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Financial forecasts and projections can be an important tool to help guide decision making for any business. To learn more about the differences between forecasts and projections, check out our previous blog post here.
One of the many uses of forecasts and projections is modeling monthly cash flow and working capital balances. For more on cash flow management, take a look at this previous blog article titled Turning Profit into Cash Flow – Managing Working Capital.
Now that we have covered the basics, let’s take a closer look at what forecasts and projections are, and how they can assist you in this type of planning.
A forecast of future results depends on assumptions that reflect probable expectations for a business. Assumptions are commonly derived using both historical results and management’s judgement, and might include revenue and expense growth rates, timing of accounts receivable and payable collection, and anticipated capital expenditures. In a scenario where growth has been steady in the past and few changes to operations are expected, a forecast can give a glimpse into the next few years.
A projection is similar to a forecast; however, changes to regular business operations may introduce unpredictable elements to expected future results. A projection can be used to model different financial scenarios based on hypotheses for how these factors will play out.
In any comprehensive forecast or projection, all three financial statements should be considered and income statement results must be integrated with the balance sheet and cash flow statements to maximize their usefulness as planning tools.
Consider a hypothetical business, Company A, that is forced to close for 12 weeks during the COVID-19 pandemic. Company A has cash in the bank from a steady cash conversion cycle that is rarely disrupted. Management believes that operations could resume in either of two ways after the closure:
Management prepares two income statement projections with hypotheses about future sales levels, one for the best-case scenario and one for the worst-case scenario. Months go by and the return of customers is slow, but steady. Given management’s planning for two scenarios, they are not surprised by the slower revenue recovery. As part of their income statement projections, they determined that even in the worst-case scenario, the temporary reduction in travel and promotion (both fixed expenses) resulting from the pandemic would allow them to remain just above their break-even point and still turn a profit.
At the end of the year, management reviews financial results and identifies some significant issues:
Company A focused on maximizing revenue, but their assumption that their cash conversion cycle would remain unchanged from previous years led them to a low cash position and, ultimately, a lot of stress.
A comprehensive projection that included an integrated income statement, balance sheet and cash flow statement could have given Company A more insight into their future cash needs. As a planning tool, this could have helped Company A manage their working capital in their uncertain situation. It could have also highlighted the need for (and ability to support) external financing to bolster their cash position until the collections on accounts returned to normal.
The example of Company A highlights the utility of a comprehensive forecast or projection in managing short-term business planning needs. A longer-term plan is just as important if you are making capital budgeting decisions, introducing new products and services, or have been thinking about selling your business. Smythe Advisory can assist in preparing forecasts and projections to help you plan for these scenarios and more.
For more information about this topic, or if you would like to discuss your individual situation or need assistance in preparing a forecast or projection, please contact Alex Wong or Mike Berris directly or fill out our Get In Touch form and one of our experienced Advisors will reach out to you.