Take a tip from the EBA and stress test your firm

The European Banking Authority (EBA) announced on 26 October that, having completed a stress test of banks operating in the EU, it has concluded that 24 banks must improve their balance sheets by raising more share capital.

The banks have nine months to raise the money, otherwise they could be shut down. There was a broadly positive reaction to this exercise and no one appeared to object to the relevance of such tests. I was reminded that the SRA asks questions of each firm about their financial stability as part of the annual practising certificate renewal, and also that insurers have been asking similar questions of us for a number of years. There are also far more important, commercial reasons for having a good understanding of cash flow.

Managers should take good care to ensure they thoroughly understand not only what cash is available for the business today, but also their forecast of future cash flows.

Some small to mid-size firms still do not produce cash-flow forecasts at all. A total lack of cash-flow forecasting means the organisation cannot sensibly answer any of the following questions:

1. Can we confirm to the SRA and to insurers that we have sound finances?

2. Do I understand how much my business might be affected if certain risks turn out for the worst?

3. How much cash will we have next week, month or year?

4. If work falls off in a particular area, what will happen to our cash and what should we do about it?

5. We could make a lateral hire: how would this impact on our cash? How long for? When will they start to make us some money? Is it right to hire this person?

6. A particular area of work has come under recent fee pressure: how can we change our processes so that we may continue to perform this work?

Firms of all sizes appreciate the fundamental importance of a properly prepared cash-flow forecast as an aid to decision making. Their cash flows have the following features:

1. The forecast is a result of a ‘ground up’ review of the business by each operating unit.

2. The forecast is a team effort, with key assumptions agreed between operating heads and the financial director.

3. The forecast assumptions are communicated and understood by everyone in the organisation who can affect the success of the plan.

4. All investment proposals are reviewed in the context of the cash-flow forecast and evaluated in terms of their effect on cash flow.

5. The board or partners buy into the forecast.

6. The forecast is continually monitored and amended to take into account any changes or previously unanticipated events.

Most businesses will already have at least one budgeting exercise a year. More developed businesses review the budget at least every month and reforecast cash flows as a result of these reviews. If the revised cash flow indicates any issues, actions are agreed to refine the business plan or to make more fundamental changes if necessary.

Proactive measures

This process moves the cash-flow forecast from a simple reporting tool to a business key performance indicator (KPI), and produces a level of control which enhances their credibility and gives confidence to outside stakeholders. A good cash flow enables businesses to take proactive measures when issues arise. Where cash flows are not used in this way, businesses are more likely to have stakeholders flagging up issues rather than the other way around.

Equity partners are business investors and should see themselves as such. They have a basic desire to see their investment is safe and continues to be safe in the future. They may take comfort from a cash flow that is produced carefully with their input, especially if they understand the underlying assumptions. As investors, they have a duty to know the answers to such questions themselves, rather than relying on others to deal with these issues.

In summary, if you are asking the right questions in your business first, and using cash flows and cash-flow sensitivities effectively to support your decision making, you are much more likely to reduce the risks when investing in new projects, to flag up and deal with issues before others are aware of them, and to avoid the risks of others highlighting issues before you do. You should also be much more likely to demonstrate financial stability to insurers
and the SRA. SJ

Stephen Chalmers-Morris is practice manager and partner at Gorvins Solicitors