PART 3

CASH FLOW
FORMULA:
 And, now, back to the question that
started this series:

“What is the secret to

SUCCESSFULLY
FORECASTING CASH?”
BY STEVEN D. LORDS

FORECASTING
CASH
In “Cash Flow Formula – Part 1,” three basic concepts about cash management
were introduced:
• That “cash” may be defined as “spending power.”
• That it was important to accelerate receipts and decelerate
payments.
• That it was important to minimize current assets and
maximize current liabilities.

These concepts were all linked to a simple formula for measuring changes
in “cash.”

That formula also provided the foundation for Part 2 of this series, where
theory was put into practice as we looked at how operational practices and
procedures can impact cash flow.

Now it’s time to put the pieces together in order to master the techniques of
successfully forecasting cash. We will start where we left off last time, with
the cash flow formula.

May-June 2006 CFMA BP

 In order to forecast cash using these techniques, all, once the building is built, the customer probably
you must be familiar with the cash flow formula – won’t need another one constructed in the foreseeable
the common thread running through all three parts future (though this may not be true for larger or geo-
of this series: graphically disbursed business customers).

EBITA, or earnings In addition, contractors often say they have difficulty

+/- Changes in A/R forecasting Sales because they don’t know if they will
win the next bid. While this may be true, astute con-
+/- Changes in Inventory
tractors know that, with a sound understanding of our
+/- Changes in Net WIP business and the markets we operate in, we can fore-
+/- Changes in Fixed Assets cast Sales.
+/- Changes in A/P
Most well-run construction companies manage their
+/- Changes in Accruals estimating departments based on reasonably accurate
+/- Changes in Debt estimates of the volume of contracts they expect to bid
during the coming year. This bidding activity is usually
= Cash Flow
separated into the broad categories of Hard Bid and
Let’s examine the components of this formula as they Negotiated contracts.
relate to cash forecasting.
These same companies also calculate their “success
EBITA or Earnings rate”– that is, the percentage of contract bids that result
in contract awards. So, to estimate Sales volume:
The key to effective cash forecasting (whether long-
Annual Bidding Volume x Success Rate % =
or short-term) is the ability to forecast Earnings, or A reasonable estimate of the volume of work
EBITA (Earnings before interest, taxes, and amortiza- going into backlog during the coming year
tion) with a reasonable degree of accuracy. Although
this task may seem daunting at first, the process can In reality, new contracts are not secured ratably (evenly
be simplified. from month to month). However, for long-term Sales
forecasting, it is reasonable to add new contracts to
First break down, or back into, the basic components backlog on an average monthly run rate. This rate is
that lead to Earnings: Sales, Cost of Sales (or Cost of based on the success rate for Hard Bid and Negotiated
Construction), Gross Margin, and SG&A Expenses. contracts (or by a vertical or other market focus, if the
Then, use this simple formula to calculate EBITA: company has “success rate” data on this basis).
Sales – Cost of Sales = Gross Margin
Gross Margin – SG&A Expenses = EBITA When forecasting cash, forecast Sales (Billings) by
month. In order to more effectively forecast monthly
It is important to exclude interest, taxes, and amortiza- Sales, separate Sales activity into Sales for Existing
tion because these three factors are significantly affect- Backlog and Sales for Projected Future Contracts.
ed by differences in organizational structure and taxing
Sales for Existing Backlog
authorities. Also, by doing so, Earnings can be more
easily compared with other companies in our industry. While most contractors track their backlog, they may not
forecast when this backlog will be worked off
Breaking down EBITA into its basic components readily and billed. When a contract is awarded, a
shows that Earnings can be predicted with a reasonable front-end loaded, estimated project billing
degree of accuracy by forecasting each component indi- schedule should be developed (as dis-
vidually. Here’s how. cussed in Part 2 of this series in the
March/April 2006 issue).
FORECASTING SALES
I have often heard contractors say they can’t forecast Each month, this schedule should be updated
Sales for their company. Generally speaking, this is be- by project management to include: 1) actual
cause contractors may not have repeat customers. After billings for past months, 2) any change orders, and

