A Quick Guide to Cash Flow Modeling

FinLync | September 20, 2021

A Quick Guide to Cash Flow Modeling 

Having an accurate prediction of future cash flows is an essential requirement for treasury and finance teams, and can factor into everything from future borrowing needs to investment decisions. So what is cash flow modeling? And why is a cash flow model important? 

Cash modeling in a challenging market 

The biggest lesson for corporate treasury and finance teams in 2020 was the importance of having accurate and up-to-date information about the company’s liquidity position. In a highly challenging market, CFOs were urgently looking for real-time information that would help them assess the changing liquidity position of their organizations, and thereby decide how to react appropriately. As such, corporate treasury and finance were increasingly required to provide the CFO with real-time reporting. 

It’s not only important to know what the current cash position looks like – finance and treasury teams also need to understand the organization’s future cash flows. Historical patterns can provide a template in stable markets, but with the pandemic driving significant changes to customer behavior, companies’ revenues were impacted almost overnight. So with cash positions deviating considerably from expectations, cash modeling became more critical to help companies respond effectively to the unfolding crisis.  

What is cash flow modeling? 

A cash flow model is a way of forecasting the company’s future cash position. This involves looking at expected inflows and outflows in order to understand what the company’s cash position will be at different points in the future. A cash flow projection model may also include modeling various scenarios to see how different eventualities might impact cash flow in the future. 

Cash flow modeling is not to be confused with a cash flow statement model, which is used to measure how effectively a company is currently managing its cash position. Whereas a cash flow model or cash flow forecast looks at future flows, a cash flow statement looks at flows that have already taken place.

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How to build a cash flow model 

With a robust cash flow projection model, the company will be better placed to make effective decisions about activities such as borrowing and investments. First, though, the company needs accurate and up-to-date information – which is why real-time access to data forms an important part of the process.  

It’s also essential to choose the right cash forecasting model to fit the company’s particular objectives and characteristics. For example, companies will choose different reporting periods depending on the nature of their businesses. 

Cash flow model example 

A simple cash model would include cash inflows and outflows over a given period of time as follows: 

Opening cash balance $15,000
Cash inflows $8,500
Cash outflows $7,000
Net cash flow $1,500
Closing cash balance $16,500 

Benefits of an accurate cash flow model 

With real-time access to dashboards that are updated on demand, companies can create a good cash flow model that will enable them to make better decisions, plan for any cash gaps, use surplus cash effectively and make sure the company has enough cash available to meet future commitments. 

Real-time cash flow modeling provides corporate treasury and finance teams with instant access to information about the company’s revenue. But that’s not all: it also enables companies to understand the liquidity options currently available, and how quickly these can be harnessed to obtain cash. A further component of cash flow modeling is the ability to understand the company’s accounts receivable and, when appropriate, to help smaller business customers by extending payment terms. Likewise, companies can use information about future cash flows to decide whether to offer suppliers additional support by offering early payments. 

Cash flow modeling can also affect decisions about debt. Some of the corporate treasury and finance teams that fared better during the pandemic decided to use excess funds to pay down debt. In particular, some opted to pre-fund their retirement and medical obligations in order to put themselves on a better financial footing in the future. 

Why is an accurate cash flow model important? 

In practice, not all cash flow forecasts are as effective as they could be. So what are the risks if you don’t have an accurate cash flow model?  

For one thing, a substandard cash flow model can make it difficult to make well-informed decisions about short-term borrowing. Without a clear understanding of available balances and limits, the company won’t know how much to draw from its existing lines of credit. This can also impede the company’s ability to negotiate higher limits with their banking partners. 

An inadequate forecast can also have a negative impact on other treasury activities, including: 

  • Counterparty management. If you don’t have a real-time view of your company’s full debt profile, and of each counterparty, you won’t be able to get ahead in the line when it comes to accessing the liquidity you need from your banking partners. Banks are likely to be more willing to extend favorable liquidity options at the start of a crisis than they will be if you wait until months later when banks are already over extended.
  • Supply chain management. Without a clear view of your company’s suppliers and real-time accounts receivable, you won’t be well placed to manage any potential supply chain risks. The corporate treasury needs current information if it is to help find solutions to speed up the collections process. Likewise, the treasury team needs real-time information before it can provide support to suppliers that may impact the company’s ability to access materials in the future.   

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Benefits of real-time cash flow modeling 

Real-time cash flow modeling is key for corporate treasury teams when it comes to taking advantage of critical liquidity options. A global view of the cash forecast will enable the company to plan ahead, assess all of the options available, and react accordingly – for example, by minimizing funding costs, or avoiding potential penalties for breaching loan covenants. 

In conclusion, companies that have access to centralized solutions will be better placed to achieve an effective cash flow modeling process. This, in turn, can generate accurate cash flow models and position the organization for future success.