Cash Flow Projection

What is a cash flow projection?

Cash flow projection (German Cashflow-Prognose, also Cashflow-Planung) refers to the forward calculation of a company's cash flows over several years, usually monthly for the first plan year and by quarter or year thereafter. As a rule, it is part of a financial model that links three sets of calculations. The planned income statement (planned profit and loss account) shows income and expenses, the planned balance sheet assets and liabilities at the end of each period, the planned cash flow statement the cash flows. This form is called integrated financial planning. Simplified projections without a planned balance sheet exist but cannot be checked arithmetically.

The projection answers the question how much capital a company needs by when and when it sustains itself. It is the basis for sizing a funding round, for credit decisions, for funding applications and for business valuation. The short-term, payment-accurate steering of the next weeks, by contrast, is handled by liquidity planning, whose monthly values should match the first plan year of the projection.

Structure of a cash flow projection in the financial model

In an integrated model, cash flow does not arise in a table of its own but as a result of earnings planning and balance sheet planning. The planned income statement supplies revenue, expenses and earnings, the planned balance sheet the balances of receivables, inventories, liabilities, fixed assets and financing. The change in these balances from period to period gives the cash flow. The closing balance of liquid funds must match the corresponding balance sheet item; if it does not, the model contains an error.

The projection is usually structured like a cash flow statement under German Accounting Standard No. 21 (Deutscher Rechnungslegungs Standard Nr. 21, DRS 21): cash flow from operating activities, from investing activities and from financing activities. The sum of the three areas is the change in cash and cash equivalents.

Indirect method

For multi-year projections, the indirect method is usual. It starts from net income for the year and adds back non-cash expenses such as depreciation and the formation of provisions. It then takes account of the change in working capital, that is, the funds tied up in inventories and customer receivables less supplier liabilities. Rising receivables and inventories tie up funds, rising trade payables release funds. The direct method, which plans every payment individually, remains reserved for the short-term horizon.

Formula: Operating cash flow = net income for the year + depreciation + increase in provisions minus increase in receivables and inventories + increase in supplier liabilities

Drivers and assumptions

The projection becomes reliable when every line traces back to comprehensible drivers. Revenue follows from number of customers, price and churn, personnel costs from the hiring plan with employer contributions, cash receipts from payment terms in days. These periods are described by the cash conversion cycle. In addition come investments, repayment schedules and tax payments. For taxes, the minimum taxation rule must be observed: losses of earlier years may offset profits above a base amount only in part, so that taxes can arise despite a loss carryforward.

Scenarios and capital requirement

Three cases are usual: a base case, a cautious case with slower growth and later cash receipts, and an optimistic case. To size a round, the projection is first calculated without the new financing. The lowest level of funds in the cautious case then shows how much capital is missing; added to this is a reserve for the duration of the next funding process. The runway that a round is meant to deliver thus also follows from the projection.

In addition, sensitivities show how strongly individual assumptions act, for example growth lower by ten percentage points or payment terms 30 days longer. A model whose fund balance turns negative even with such deviations requires a larger reserve or an earlier start of the next round.

Significance in financing, due diligence and valuation

In due diligence, the review before the contract is concluded, investors examine above all the plausibility of the projection. They ask whether growth rates fit the sales pipeline, whether personnel costs per head and payment terms correspond to the past and whether the first plan year matches current actual figures. Lenders derive debt service capacity from the projection, that is, the ability to pay interest and repayments from ongoing business.

In business valuation, the projection is the starting point of the DCF valuation: the future free cash flows are derived from it and discounted. In a company sale, the seller presents its planning, the acquirer reviews it and develops its own buyer plan from it. Outside transactions too, the projection carries weight. For the going-concern forecast in insolvency law, the next twelve months count (Section 19(2) of the German Insolvency Code, InsO), and for imminent illiquidity as a rule 24 months (Section 18(2) InsO). Both rely on the company's planning.

Worked example: cash flow projection using the indirect method

A technology company that sells software with its own hardware plans EUR 3.65 million in revenue for the coming year, that is, EUR 10,000 per day, and a net loss for the year of EUR 400,000. Liquid funds at the start of the year are EUR 800,000. A capital increase of EUR 3.0 million is planned in the second quarter.

