Purpose of cash flow projections
The main objective of cash flow forecasting is to determine the company’s repayment ability. This can be broken down into 2 main categories: operating expenditures (OPEX) and capital expenditures (CAPEX). Working capital requirements are the short-term obligations that the company needs to meet for daily operations. These operating expenditures are the cash outflows for inventory, vendor payables, rent/utilities, contract labor, and payroll. Capital expenditures are larger cash outlays for machinery/equipment, property (such as warehouses), vehicles and other assets that will increase the business’ capacity.
An effective cash flow model will allow management to determine the timing of cash requirements and evaluate the impact of raising capital on future cash flows.
Cash Flow Projection Basis
There are some basic principles about the relationship between the balance sheet and income statement to remember when constructing a cash flow forecast. Revenues drive the income statement as sales determine variable direct costs and long-term revenue growth necessitates expansion through investment in assets that increase capacity. The income statement thus steers the balance sheet as sales require receivables, inventory, and payables management.
With this foundational approach to considering cash flow needs, the company must determine the limits of its operating performance to evaluate the investments needed to facilitate growth. Accordingly, the best place to start a model is to determine the company’s Annual Sales Growth Rate (ASGR). For startups with operating history, calculating year-over-year (YoY) revenue growth, and examining the trends in growth is the best starting point for forecasting this growth rate into the future.
The next step is to determine the company’s Sustainable Growth Rate (SGR), the maximum revenue growth the company can afford without issuing new debt or equity. The SGR incorporates a few key concepts:
Retention rate: 1 - dividend ratio
This is the percents of earnings that the company will keep invested in the business and is driven by the percentage of profits the company will pay out to equity holders (the dividend ratio). Note that this should include amounts that owners take out of retained earnings as a return of capital.
Return on Equity (ROE): Net Income / Avg. Equity
This metric shows how much profit (net income) the company generates per $1 of equity investment. It is thus derived by taking net income over the average amount of equity over the period that profit was earned.
Once you have these two calculations, you can multiply them together to determine your SGR. Thus the formula for SGR (often mathematically referred to as g in financial planning models) is:
SGR (g) = (1 – dividend ratio) x (Net Income/ Avg. Equity)
Growth rate analysis
With these calculations complete, the company can compare its ASGR projections with its SGR to determine if additional resources will be needed in the future to drive growth. Put simply:
IF ASGR < SGR: The company has sufficient capital to grow the business if it maintains its current ROE and Retention Rate.
However,
IF ASGR > SGR: The company will require an increase in capital to finance its growth as it scales.
Returning to the financial statements, growth rate analysis can thus be summed up as follows:
If the future sustainable growth rate exceeds the anticipated revenue growth, then the balance sheet will not be negatively affected by growth. If revenue growth exceeds the current capacity, then the balance sheet must grow as well.
Strategies for improving your cash flow
Companies can improve their cash flow and thus limit the amount of outside capital they need to raise by making internal improvements to enhance profitability. This can include increasing margins by improving labor efficiency, reducing inventory breadth to lower holding costs or securing more favorable pricing on inventory. Companies can increase their cash “float” by negotiating longer payment terms with its vendors and correspondingly speeding up collections on outstanding receivables by tightening credit policies. This is known as improving your payable deferral period. Additionally, you can consider short-term debt, such as lines of credit, to bridge the gap related to working capital deficiencies, however, short-term debt should not be used for your growth capital requirements as it is more expensive than longer duration debt agreements.
For closely held companies, the easiest solution is often a deferral of compensation paid to owners and an increase in earnings retained by the business (remember the Retention Ratio). These considerations should be factored into OPEX and working capital assumptions as the business projects their cash flow. Other considerations should be paid to CAPEX, for example, consider if repairs and maintenance are an option so that large purchases can be delayed until profitability improves with scale.
There is a compounding affect for making these internal improvements as it not only improves the company’s cash flow, but it also strengthens the company’s financial position which will make obtaining financing easier and more affordable when it is ultimately required.
Important liquidity metrics
To monitor liquidity and effective cash flow management, a company should focus on these key liquidity ratios:
Current Ratio: Current Assets / Current Liabilities
The current ratio measures the ability to pay its short term liabilities with all of its current assets. This is often also called the Working Capital Ratio. A current ratio of under 1 indicates a need to obtain new financing as the company will not be able to meet its upcoming obligations. However, a ratio of > 3 is often indicative of less than efficient operations. This means that the company is likely not invested sufficiently in the business for sustainable growth.
Quick Ratio: Current Assets (excluding inventory) / Current Liabilities
The quick ratio is similar to the current ratio, but focuses only on the most liquid assets of the business, i.e., assets that can be most quickly converted to cash. Accordingly, inventory, which typically has a longer conversion cycle to cash are excluded from assets.
Cash Ratio: Cash and Cash Equivalents / Current Liabilities
The cash ratio is the strictest measure of liquidity as it only considers cash balances relative to liabilities. This very stringent ratio is less popular as it disregards other assets that can be highly liquid, however, if you want the most conservative measurement of liability it can be helpful to monitor.
Determining your cash burn rate and cash runway
When growth rate analysis shows that the company will require additional funding, the next natural question is: “How much will I need and when?”
This is where the concept of “burn rate” comes into play. The burn rate can be thought of as gross burn rate which is the total monthly amount of cash expenses and the net burn rate which is the difference between monthly cash from sales less the gross burn rate.
Once determined you can calculate your cash runway, the amount of time before capital runs out.
Cash Runway = Cash on Hand/ Net Burn Rate
Ideally, the company should have a year to 18 months of cash runway as this provides sufficient time to evaluate financing options, attract investors, submit applications for loans and allow operations efficiencies and other cash flow strategies to make an impact. If you find that you are short of this target then aim to raise amounts to get to this level of runway, considering any changes in CAPEX that will be required over this time horizon.
Conclusion and actions items for CPG startups
Keeping a watchful eye on your company’s financial hygiene has a compounding affect on its growth potential. The daily decisions made that improve efficiency and preserve capital build a strong balance sheet, improve credit risk, and allow for greater flexibility in evaluating financing options when the company needs cash. Many startup founders find that the time to maintain and analyze financial data necessary in determining growth rates and capital requirements directly takes away from their operational duties. Reliable financial data and simplified planning and analysis are the table stakes for making informed decisions. MyPocketCFO eases this burden by consolidating these prerequisites with an all-in-one solution that also provides access to experienced fractional CFO’s and a partner network of lenders to help you determine when you will need capital and connecting you with those that can provide it.
