactly what will happen and exactly when it will happen, but this is incorrect. A good forecast will simply enable you to say, “This disaster may happen unless I do something to prevent it”.
It’s important to emphasise the range of possible outcomes when forecasting. Bob’s preference is to always include at least one very pessimistic view of the future and a contingency plan.
Most business people are educated to be go-getters, which generates in us a tendency to be optimistic and overly confident. We tend to exist under the illusion that we have more control than we really do and so forecasters’ personalities have a tendency to get in the way of their forecasts.
Bob concludes that to do a better job of forecasting, we need to get behind the forecast itself to the assumptions. We need to continually challenge ourselves by asking why we think certain things will happen. And we have to be clear that a forecast only tells us what might happen, rather than what will happen.