Balance sheet – a volatile driver of cash movements
Forecasting balance sheet changes can be somewhat more complex than forecasting profit and loss outcomes. It is fair to say that, in general, businesses focus heavily on their profit & loss reporting and have less focus on forecasting their balance sheet movements. 3-way forecasting gives the balance sheet movements a more prominent emphasis.
There are five broad areas of balance sheet movements that need to be forecast. These are:
- working capital
- fixed assets and investments
- loans and other long-term liabilities, and
- owner dividends and drawings
Cash is not actually forecasted in a 3-way model. It is the balancing figure. That is, the forecast EBITDA, plus forecast “other” income/expenses, plus the forecast movements to the five balance sheet areas results in a net cash inflow or outflow. The forecast cash position then becomes the starting cash balance plus the net cash inflow/outflow generated by the forecast.
Each of the five forecast areas has its own unique issues to deal with when forecasting for the upcoming period. There are usually factors that are business-specific as well. These are due to the type of business, existing trading and operational arrangements, and the business cultures, norms, and regular practices within each business.
At its most basic, working capital forecasting can use basic metrics such as debtor days, stock turns, and creditor days. However, in practice, it can be more complicated. Receivables forecasting can be complicated by bad debts, intercompany sales, or special offers. Inventory levels can be influenced by the existence of slow-moving and redundant stock, by long lead times where stock is made to order or purchased from overseas, or from stock build-ups ahead of seasonal production. Payables are more complex to forecast because a proportion of expenses do not come through the accounts payable process. Examples of this include remuneration costs and on-costs, and a range of prepaid expenses.
These can have a substantial impact on cash movements at different times. Businesses collect and pay GST, they withhold PAYGW from payroll and they withhold superannuation and payroll tax. There are generally arrangements in place with the ATO to pay income tax based on a predetermined formula
(eg: % of sales levels). This can be considered a prepaid withholding. And each of these withholding types could be paid by the business at different times, usually monthly or quarterly.
Fixed assets and investments
Capex plans need to be factored into the forecast. Fixed assets are purchased to contribute to output or to support management and administrative performance. We have found the annual budget process to have weaknesses in this area. Capex plans will regularly change in relation to timing, and this is best suited to a rolling forecast process. Capex costs can exceed planned levels and the implementation process can often be more demanding than initially thought. All of these issues can be best addressed when management can be responsive and can modify near-term plans in this area.
Loans and other long-term liabilities
Planning new financing requirements can be a key to successfully acquiring the necessary funding. Nowadays, most lending bodies are requesting 3-way forecasts to support their financing decisions. The 3-way forecast will demonstrate; the need for funding (its purpose), the business’ capacity to meet repayments as they fall due, and the business’ covenant position in relation to the lender’s required covenants.
Planning to meet upcoming balloon payments and other major liabilities that are falling due in the next 12 months is also undertaken in the forecast. This could include the repayment of shareholder loans or other related party loans.
Owner dividends and drawings
Finally, owner dividends need to be included in the forecast model. This can provide owners with a greater level of assurance that the planned dividends will be paid at the appropriate time.