CFMA BP May-June 2006

3) any changes in estimated future billings by month Month 1, 5% Month 7, 11%
through the end of the project. Month 2, 8% Month 8, 9%
Month 3, 9% Month 9, 8%
This schedule, along with the project’s current status Month 4, 11% Month 10, 7%
report on estimated costs to complete, should be sub- Month 5, 12% Month 11, 5%
mitted to finance. The sum of these schedules, corre- Month 6, 12% Month 12, 3%
sponding month by month for all projects currently in
backlog, will provide a reasonably accurate estimate of (Remember, we have made reasonable attempts to
future Sales (Billings) for projects in backlog. front-load the projects as described earlier.) With these
assumptions, we can create a simple Sales Forecasting
Sales for Projected Future Contracts Schedule, like the one shown in Exhibit 1.
The next step is to create estimated billing schedules
for projected future work. For existing contracts, such This schedule shows a six-month forecast; however, the
schedules are developed based on contract terms and same format applies for forecasting periods up to one
expectations, along with the detailed project con- year or longer. I recommend forecasting one year out;
struction schedule. Since this data does not yet exist longer forecasts can be done, but they tend to become
for projected contracts, we must look elsewhere for less and less accurate as your knowledge of future mar-
guidance. ket conditions diminishes.

A sampling of past construction projects can help estab- According to the schedule, Projects A & B are cur-
lish the average length and the pattern of monthly bil- rently in backlog, with billings prior to July ($286K for
lings for an average project. This data can be plotted on Project A and $105K for Project B). The estimated
a bell curve, and then used to make projections. Say the monthly billings for projects in backlog are based on
sampling shows the average project length is one year the estimated project billing schedules submitted to
and the average monthly billings are: finance each month by project management.

Exhibit 1: Sales Forecasting Schedule

(000S)
Contract Current Jul. Aug. Sep. Oct. Nov. Dec.
Project Price Backlog 2006 2006 2006 2006 2006 2006

Project A Addns./COs 1,300 0 0 0 0 0 0

Billings 143 156 156 143 117 91
Contract Bal. 1,014 871 715 559 416 299 208
Project B Addns./COs 2,100 0 150 0 0 0 0
Billings 168 203 248 270 270 248
Contract Bal. 1,995 1,827 1,774 1,526 1,256 986 738
New Contracts - May Addns./COs N/A 2,900 0 0 0 0 0
Hard Bid Billings 0 145 232 261 319 348
Contract Bal. N/A 2,900 2,755 2,523 2,262 1,943 1,595
New Contracts - June Addns./COs N/A 0 2,900 0 0 0 0
Hard Bid Billings 0 0 145 232 261 319
Contract Bal. N/A 0 2,900 2,755 2,523 2,262 1,943
New Contracts - May Addns./COs N/A 1,250 0 0 0 0 0
Negotiated Billings 0 63 100 113 138 150
Contract Bal. N/A 1,250 1,187 1,087 974 836 686
New Contracts - June Addns./COs N/A 0 1,250 0 0 0 0
Negotiated Billings 0 0 63 100 113 138
Contract Bal. N/A 0 1,250 1,187 1,087 974 836
Small Contracts/ Addns./COs N/A 850 850 850 850 850 850
Service Billings 850 850 850 850 850 850
Contract Bal. 1,000 1,000 1,000 1,000 1,000 1,000 1,000

Total Monthly Billings 1,161 1,417 1,794 1,969 2,068 2,144

Changes in Net WIP 100 (120) 50 210 (90) (110)

Net Monthly Billings 1,261 1,297 1,844 2,179 1,978 2,034

May-June 2006 CFMA BP

 You can reconcile to the current actual billing status for Our best estimate of future Gross Margin on construc-
each project by maintaining the Contract Balance line tion projects begins with the Gross Margin percentage
(the prior month’s remaining contract balance, plus or your company has achieved on its most recent projects;
minus change orders and the current month’s billings). this should be modified up or down for current market
conditions or specific changes planned in methods of
New contracts have been added to the schedule for July performance. To convert Gross Margin percentage to
and August and subdivided by Hard Bid and Negotiated dollars, multiply it by forecasted Sales.
contracts, since your company’s success rate in bidding
these two categories may be significantly different. New SG&A EXPENSES
Hard Bid contracts have been added at a run rate of Just as Gross Margin is a standard measure of profitabil-
$2,900K per month; new Negotiated contracts at a run ity for the construction industry, SG&A Expenses are a
rate of $1,250K per month. common business benchmark and a standard compo-
nent of most P&L statements. Once again, most astute
These run rates are based on the following formula:
contractors know what their overhead (SG&A Expen-
Forecasted Annual Bidding Activity x ses) rate is as a percentage of Sales.
Appropriate Success Rate (%) ÷ 12 =
Monthly Run Rates This rate may change with significant fluctuations in
Sales volume, since some components of SG&A Expen-
The monthly billing amounts for these future projects
ses are fixed, rather than variable, costs.
are entered based on your company’s average billings by
month over the life of an average 12-month project. The Estimate future SG&A Expenses by taking the SG&A
schedule can be expanded for additional projects in Expenses percentage achieved over the most recent
backlog, and for the additional months of new projects past and modifying it for current market conditions or
added in the Hard Bid and Negotiated categories. specific changes planned in spending patterns.

