Cash Flow Modeling

Cash flow modeling is the practice of using cash flow models to estimate a business's income and expenditure. It revolves around forecasting cash movements and factoring in varied scenarios to keep the business afloat in the near and far future.

Cash flow models forecast a business's expected amount of outflows and inflows of cash for management and planning of surpluses and shortfalls. It helps in predicting the future cash flows through which an organization's solvency can be analyzed. It aids in optimizing an organization's working capital and effective risk management. 

Cash flow modeling is the tool that is used to forecast and predict the cash flow in and out of an organization over a period in the future. It uses historical financial data, future predictions and expenses and income analysis. These give A detailed projection of the organization's financial health.   

Cash flow modeling involves cash flow drivers. They are elements of inflows and outflows of cash.  Some cash inflows are customer cash payments, interest income, collection of accounts receivables etc. They also include the sale of assets. The cash outflows include supplier payments, utility bills, employee wages and benefits etc. Cash outflows also include local, federal and state taxes.  

The strategic tool helps plan the growth and planting stability for the future. It aids in risk management through the estimation of cash shortages and surpluses that may occur. 

Businesses using the data can strategize risks, arrange financing, or identify cost-reduction areas to improve their liquidity. The cash flow helps understand where money comes from and where it goes. This helps businesses make decisions on expansion, divestitures, investments etc.  It also helps in identifying if or whether the company has operational efficiency. Similarly, efficient management of risks and ensuring stability can bring confidence to lenders, investors and stakeholders. 

Given below are some steps to build a cash flow model:

1. Financial data gathering - Organizations shall collect their financial historical data. This includes a company's cash flow statements, income statements and balance sheets from previous periods. This helps gain a comprehensive yet detailed purview of their financial history, revenue trends, cash flow and trends.  They can reveal patterns that can be used to make strategic decisions. 
2. Projection of expenses, cash flow and revenue - With the help of financial data gathered, companies can proceed with projections of future sales, cash flow and expenses. This step, hence, necessitates the analysis of past trends and critical estimation of future cash flow.  
3. Inclusion of expected changes - Organizations are subject to internal and external changes and all factors that result in it invariably affect the cash flow. These include expanding into a new market, introducing new products, etc. This is important as it estimates the cost involved in the changes, such as development costs, marketing expenses, incoming sales revenue etc. 
4. Adjustment of seasonal variations - Businesses go through cycles and, hence, are subject to seasonal fluctuations. This has impacts on the sales and expenses. Understanding these patterns can help organizations fall into unexpected losses or setbacks. Similarly, being aware of the market and the changes can also help improve the organization's future projections.  
5. Regular updating - Cash flow models shall be updated regularly as there may be continuous market changes and revenue-expenses changes. It helps businesses stay afloat in times of turbulence. 

Given below is a visual template of how a model of cash flow looks like

Source: Cash Flow Excel Template: Forecast Your Cash Flow (us-analytics.com)

Let us look into some examples to understand the concept better.

Example #1 - A Hypothetical Example

Imagine, Dan, a small business owner, is using cash flow modeling to plan for his future business expansion. For sales projection, he considers factors such as market growth, the demand of customers, the capacity of the business to meet the demand etc, to make predictions. Similarly, for expenses, he factors in fixed costs such as rent and employee salaries and costs such as material and utilities that are variable. These elements are considered to give a realistic approach to his model. Dan also tries cash flow modeling for asset-backed securities. This is to give him an idea of how much his company assets will help him get the desired financing. The use of cash flow modeling for asset-backed securities, along with regular modeling, gives him a comprehensive analysis coverage to help him plan for the future.

Example #2 - A Real-Life Example 

JP Morgan Chase & Co. announced a cash flow management tool incorporating artificial intelligence. The tool is free, and clients can easily perform cash flow modeling.  The tool analyzes an organization's cash flows and creates custom forecasts in seconds.

Given below are common mistakes that should be avoided while modeling cash flow 

• Improper gathering of data is a major drawback. Organizations need to gather, read and analyze data carefully. Poor forecasting leads to poor cash management, poor capital allocation, inadequate funds and high debt.  
• Over-estimation of future sales is another such issue. Estimation sometimes may vary from the actual results, which is why over-optimistic thinking becomes a negative factor here. Practical estimation can reveal a realistic expectation of inflows.  
• Not accounting for seasonal variations can be a huge problem, as sales can vary due to seasons. Pattern analysis of sales and revenue helps in revenue and risk management. 

Some of the reasons why modeling cash flow is important are given as follows.

• Modeling of cash flow helps in providing an understanding of an organization's operations.  
• It helps focus on liquidity, pushing thinking into improvement areas, such as processes, tools and controls that aid in cash flow. This helps management make decisions that suit the organization in whichever part of their economic cycle.  
• It helps anticipate the faults in cash flow management and the efforts required to correct them. This helps in the survival of the company in the long run.  
• It provides insights on transactions at the vendor level through changes in the line of accounting items. 
• Cash flow modeling helps provide weekly cash flow projections to lenders. They often require them to understand the chances of the organization going into liquidity, defaulting on debt payments or simply chances of failure to fund daily operations.  
• Preparing cash flow models can help improve capital allocation and better decision making. This is done by understanding the balance sheet's potential and looking for improvements, profitability and investment opportunities.
• Modeling cash flows helps in quick and strategic decision-making that could give companies a competitive advantage. It further provides inputs to decide on different issues, such as the need for slow customer collection and the limitations of such arrangements.