Avoid the Downside of Cash Flow Modeling Your Business

Cash Flow Modeling offers a number of upsides to proactive business management.  This discipline requires that the model represent a reasonable representation of how your business will respond dynamically to various business conditions, stimulus or adversity.  Consequently executive management can anticipate a cash crisis ahead of time, adjust the timing of various cash based decision, and establish strategies to address business processes and policies to better handle unexpected demands for cash.

However, a cash flow model can result in unintended consequences better known as downsides in business that can result in serious “cash” surprises.  The following details a number of conditions where you can be at risk when using a cash flow model in your business.

Model Validation
Building a cash flow model is not a trivial undertaking and requires the integration of business knowledge from various operations and departments and a high degree of attention to detail.  It is not unusual to “rush” a recently developed model into use without exercising the range of conditions it was designed to handle to make sure that the numbers produced are reasonable and appropriate.  Any model should be used for several cash forecast cycles to improve the confidence level of the model before putting it into use as a major decision tool. 

Executive Understanding
The model is not usually designed or built by members of the executive team but they are the ones who will ultimately make decisions based on what it produces.  Therefore, they must commit the time to understand the assumptions upon which it operates and its sensitivity to handling various parameters and the level of confidence that they can then place on the results.  The management team, for each cash flow projection, should agree and approve the table of assumptions and conditions that drive the model.

New Information
A model will forecast a cash position based upon a set of assumptions and parameters, which are carefully predicted values.  However, things happen and what was “assumed” to happen in a particular sequence or on a certain date in the forecast period and it occurs differently then that new information needs to be entered into the model and the forecast regenerated to see if there is any significant change in the forecasted cash position.  Executive management can then take corrective action if necessary.

A cash model must be reviewed at regular intervals to make sure that the table of assumptions and parameters are appropriate for the current and forecasted business conditions.  Another important element of the model are the formulas used to calculate data from period-to-period, which may be affected by regulations, processes and organization changes.  Your model will need to regularly have a “tune up” which will require key people to be involved for this maintenance responsibility.  In addition, a degree of (dreaded) documentation is necessary so that changes can be made accurately without putting the confidence in the model in doubt.

Forecast to Actual Analysis
Cash flow models are used and decisions made but it is common for the actual results to not be compared to the projections of the model.  No model is perfect and it is important to measure the degree of error (variance) that occurred as the time over which the model forecasted passes.  This allows the executive team to

  • Determine if the cash forecast was reasonable?
  • Understand the over (+) / under (-) deviation and why,
  • Did the model assumptions and parameters match the actual conditions that occurred?
  • Determine if new conditions were such that the model should be adjusted to account for them.

Do all of the considerations above void the value of using a cash flow model? No! Like any other business tool you need to know how to use it, when to use it, when it needs to be serviced and when to upgrade it. Effectively using a cash model and related process will give you a leg up in managing your business wisely and competitively.

Do not let the task of developing a cash flow model keep you from doing one. You will learn a lot about your business that will be invaluable. Your model can be developed in stages where with each new stage you can place increasing degrees of confidence in the results forecasted. Even an elementary model can be of value by causing you to bring all of the data together that influences the use of cash that would otherwise be overlooked. If you keep the value of the cash flow model in perspective and manage its role responsibly you will avoid many of the downside considerations discussed above.

Good luck in developing and using your cash flow model responsibly!


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