Small Contracts and/or Service activity are added in Note: I have discussed the Cost of Sales and/or Gross
aggregate. Forecasts are based on average run rates for Margin and SG&A Expenses to address the predictability
new small contracts and/or service work and monthly of all parts of our simplified formula for EBITA. For fore-
billings for the same. The schedule in Exhibit 1 shows a casting purposes, only the Sales and EBITA numbers are
flat run rate; however, your individual company may ex- required.
perience more seasonality and/or growth.
All Other Components of the
Reconciling Billings vs. Sales Cash Flow Formula
In construction, the difference between “Billings” and
“Sales” is reconciled through entries to create over- and Returning to our formula, we are only interested in
underbillings (or more properly, Costs and Earnings in changes in A/R, Inventory, Net WIP, Fixed Assets, A/P,
Excess of Billings and Billings in Excess of Costs and Accruals, and Debt. Our ability to predict these changes
Earnings). will be based on our knowledge of how individual bal-
ances have changed in the past.
To handle the monthly Changes in Net WIP, or net
changes in over- and underbillings, I have simply added We will need to establish predictable patterns (trends)
a line at the bottom of the schedule following Total for each component, and to understand the underlying
Monthly Billings. With this factored in, we have a proper reasons for these trends, as well as how operational
monthly forecast for Monthly Billings or Sales. practices affect them (as discussed last time in Part 2).

COST OF SALES AND/OR GROSS MARGIN These patterns can be established by using the same
Cost of Sales and Gross Margin are the inverse of each schedule we will ultimately use for forecasting future
other; therefore, if we can forecast one, we can forecast cash flows. Exhibit 2 shows a sample Schedule of
the other. Since Gross Margin on projects is the focus of Monthly Cash Flow. Collecting the data and filling out
most estimating efforts (and subsequently becomes the the schedule for prior months should get you comfort-
base measurement of project profits in the construction able with how the schedule works, and make it easier to
industry), this will be our measurement focus. forecast future months.

CFMA BP May-June 2006

 THE BASICS Cash Flow (at the bottom of the schedule) is calculated
The schedule includes all of the basic benchmarks dis- as the sum of EBITA and the change number for each
cussed so far. The data is listed in columns by month, component, just as the Cash Flow Formula dictates.
and totaled by quarter, in the same order down the page TRENDS & ANALYSES
as the Cash Flow Formula.
Trends can be established using just this data; however,
In addition, a line for Sales has been inserted at the top it is useful to expand the analyses by providing bench-
of the schedule, and lines for SG&A Expenses and marks of how the four main components (A/R,
SG&A Percentage have been added at the bottom. Inventory, WIP, and A/P) change relative to Sales. Since
Sales, EBITA, and SG&A Expenses are the only three A/R is generally composed of more than one month’s
non-balance sheet items on the schedule and, accord- Sales, the schedule compares the monthly balances as a
ingly, are single entries by month from the company’s percentage of the most recent three months of Sales
P&L statements. (noted on the chart as End A/R / MR 3 Mos).

The other components of the Cash Flow Formula are I have used this same three-month benchmark for all
presented in three-line sets that show the beginning four components. (You may choose to use a different
and ending balances, and the monthly change in each. comparative benchmark that you feel is more represen-
tative of your company.)
Only the changed numbers for Fixed Assets and Debt
are provided; however, these are calculated in the same PROBLEMS & OPPORTUNITIES
manner as the other components. (For my company, In addition to providing cash flow data for forecasting
changes in Fixed Assets and Debt are typically inconse- purposes, the schedule can also highlight developing
quential, so I have chosen to simplify the presentation. problems and areas where cash management might be
You may choose to break them out into the same three- improved. For example, note that the A/R-Net balances
line presentation as the other components.) (net of allowances for bad debt) as a percentage of Sales

