Cash flow is the critical component in credit assessment. Our belief that the business can generate future cash flow to service and repay the debt being considered is of paramount concern in reaching a decision to lend. To determine whether the business is likely to to do this, we often ask the client to provide a cash flow forecast but unless that information is reviewed critically, there is really no point in asking for it.
There are some key considerations to be applied when reviewing a cash flow forecast. The following are some suggested steps;
- The assumptions on which the forecast is based have to be supplied by the client, otherwise the information is meaningless.
- As with operating budgets, most of the assumptions in the forecast are based on estimated future revenue. Lenders need to be comfortable that the estimates are reasonable taking into account the possible market and macro-environmental challenges that the business is likely to face during the period of time covered by the forecast. Don’t rely on past performance in doing this, consider the drivers of revenue and cash flow and how they will have an impact on the business in the future.
- Check that the level of operating expenses in the cash flow forecast corresponds with the latest financial statements. Some variation can be expected since the business is anticipating revenue growth. If there are major differences in the level of expenses the lender needs to know what the drivers are for the operating improvement or deterioration.
- Check that the debtors’ and creditors’ days are in line with the ratio analysis of the historical annual financial statements. If you have a budget alongside the cash flow forecast, the information can come from there – otherwise you can only get the assumptions underlying these figures from the person who created the cash flow forecast. Again, any improvement or deterioration in these collection and payment periods should be explained.
- Are there any inflows or outflows that are missing (especially loan repayments and interest) or alternatively, are there items that should not be included (such as depreciation, amortisation etc)?
- Is the opening cash balance in the forecast reasonably accurate? Check that against the balance of the bank account at the starting date of the forecast.
Remember that this is a forecast and will never be completely accurate. A prudent lender will use this forecast as a tool to check on progress when conducting future reviews with a client after the loan has been approved.