15 March 2021

An Integrated Financial Forecast | The Three Legged Stool

An Integrated Financial Forecast

A cashflow forecast is different to a profit forecast.  Understanding the difference can be the difference between success and failure in a business.  You can make a profit but loose cash.  You can be generating cash but not be making a profit.

Why just a cashflow forecast or just a profit forecast is incomplete

Let’s look at an example.  You buy an item for £4 and sell it for £10.  That’s £6 profit.  What if your customer only pays you 30 days after you sell the goods to them and the supplier of goods won’t let you have them until you pay for them in full?  In this situation, you need £4 to set up trading and then wait 30 days before your customers pay you £10.  It’s profitable – but you’re £4 down in cash for 30 days.  If you wanted to sell 10 items you would have to fund 10 x £4 for 30 days.  If your customers didn’t pay you on time, that funding need would be for longer.  So it’s a profitable business but the more business you want to do, the more cash you need to initially fund it.

A cashflow forecast will show the £4 out immediately and the £10 in 30 days later.

A profit forecast will show the item being sold at £10 with a £4 cost, making a £6 profit.

Neither is wrong, but in isolation each forecast gives an incomplete picture.

Balance sheet within the integrated forecast

Let’s extend this example to look at this business at day 15.  You’ve already paid for the goods and made the sale.  You’re owed money by your customer, £10, but have not received it yet.  How do you compare this to someone who had sold the product for only, say, £8?  You need to be able to produce a snapshot at any point in time showing the cash you have now, the money you owe your supplier and the money you are owed by your customer.  In accounting terms this report showing a snapshot at a point in time is called a balance sheet.  A balance sheet linked to the cashflow and the profit elements gives the full picture as you can now see what you have now as well as what you will receive and pay out in the future.

3-way refers to 3 reports, each an essential leg of the stool

Being able to see the profit, cashflow and balance sheet all linked together is known as an integrated, or 3 way, financial forecast.  3 way refers to the three financial reports, being the Profit (commonly referred to as Profit and Loss), Cashflow and Balance Sheet.  This gives a full picture of the forecast position of the business of any point in time.  Changing any assumption or figure will automatically feed through the model and update all aspects in all three reports if needed.  This is a 3-legged stool and without any one of the 3 legs it will fall over and not fulfil its purpose.

Other factors

In our simple example above we have only looked at cash, suppliers and customers.  There may be VAT, loans and other factors to take into consideration.  Every factor that changes profit or cash will affect the other and the snapshot as well.  An integrated model will ensure all these are tied together seamlessly.

Banks often require an integrated forecast

Banks and other lenders often ask for an integrated forecast because of the overall picture it gives.  They will set covenants (ratios that must be hit) as a combination from the three linked reports, as focussing just on cash or just on profit will likely lead to distortions.  An integrated forecast gives an overall view of the business and allows meaningful “red flags” to be set.  These are early warning signs allowing corrective actions to take place in good time.

Due to the linked nature of an integrated forecast it is more complex than a standalone cashflow forecast or profit forecast or balance sheet forecast.  It is a 3-legged stool and without all 3 legs it will fall over.  The forecasts cannot be produced independently and then stuck together, somehow hoping they balance.  The model must fundamentally be designed to accommodate an input feeding through to all three elements.

In summary, an integrated, or 3-way, financial forecast pulls together the Profit, Cashflow and Balance Sheet financial reports in a linked model, allowing changes in inputs to automatically feed through all three.  This gives a complete overall financial picture which any of the reports looked at individually does not do.  It’s a balanced three-legged stool and if you’re not careful just using one leg in isolation could leave you a bit wobbly.