Exhibit 2: Schedule of Monthly Cash Flow

(000S)

FY 2005 FY 2006 FORECAST

Total Total Total Total Total
Jul. 05 Aug. 05 Sep. 05 Q3 Oct. 05 Nov. 05 Dec. 05 Q4 Jan. 06 Feb. 06 Mar. 06 Q1 Apr. 06 May 06 Jun. 06 Q2 Jul. 06 Aug. 06 Sep. 06 Q3

TOTAL SALES 18,246 24,274 24,088 66,608 21,519 23,538 24,653 69,710 19,083 23,845 21,057 63,985 17,574 21,461 22,806 61,841 20,825 22,110 22,050 64,985

EBITA 1,104 1,747 4,016 6,867 195 (637) (24) (466) 458 2,285 2,012 4,755 414 2,173 2,708 5,295 2,241 2,505 2,532 7,278

A/R - NET:
Beg A/R 59,363 59,866 60,172 59,198 64,460 59,508 58,725 60,286 59,939 61,908 63,314 57,538 57,559 56,800 55,900
End A/R 59,866 60,172 59,198 64,460 59,508 58,725 60,286 59,939 62,856 63,314 57,538 57,559 56,800 55,900 55,100
Change (503) (306) 974 165 (5,262) 4,952 783 473 (1,561) 347 (2,917) (4,131) (1,406) 5,776 (21) 4,349 759 900 800 2,459
(End A/R / MR 3 Mos) 95% 94% 89% 92% 86% 84% 90% 89% 98% 101% 96% 93% 87% 85% 85%
INVENTORY:
Beg INV 7,258 7,365 6,857 6,988 7,029 7,045 7,011 6,883 7,038 7,143 7,290 7,030 7,019 6,700 6,800
End INV 7,365 6,857 6,988 7,029 7,045 7,011 6,883 7,038 7,143 7,290 7,030 7,019 6,700 6,800 6,600
Change (107) 508 (131) 270 (41) (16) 34 (23) 128 (155) (105) (132) (147) 260 11 124 319 (100) 200 419
(End INV / MR 3 Mos) 12% 11% 10% 10% 10% 10% 10% 10% 11% 12% 12% 11% 10% 10% 10%
WIP - NET:
Beg WIP (50) (617) 815 (710) (3,044) (753) (4,373) (4,167) (2,887) (2,221) (3,559) (2,497) (4,006) (4,100) (4,200)
End WIP (617) 815 (710) (3,044) (753) (4,373) (4,167) (2,887) (2,221) (3,559) (2,497) (4,006) (4,100) (4,200) (4,050)
Change 567 (1,432) 1,525 660 2,334 (2,291) 3,620 3,663 (206) (1,280) (666) (2,152) 1,338 (1,062) 1,509 1,785 94 100 (150) 44
(End WIP / MR 3 Mos) -1% 1% -1% -4% -1% -6% - 6% -4% -3% -6% -4% - 6% -6% -6% -6%

FIXED ASSETS (CHANGE) (63) (259) (17) (339) (69) (10) 48 (31) 14 (19) (1) (6) (10) (5) 70 55 (15) 5 45 35

A/P:
Beg A/P (12,785) (4,718) (11,941) (19,340) (3,242) (8,739) (19,199) (9,283) (13,855) (18,549) (8,835) (11,440) (15,024) (6,500) (11,500)
End A/P (4,718) (11,941) (19,340) (3,242) (8,739) (19,199) (9,283) (13,855) (18,549) (8,835) (11,440) (15,024) (6,500) (11,500) (17,500)
Change (8,067) 7,223 7,399 6,555 (16,098) 5,497 10,460 (141) (9,916) 4,572 4,694 (650) (9,714) 2,605 3,584 (3,525) (8,524) 5,000 6,000 2,476
(End A/P / MR 3 Mos) - 7% -19% -29% -5% -13% -28% -8% -12% -29% -14% -19% -24% -6% -11% -27%
ACCRUALS:
Beg DEF INCOME (6,616) (6,295) (6,180) (6,443) (6,799) (6,645) (6,819) (6,533) (6,411) (6,972) (6,819) (6,419) (6,537) (6,650) (6,700)
End DEF INCOME (6,295) (6,180) (6,443) (6,799) (6,645) (6,819) (6,533) (6,411) (6,972) (6,819) (6,419) (6,537) (6,650) (6,700) (6,750)
Change (321) (115) 263 (173) 356 (154) 174 376 (286) (122) 561 153 (153) (400) 118 (435) 113 50 50 213

