Cash flow or profitability: what should you focus on?

?As a business owner, should cash flow or profitability be the focus of your financial planning?

“Both, and also keep an eye on your balance sheet and a dozen of different ratios!” I can already hear hardcore finance analysts scream.

They do have a point. Diligent approach to all aspects of financial planning does have its benefits and they do have large finance teams in big corporations for a reason.

But if you run a services firm with 10, 20 or 30 employees, I recommend you focus on cash flow forecasting. In most cases, if your cash flow is strong, this will also mean you are profitable.

You can’t do everything

If you run a small or medium services business, most probably you don’t have any in-house finance experts.

An external accounting firm is preparing reports on your past transactions, but when it comes to planning the future, it’s all on you. And financial planning is just one of 20+ of your responsibilities.

Cash flow forecasting is unavoidable. Other aspects of planning are desirable - but you can skip them if you are doing a decent job on cash flow forecasting.

Why is cash flow forecasting essential?

“Will we be able to pay all our bills on time?” is the main question that cash flow forecasting helps to answer.?

Your planning horizon should cover a lot more than the next couple of weeks. The best practice is to plan at least for the “revenue cycle plus 1 month”.?

“Revenue cycle” is the amount of time it takes to win and deliver a new engagement/project, invoice the client and get paid. For some companies it can be as little as 2 months, while for others it can also be 6, 9 or more months.

“Revenue cycle + 1 month” is recommended for a very simple reason. What if your cash flow forecast suggests you are going to have a cash shortage during the coming months??

If it is a temporary cash shortage, you might as well prevent it by accelerating some of your current projects, negotiating extended payment terms for a few payments to suppliers or securing a temporary overdraft with your bank.

But in some cases such simple tricks won’t work and the only real solution is to win and deliver more work. So you want to see such problems coming while you still have time to react - therefore “revenue cycle + 1 month” is the period you have to forecast for.

Can a strong cash flow be misleading?

If your cash flow forecast suggests your company will have a healthy cash reserve during the coming months, can your company be loss making and with a weak balance sheet? Yes, it can - but this happens very rarely. Main keywords are “advance payments” and “loans”.

If your company is lucky enough to have negotiated large advance payments with most of its clients, it can temporarily have a lot of cash in the bank despite running a loss-making operation.?

However if you forecast for a sufficiently long period of time (“revenue cycle plus 1 month”) you will notice that your cash reserve is set to shrink very fast and this is a major red flag. When investigating the reasons for this, you will uncover the true reason, i.e. that you plan to spend more than you receive from clients.

Strong cash flow can also be misleading if you are planning to borrow from banks, shareholders or other parties. If you are not careful, this funding can be spent to finance a loss making operation rather than investments into making your company stronger. A simple test for that is to subtract the expected loan balances from your expected cash balance over the entire period that you are forecasting for.

How to pick all the right signals from your cash flow forecast?

In one sentence: forecast for a sufficiently long period, have a very granular forecast, review it at least once a week and zoom in on the project level.

We already covered the recommended duration of your forecasting period. But it is equally important that your forecast is granular enough.?

It is ok to cluster several smaller transactions into one - but it is not ok to cluster days into weeks or even months. It is tempting to do only monthly forecasts. But even if the forecast shows you will receive more than you will pay others during a particular month - what if most of the incoming payments are likely to arrive at the end of the month while most of the outgoing payments need to be paid during the first week of the month?

Daily forecast at least for the next 3 months can help mitigate this risk. Also, it makes a lot of sense to review your forecast at least once a week as your assumptions may change very quickly. The sooner you detect potential problems, the higher the chance that you will prevent them!

Lastly - it is very helpful if your forecast allows you to “tag” planned transactions and see not just the overall forecast for your company but also cash flow forecasts for each of the major engagements / projects that you deliver for your clients. Zooming in on the project level will help detect the need to renegotiate payment terms with certain clients or suppliers or it can also signal profitability issues.

All of that - a granular forecast for a long period that gets updated every week and allows you to zoom in on a project level - sounds and actually is very time consuming if you use a spreadsheet for cash flow forecasting.?

Therefore we built Tailwindapp.eu: Simple & Easy Cash Flow Forecasting - a visualized and automated tool that helps to be in control by spending just 5-10 minutes a week, is free of any accounting jargon, always starts on today's date, allows to zoom in by any criteria you can imagine and updates itself every time you log in. Cash flow forecasting can and should be simple!