Many times, I am called into a company that is in the midst of a cash crunch. It may be the result of any number of things — a dip in sales, an “underwater contract,” construction of a new plant, or some other unanticipated event.
Often, the client can manage its way through, at least for a little while. Then…
kaboom! A crisis hits — they run out of cash and/or the lender clamps down. They should have seen this coming, but didn’t.
How did they miss the warning signs? Simple. By not financially projecting what might lay ahead.
More specifically, that means developing a set of assumptions using (at least) three different future scenarios: realistic, optimistic and conservative to dire. As for time frame, 18 months to three years is about right. Anything beyond that is widely speculative and not of much use.
Most important is projecting the income statement and balance sheet for at least one year, and ideally three.
This can be done monthly or quarterly, but as a practical matter, it is often easier to have monthly models, since these are more useful when looking at the next one to two quarters.
Cash flow should be projected, too,
ideally as part of the balance sheet model (and not by using the
GAAP Cash flow
model that effectively “plugs” cash).
To ensure your projections are realistic,
check your projected benchmarks against recent historical benchmarks. Look at measures such as revenue growth rates, costs and revenue per unit of sales volume, capacity ratios and so forth. Check the balance sheet using measures such as Days Sales Outstanding (DSO), inventory turnover, projected vs prior years, Capital Expenditures (CAPEX), etc. See if any balance sheet items are too large or too small relative to past history.
Once the projection model seems reliable,
check liquidity and balance sheet ratios to make sure you are not headed for trouble.
Will you meet the covenants of existing loan agreements? Can you satisfy realistic requirements for any new projected financing? I wrote recently about
fixed charge ratios
, but look at
too. Will you need to have your credit line increased? Will you need additional financing to fund the path you are on?
Now that you have a viable model,
start running scenarios. Besides revenue upsides and downsides, look at planned capital projects and expenditures. Do you have the cash flow, balance sheet and financing in place to complete them? What happens if revenue declines or new projects get pushed back? Don’t forget that upside scenarios usually mean more revenue and more revenue takes more working capital, which takes funding.
Sure, in the short term you can stretch vendors, shave a bit in costs and find other ways to squeeze.
But is your business really generating enough cash, quickly enough, to get and stay current? Many of my clients haven’t done this exercise and simply kick the can down the road. When the pavement ends, I get the call.
A few tips and pointers…
Ideally, your projection model should be as “driver-based” as possible. In other words, rather than simply rolling forward historical account detail without a reason or extrapolating on a percent of sales basis, your projections should be rooted in realistic formulas. Unit sales volume times a unit price for revenue, for example. Or factory labor costs, which might be a productivity measure times labor unit cost. Sometimes things such as staffing levels for stores, etc., need to be manually set, given rough sales/volume ranges, minimum staffing requirements and so forth.
Your particular industry may have its own, additional relevant drivers. When I was in the rent-a-car business, we looked at things called, “daily dollar average for per unit revenue” and “revenue days for volume.” When I was in the paper business, the key metric was “tons produced times price per ton.”
But, if you don’t yet have a driver-based model, don’t skip doing this projection. Do the best you can with what you have.
Consider “reasonableness” when reviewing critical ratios and changes vs prior periods. Look at gross margins, operating margins, return on invested capital, etc. Many times, businesses think they can raise gross margins more or less forever. (That is what KKR thought when they bought RJR Nabisco.)
Sometimes, you will spot unwanted optimism. Other times, you will realize that
the collective effect of many individually reasonable stretch goals has led to unrealistic profit projections. Can you really grow revenue while cutting back sales and/or marketing? Are you projecting to be so profitable that there will be a competitive response, at which point you will become
For larger companies,
the reasonableness assessment can be a good corporate check on the annual planning process. When I was at Kraft Foods, for example, the annual plan process was suspect. In conjunction with an outside consulting firm, we in corporate built a projection model along these lines as a check against overly detailed business unit plans. All sorts of issues came to light. The International unit, for example, had submitted the same detailed plan in local currencies (pre-Euro) for five years in a row! Our model allowed us to take out the optimism baked into operating unit plans and get a better sense of where the company was really headed. In fact,
the annual planning process, which is often really a goal setting process, is not a substitute for a separate, objective look ahead analysis. Same for periodic company-wide forecasts. And in larger companies, Treasury should do these analyses for financing purposes, anyway.
You can’t drive a car safely without looking further ahead than just the road beneath your wheels. You can’t operate a business safely that way either.
Make time to honestly and realistically assess what’s on the horizon. The news won’t always be good, but at the very least, you’ll have some warning of what lies ahead and time to adjust as needed.