DEBT (CHANGE) 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

CASH FLOW (7,390) 7,366 14,029 14,005 (18,585) 7,341 15,095 3,851 (11,369) 5,628 3,578 (2,163) (9,678) 9,347 7,979 7,648 (5,013) 8,460 9,477 12,924

SG&A EXPENSES 3,382 5,506 4,261 13,149 4,588 6,250 5,986 16,824 4,732 4,898 4,149 13,779 3,890 5,000 4,373 13,263 3,950 4,320 4,100 12,370

SG&A PERCENTAGE 19% 23% 18% 20% 21% 27% 24% 24% 25% 21% 20% 22% 22% 23% 19% 21% 19% 20% 19% 19%

May-June 2006 CFMA BP

 increased significantly at the end of Q1 and the begin- For instance, your Sales forecasts should be more
ning of Q2. Note also that the WIP-Net credit balance accurate because you can look at monthly billings for
(net of credit and debit balances), or overbilling, sig- specific projects. EBITA estimates can take into
nificantly improved during Q4 and has remained account recent profitability, rather than last year’s
there. averages.

Note, too, that the balances in A/P regularly drop at the However, changes in the balance-sheet components of
beginning of each quarter, then build through the end the formula will tend to strongly follow the trends that
of the quarter. This may be important for publicly trad- you have identified – and you will probably not want to
ed companies, as it strengthens a company’s overall forecast any significant short-term changes anticipated
cash position, and less important for privately held as the result of improved business practices. Generally,
companies. it takes a while to see the effect of such changes.

Forecasting Future Cash Flows Conclusion

So, using these theories and practical tools, you can now This concludes our series on forecasting cash. With your
begin forecasting future cash flows for your company, as expanded definition of cash and grasp of the concepts
shown in Exhibit 2. Sales figures would come from the that drive cash flow, along with your understanding of
Sales Forecasting Schedule explained earlier. the Cash Flow Formula and how operational practices
affect cash flow, you should be able to produce a reliable
The EBITA forecast would be derived from a combi- cash forecast with confidence.
nation of prior actual results and knowledge that, for
example, your company’s profitability is stronger dur- Since every construction company is unique with its
ing the summer months. own individual culture and set of strengths and weak-
nesses, your challenge as a CFM is to apply your new
Changes in the other components of the cash flow for- knowledge and tools in the manner most appropriate
mula are forecast based on trends established over the for your company. BP
prior months and quarters, as well as expectations
based on such things as market conditions, changes in
company policies, operational practices, etc. Editor’s Note: The original version of this article
appeared in the May/June 2003 issue.
And, keep this in mind: In the interest of not overstat-
ing estimated cash flow, it is best to be conservative
when forecasting, especially as it relates to factoring STEVEN D. LORDS, CCIFP, is the CFO for Martin-
Harris Construction in Las Vegas, NV.
in market conditions and improvements based on
changes in operational practices. Prior to joining Martin-Harris, Steve was operations con-
troller for SimplexGrinnell LP in Houston, TX and CFO
Once you understand the schedules, you can customize for other construction companies. Before entering the
them to fit your company’s individual needs. For construction industry in 1987, Steve spent more than
instance, you may not care to see the numbers pre- eight years in public accounting. He graduated from
sented by quarter, or you may want additional break- Brigham Young University with a BS in Accounting.
outs on Fixed Assets and Debt.
A longtime member of CFMA, Steve has held a variety
Short-Term Cash Forecasting of national leadership positions, including President,
President-Elect, Secretary, and Treasurer. Steve is the
So far, we have been talking about long-term cash President of CFMA’s Las Vegas Chapter, and was
forecasting, which is forecasting at least a year out. President of both the Albuquerque and Southern Missis-
sippi Chapters. In 2002, he received the Danny B.
But, the same principles apply to short-term cash
Parrish Outstanding Leadership Award.
forecasting and the same schedules can be used. How-
ever, your assumptions should be more accurate rela- Phone: 702-474-8232
tive to the short-term since you can rely more on E-Mail: [email protected]
known circumstances. Web Site: www.martinharris.com

CFMA BP May-June 2006