Digging Deeper With Cash Flow Sensitivity Analysis

March 2011

Effectively managing cash flow is what keeps you in business. Understanding its sensitivity—the cash flow "what ifs"—and how it can affect your business, can help you better prepare for any eventuality.

"What we're talking about in general is looking at the issues that impact not just revenues, but at the ways cost streams and net cash flows are affected by the market at large—competitive issues, cost drivers, etc.," says Mike Boehlje, Distinguished Professor, Ph.D., Purdue University, and part of its New Ventures program. "Cash flow sensitivity analysis is about performing 'what if' scenarios. For example, how will an unexpected cost increase of 3% affect cash flow? Modeling cash flow sensitivity helps you see where you might have cash shortfalls and prepares you to seek alternate ways to meet your commitments, should you need to."

Modeling Cash Flow Sensitivity
Developing a cash flow sensitivity model doesn't have to be a complex process. The two keys are revenues and cost drivers. Boehlje notes that long-term capital expenditures matter, but are not critical to this model. What you'll be tracking on a monthly, quarterly, or annual basis are the issues associated with the revenue stream—prices, market share, quantity sold, etc.—and the costs side, like prices on raw materials.

"It's a pretty straightforward process," he says. "If you use your monthly or quarterly income statement spreadsheet as a basis, cash flow sensitivity can be fairly easy to map out. Take sales, for example. If you have a base chart of expectations and then lower prices or sales volume by a few percentage points, it's easy to see how that will affect the cash position, and it tells you when you might have a shortfall or surplus. You can do the same thing on the cost side, say by raising fuel prices up or down by a few points. Having those scenarios set up for both revenues and costs, you can see how shifts impact your net cash position at any given time. It makes you think about how you might need additional financing or what you may do with an unexpected uptick going forward."

A second, but related issue is the cash conversion cycle, or how quickly you're converting inventory into sales and sales into cash. The speed with which that conversion takes place affects cash flow sensitivity, as it tells you, for instance, how quickly you'll have cash for operating purposes or debt servicing, or, if needed, how long you might have to delay payment. "While the cash-flow-sensitivity analysis can tell you what your cash position is at any given time, keeping on top of your cash conversion cycle gives you a realistic view of how long your cash will be tied up in non-liquid form."

Cash-flow-sensitivity analysis can help you in two different ways. First, it gives you an ongoing way to be proactive in the case of market or business shifts on the revenue and cost side—you've created the possible scenarios and have "plan B" approaches if needed. Second, you have historical records that, when reconciled, show you actual past trends, which can help with future projections.

If you're looking for additional information about cash-flow-sensitivity modeling, check out:

  • CCH Business Owner's Toolkit's Cash Flow Sensitivity Analysis Worksheet;
  • the Small Business Store's Cash Flow Sensitivity spreadsheet; or
  • JaxWorks' Cash Flow Sensitivity Analysis spreadsheet.

Sources: "Digging Deeper into Cash Flow," Purdue

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