Bridging the Gap: Effective Cash-Flow Sensitivity Analysis
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Cash flow is the lifeblood of any business. When you’re cash-flow positive, you can pay your bills on time and maintain a good relationship with vendors and other stakeholders.

When it turns negative, watch out: even a business that shows a profit on paper can find itself in dire straits. Modeling your company’s cash-flow sensitivity can help you forecast your cash situation and address any potential shortfalls before they happen.

“It’s about making sure you have sufficient cash on hand to meet current obligations and anticipating fluctuations in receipts and disbursements,” says James Hicks, head of treasury services at Regions Bank. “Honoring obligations is critical to the relationship businesses maintain with their supplies, balancing against being nice to clients when it comes to receivables.”

Here are the key components to setting up a cash-flow sensitivity analysis:

What if? A cash-flow sensitivity analysis begins with a simple tally of all expected inflows (client receipts, loan proceeds, etc.) and outflows (vendor and loan payments, capital expenditures) in a given period. The formula is: current cash balance + inflows – outflows. But what if the cost of raw materials rises unexpectedly? Or if sales are lower than expected? You can account for these possibilities by incorporating them into a new scenario and seeing how they affect the end result. By preparing a most likely (base) case, best case, and worst case scenarios, you’ll have a clearer sense of what might lie ahead. Let’s look at the two key factors involved: revenue and cost drivers

Revenue. Like peanut butter, revenue comes in two varieties: smooth and chunky. Smooth revenue is steady and predictable, (e.g., the income from service contracts or other ongoing revenue streams). Chunky revenue experiences peaks and valleys to varying degrees of predictability, which may be seasonal or project-driven or even based on the market conditions your clients face. Most businesses have a mix of both, but the “chunkier” your revenue, the wider margin there is between best- and worst-case scenarios. Remember that unless you’re in a cash business such as retail, revenues are not equivalent to inflows. Base your predictions on the payment habits of your clients, rather than your terms. If, for instance, you offer 30-day payment terms but your largest client takes 45 days, use the longer timeframe.

Cost factor. Costs, too, may be more or less predictable, (e.g., fixed costs like rent, variables such as raw materials, and unexpected expenses such as equipment failure or weather damage). A gas station, which sells a volatile commodity, will need a larger cushion against price fluctuations than a service provider such as a law office. Variable costs should of course be calculated as a percentage of revenue, to rise and fall according to your income forecasts.

What now? If you anticipate a shortfall, Hicks explains, you can draw from an investment savings account or line of credit. “That can come in a couple of forms,” he says. “There’s the traditional line of credit, or you could use a purchase card for receivables: Your supplier is paid today but you have 35-40 days before you have to pay the balance.”

A cash-flow sensitivity analysis is also an opportunity to review your cash conversion cycle – how quickly you’re converting inventory into sales and sales into cash. Pay particular attention to trends in inventory levels and client payments. If your inventory is growing, you may be looking at slowing sales. If your clients are taking longer to pay, they may be under pressure to reduce their own purchasing. Adjust your negative scenarios accordingly.

Finally, consider the time frames you’re looking at. Hicks recommends performing analyses with 90-day, six-month, and 12-month horizons. “You should also match the remedy with the time frame,” he advises. Brief shortfalls can be offset with short-term credit or purchase-card transactions, but regular or longer-term deficits may indicate a need to increase your savings cushion or consider a term loan. “The more time you give yourself to anticipate need,” Hicks concludes, “the easier it will be to come up with solutions that keep your business viable and poised for long-term success.”

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© 2015 Regions

This information is general in nature and is provided for educational purposes only. Regions makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented. Information provided and statements made by employees of Regions should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Regions encourages you to consult a professional for advice applicable to your specific situation.