The Rule of 3 Scenarios
Once you clearly understand the cashflow you have and you have taken measures to tightly control it moving forward, you should shift your focus to the future. What does that future look like? Right now, many states are beginning to re-open their economies, but there are significant restrictions on how businesses can operate and at what capacity. How do you think things will play out in your areas of operation? To answer these and other questions you need to create a cashflow forecast.
You should begin with creating at least three scenarios: a best case, worst case, and base case (most likely). For every scenario, create a list of assumptions that will be applied throughout the forecast horizon. Each scenario will have different assumptions for the unknown future variables that are being estimated. Each scenario must include the following:
- Multiple time scales: the now, the next, and the later
- A list of all future events and uncertainties that could potentially impact your business
- Develop contingency plans for each scenario: What happens if you don’t hit it? What’s next?
- Define leading indicators for each scenario that inform actions
Your cashflow forecast should inform you on the business’s cash burn rate. The cash burn rate can be calculated in two ways:
- Gross Cash Burn Rate: The total amount of cash a business is spending per month. This should be calculated on a weekly and monthly basis.
- Net Cash Burn Rate: The net difference between cash in and cash out per period. If the number is positive, you’re not burning cash, you’re building cash!
For summary purposes, you can sum both metrics over your forecast horizon and then divide by the number of periods (e.g., number of weeks in the forecast or months in the forecast). Take each metric (Gross Cash Burn Rate, and Net Cash Burn Rate) and divide them by the company’s current cash balance, respectively. This is how long, in number of periods, the company has to survive and is also the amount of time management has to effectuate a turnaround or restructuring.
During times of stress, people tend to freeze up causing action paralysis. This inaction is almost always the worse reaction. Creating scenarios helps to plan out the steps that need to be taken ahead of time, given certain events.
- Your cashflow forecast should be at least a 13-week forecast
- Don’t fall in love with your Base Case cashflow forecast. Remember the old proverb, “Plans are worthless, but planning is everything.”
- Continuously monitor your economic environment for changes
- Have a contingency plan. Sometimes the best laid plans don’t work