• Net income for the year: minus EUR 400,000
• Depreciation: plus EUR 150,000, increase in provisions: plus EUR 20,000
• Increase in receivables: minus EUR 250,000, increase in inventories: minus EUR 50,000, increase in supplier liabilities: plus EUR 80,000
• Cash flow from operating activities: minus 400,000 + 150,000 + 20,000 minus 250,000 minus 50,000 + 80,000 = minus EUR 450,000
• Cash flow from investing activities: minus EUR 300,000
• Cash flow from financing activities: EUR 3,000,000 capital increase minus EUR 100,000 repayment = EUR 2,900,000
• Change in funds: minus 450,000 minus 300,000 + 2,900,000 = EUR 2,150,000, closing balance 800,000 + 2,150,000 = EUR 2,950,000

In the cautious case, customers pay 20 days later on average. At EUR 10,000 of revenue per day, receivables rise, simplified without value added tax, by a further 20 × 10,000 = EUR 200,000. Operating cash flow falls to minus EUR 650,000, the closing balance to EUR 2,750,000, although nothing changes in earnings. If the capital increase is also delayed, only monthly planning shows whether the balance of EUR 800,000 lasts until the inflow.

Distinction: cash flow projection, liquidity planning and business plan

• Liquidity planning: the short-term, payment-accurate planning on a weekly and monthly basis under the direct method. The cash flow projection calculates over several years and derives cash flow from earnings and balance sheet.
• Integrated financial planning: the linked planning of planned income statement, planned balance sheet and liquidity plan. The cash flow projection is its multi-year cash part; operational liquidity planning refines the first months.
• Forecast: the continuous projection for the current financial year from actual values and current expectation. The cash flow projection extends over several years and shows the capital requirement up to future milestones.
• Free cash flow: a metric that can be read from the projection for each plan year: operating cash flow after investments. For DCF valuation, it is usually derived separately before interest and discounted.
• Business plan: describes business model, market, strategy and team. The cash flow projection is its financial core.

Common mistakes

• Working capital not modelled. Anyone who sets cash flow as earnings plus depreciation overlooks the funds that growth ties up in receivables and inventories.
• No link to the balance sheet. Without a planned balance sheet, there is no check whether the projected fund balance is arithmetically correct.
• Ancillary personnel costs too low. Employer social security contributions, levies and contributions to the employers' liability insurance association (Berufsgenossenschaft) are missing or set too low as a flat amount.
• Only the base case. A model without a cautious case provides no reliable basis for the size of a funding round.
• No updating. A projection that is not reconciled with actual figures and updated loses its informative value within a few months.

Frequently asked questions

Over what period does a cash flow projection run?

In funding rounds usually three to five years. The first year is planned monthly, the following years by quarter or year.

Is the cash flow projection calculated directly or indirectly?

For the multi-year projection, the indirect method, because it follows from the planned income statement and planned balance sheet and can be checked arithmetically. For the next weeks, the direct method of liquidity planning is more accurate.

Is there a template for a cash flow projection?

Yes, usually as a spreadsheet template for the financial model. It has a sheet with the assumptions from which the planned income statement, planned balance sheet and planned cash flow statement are fed, monthly in the first year, then by quarter or year. The template becomes reliable only with its own drivers. A projection with flat growth rates rarely withstands review by investors.

How accurate must the projection be?

Comprehensible, not exact to the point. Investors do not expect exact values for the third year, but they do expect assumptions that fit the development so far and a calculation that is internally consistent.

What happens if actual figures deviate significantly?

The projection is adjusted and the deviation explained. Unexplained deviations between earlier plan versions and actual development are among the first points that investors raise in due diligence.

The Roemer Capital view

The financial model that we build for funding rounds and sale processes runs for at least three years and contains a base case, a cautious case and an optimistic case. The cash flow projection in it is the result of the planned income statement and planned balance sheet, so that every figure can be traced back to its assumption.

We derive the capital requirement of a round from the cautious case: lowest level of funds plus a reserve for the next process. In a sale, the same projection serves as the starting point of the valuation discussions, and acquirers recalculate it before they talk about the price.