If your business has been negatively impacted by COVID-19, one way to help with the success rate is to model expected cash flows.

Cash flow forecasting

The future is changing and so should your cash flows forecast

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Mike Metzler, CPA, ABV, CMA, CGMA, ASA

COVID-19 has impacted every business in some way over the past months, some negatively and some positively. If your business is one that has been negatively impacted, one way to help with the success rate of your business is to model expected cash flows over the next 12 months.

Before a cash flow model is started, you should understand the key drivers of revenue, the cost structure of your company, the investment rate in fixed assets in the next year, and the terms of your company’s debt. Additionally, you can select the cash basis of accounting or accrual basis of accounting in your modeling. Here’s an explanation of the cash basis of accounting.

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In these volatile times, begin by modeling monthly revenue over the next 12 months and implement dynamic inputs. There are many ways to arrive at forecasted revenue. You can use price times volume, specific contract identification or analyze current back log. The point is, begin to understand how your organization’s revenue behaves and model what the next 12 months will look like. Be sure to put in the time to make the inputs dynamic, so as conditions change you can easily change the assumptions quickly and update the cash flow model.

Next, using historical data and what costs look like today, model cost of revenue and operating expense over each month.  Some costs will be 100% variable, some costs will behave like a step-function cost, and some are 100% fixed (don’t forget to model expected depreciation expense and interest expense). Again, try to model your cash flow dynamically so as revenue changes, appropriate costs will change automatically.

Another cash flow component are federal and state income taxes. Even though most enterprises are pass-through entities, meaning income taxes are paid at the individual level and not at the entity level, a deduction for income taxes is warranted because the cash to pay the taxes comes from the entity. Therefore, deduct 32% from earnings before taxes as a proxy for income taxes to arrive at net income.

Once you have modeled net income, add depreciation, deduct capital expenditures and deduct principal payments on interest-bearing debt.

Cash Flow Modeling (cash basis of accounting)
Pro Forma Net Income $100
Add: Depreciation 25
Deduct: Capital Expenditure Purchases 20
Deduct: Principal Payments 15
Cash Flow to the Shareholders $90

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You can model cash flow to the firm and cash flow to equity (which we have done above). The difference between the two is that cash flow to the firm is indifferent to the amount of interest-bearing debt (bank loans) your company holds and provides you an understanding of the total cash flow the enterprise is able to produce. Cash flow to the equity holders provides insight as to the cash flow the shareholders can expect to receive, both positive cash flow or negative cash flow.

Be sure to chat with your Henry+Horne tax advisor if you have questions or concerns about cash flow modeling. For more information and resources on COVID-19, see our coronavirus page.

Mike Metzler, CPA, ABV, CMA, CGMA, ASA, Director, specializes in litigation + valuation services including shareholder value maximization, fraud investigations, operations and more. He can be reached at (480) 483-1170 or MikeM@hhcpa.com.