“That’s an amazing ROI, let’s do it!”
- said no smart entrepreneur ever
When you are assessing a new business idea, like opening a shop, expanding a product line, or even building a company from the ground up, you might rightly start with estimating your Return on Investment (ROI). Put simply, the ROI indicates how much more you would be earning by making that investment than by leaving your money in the bank to accumulate interest. But it won’t say more than that. In particular, the ROI won’t tell you much, if anything, about the cash flow challenges you would be imposing on yourself.
Say you’re thinking of purchasing a cab. Presumably, from day one, you will be driving clients around and making returns on your investment. Now say instead you are thinking of purchasing a new plough machine that will allow you to plant larger tracts of land before the winter. In that case, you probably won’t see much of a return before the spring. These two investments might well have the same ROI, but they’re not equal from a cash flow perspective. One of them - the plough-machine - has a higher risk of leaving you cash-strapped for months.
Assessing a venture’s cash-flow risks is a bit more involved than calculating its ROI. It requires building a cash flow model to project and review cash ins and outs, ideally until the investment is fully employed and at minimum, over an initial period of 12 to 18 months. Below is a sample cash flow model, of the kind that Bernoulli Finance builds for clients. Often, we not only project the cash on hand but also the credit balance, and use the tool to monitor the difference between projections and actuals every week. We also develop separate projections for different divisions of a business, enabling us to locate cash flow-risks and assess the health of each division individually.
Your cash flow model can relate your cash story, its triumphs and pitfalls, using several indicators. Some important indicators include:
. Cash on hand, which is the amount of cash you can readily access. You want this indicator to be comfortably positive at all times. If your simulation shows your cash on hand dropping into the negative - which, in reality, is an impossibility - this means that you will have to lean on some form of external financing to keep the venture going. Unless you already have this piece of the puzzle figured out, this drop is likely an indication that your cash-flow risks are way too high. You should take a step back and figure out what you can do differently (or simply not do) to protect your business.
. Cash runway, which is the amount of time for which your business could keep running on existing cash in the event that it suddenly stopped generating revenue. What if a critical piece of equipment on your production line broke and needed two weeks to get fixed? What if this year’s harvest turned out particularly poor? Your cash runway will tell you how prepared your are to weather through (and survive) such unpredictable challenges.
. Cash coverage ratio, which speaks to your ability to pay off any obligations on your business capital. It can be calculated as the ratio of cash on hand to interest expenses. One reason why this indicator is important is because it is requested and scrutinized by banks and other lenders when you apply for a loan or a credit line. A cash coverage ratio of 1 says that you have just enough cash to pay off your interest expenses. Ideally, you should aim at a comfortably higher number.
But let’s go back to the creation of the cash flow model, and specifically to the projection of cash ins and outs, which is the hardest and lengthiest part of this exercise. The key to doing it efficiently resides in two principles: consolidating and identifying patterns.
Consolidating is about pulling together cash flow items that are reasonably related. For example, it generally makes sense to have a single projection encompassing electricity, water, cleaning, and other utilities or maintenance costs.
Identifying cash flow patterns is important to avoid having to estimate and manually enter cash movements separately for each week in your projected timeline. Cash movements always follow a pattern of some sort that you can model in Excel (or another spreadsheet software). At Bernoulli Finance, we’ve boiled it down to three pattern types:
1. One-time pattern that applies, for example, to the purchase of a delivery truck. It is costly enough to be an entry of its own in your cash flow model, and probably happens only once in your projected timeline
2. Periodic pattern that applies, for example, to office expenses, which are incurred every month, if not more often. You can model such cash movements simply by identifying their general frequency (e.g. weekly, monthly, etc.) and their average value per period (e.g. $200/month). Sometimes, getting a little fancier is important, like when you’re projecting revenue, which is rarely constant across a year. In such cases, you ought to layer up your projections with seasonality and growth rate factors.
3. Multiplier pattern that applies for example, to sales tax, which is proportional to sales. There is no need to create a sales tax projection from the ground up. All you need is to multiply the already-projected sales by the appropriate tax rate.
Once all cash movements have been consolidated and projected, their simple addition is your cash flow model. Mind you, I am not trying to make this sound simpler than it is. It is a pain, especially if your day job is not finance but it is not as daunting as might first appear. Also, the few hours that you will put every month into updating your cash model and checking your projections will likely feel better spent and more gratifying than those you’ve had to use filling emergency loan applications in the past.