Cash Flow Modeling: An Early Warning System to Manage Business Financial Health

The day-in day-out duties of running a business can give you a false sense of confidence that you have a good handle on the financial challenges that lie ahead for your business.  One of the most significant omissions that owners and founders make is not committing to a regular process that forecasts or models the cash flow of the business.

A regular review of your cash flow forecast can cause you to look at a wide number of variables that influence your business and when they occur on the downside in combination with each other can have a dramatic, possibly crisis, affect on your cash position.  A solid cash flow model or simulation of your business can serve as an excellent early warning system to help take corrective action and manage the financial health of your business.

Why is cash flow important? 

Cash is the lifeblood of any business.  It is easy to see it leave the business and how very hard it is to get cash to come into your company.  You management practices should be developed around the principle of protecting cash.  The unexpected will always happen and you need to have the necessary reserves to meet these unexpected needs.  Poor cash management practices will put you at risk and raise the possibility that your business will go out of business.

Cash Flow Variables

Income Statement

The Income (Profit/Loss ) Statement is an important element in the management of cash flow.  However, a profitable company can go out of business by not having enough cash.  How is that?  You may show a positive bottom line but that may not represent how payments are coming in from your customers, or how you are committing to increasing inventory levels, or payments for capital improvements.

Collection/Payment Cycles

You may record a sale on the Income Statement but that does not indicate that the money for the sale is in your hands.  The customer may not pay for 30, 60 days or in some cases much longer.  Your business model and cash reserve strategy is dependant upon what the average customer payment policy is (normally referred to as Days Sales Outstanding – DSO).  Companies that wait until the payment due date to begin the collection process often find that the customer is just starting the payment approval process.  Companies with a strong collection strategy will contact the accounting department well in advance of the payment due date to see if anything is preventing the payment of the invoice and this often leads to early resolution of any problems and a lower DSO than their competition.

A similar process is true when paying for items that the company has purchased.  Orders for nonregular items should be timed or planned with other regular payments such as payroll, tax payments, utilities, etc.  Poorly timed payment obligations can result in difficulties paying for badly needed items and if not taken seriously can result In a vendor putting the company on credit hold until your account is current.  Normally a company will take advantage of using the maximum payment period (Average Daily Purchases – APD) and take advantage of each dollar in its own cash flow.

Cash Flow Statement

A cash flow statement is a good start but is only a snapshot of conditions at the time. This can be done weekly using a rough cut method that includes the cash receipts that have been recorded from customers, what payments are scheduled to vendors, known weekly or biweekly payments such as payroll and associated benefits, utilities and rent, and bank balance.  As a result the immediate cash position can be reasonably determined.  The calculated cash horizon is very short term using this method.

A more comprehensive statement projects cash flow out several accounting periods – 90 or 180 days.  This type of analysis requires a lot of “predictive” or “forecast” data that have various degrees of accuracy and may include “conservative” or “sand bag” bias.  Knowing what assumptions were used in creating the various components is critical so that you can determine what level of confidence you can have in the projected cash balances.

Cash Flow Simulation

A good compliment to generating a static cash flow statement is using a simulation tool that models the important cash variables of your business.

What is the advantage of using cash flow model?  

The simulation tool (normally done in spreadsheet) allows you to vary the range of values for various P/L elements that are the primary cash flow variables.  Understanding the sensitivity of your business to various cash flow conditions can greatly help you develop short term or long-term strategies that will help you maximize your cash flow.  Key among these are DSO, APD, timing on buying of capital equipment, adding new people to the payroll, impact of pay raises and changes in benefits.  A simulation model can also be of value when developing management objectives and metrics, as the model will identify the operating factors that have the greatest value to influencing improved financial performance.

Simulation Example

I have developed the elementary cash flow model below hat might be used as an initial step toward developing a more comprehensive model that you or your CFO would use to manage your cash flow. The model shows that starting cash reserves (beginning cash) are good and for the initial three periods ending cash grows comfortably.  However, in period 4 a drop in sales along with the addition of new people on the payroll results in a negative cash flow for the period. In order for the company to continue to operate it must address the negative cash flow position with a cash infusion from its bank line of credit.  Seeing this in forecasted condition in advance, decisions can be made to adjust hiring dates, work with customers to bring orders in, offer spiffs to increase order activity, become more aggressive on collections, delay payments for materials, etc.

Please contact me (click here) if you are interested in trying this model out to help you make a decision toward developing a specific model for your business.  This model is for trial purposes only and is not intended to address cash issues in your company. The model also uses some pretty vanilla rules for DSO and APD to distribute the incoming receipts and outgoing payments.  You can alter the spreadsheet to be more specific to your business by adding line items or modifying formulas.


Good cash management requires a disciplined approach to managing cash in your business.  This is more than just the creation of the reports but is also dependant upon the business processes that produce the data used to drive the reports.  Accuracy and timeliness is paramount for reports to have a high level of confidence.  Using a simulation tool gives you an improved understanding on the degrees of sensitivity that various factors play in your business and significantly improves your ability to effectively manage cash flow.

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