What is Base Case Cash Flow?
Financial planning is a crucial part of any organization. Businesses need to see how their sales, production and cash flows will work out in the future.
A key concept in financial planning is to follow a basic set of assumptions, making up a ‘base case’ of figures and events.
A base case uses a likely set of assumptions about the business to build up a cash flow. This cash flow will work as a base case cash flow. Building these basic assumptions is a vital part of financial planning and projections.
Base Case Cash Flow: What is a Base Case
Base case assumptions fall under the head of scenario analysis, which helps users to relate and visualize differing results for a business.
A business can improve its planning process when it has forecasts that consider all possible situations.
Scenario analysis has three cases: the best, the worst, and the base case scenario. The base case is usually based upon realistic figures and is usually neutral in its perspective. Life will be vanilla, and inflation will be based on current or next year's forecasts. Interest rates will be at current rates, and prices will stay within current ranges.
For instance, many public companies use base cases to assess the feasibility of stock buybacks or project loans. Smaller businesses can use base cases to plan their capital expenditures or new hiring.
Building up a Base Case
Financial modelling involves assumptions based on independent (inputs) or dependent (outputs) variables. Many variables use historical values, for instance, last year’s cost of goods sold, sales figures, average market growth, inflation rates etc.
For instance, to build a base case for next year's sales growth, you can assume units of sales based on last year’s sales. For instance, if you have a shoe outlet and last two years sales growth was 5% and 1% respectively. Last year was slow due to the pandemic, so you can assume that at least 2-3% sales growth can be expected from the previous year.
This figure will work as a base case scenario for projecting growth for the shop.
Why Base Case Evaluations are Important
A base case works as a ‘reference point’ for planning and allows for easier comparison.
Building up a base case requires that an analyst builds up a base case using the COGS, previous year’s sales and profit rates, sales returns, overheads, seasonal load, etc.
All these inputs will have an impact, but some will impact the bottom line more than others. These high impact variables are essential and can vary from one business to another.
The base case can help highlight which variable is more impactful for a business and help it pay more attention to its movement.
Base Cases are not Stand Alone
Base case scenarios show probable results from likely situations, but they should not work as a single reference point. The number of variables involved in financial modelling impacts the outcome dramatically.
Business decision makers need to thoroughly assess a range of possibilities like their best-case and worst-case scenarios to understand their company’s future outlook.
For example, if our shoe store forecasts a 20% drop in shoe sales if the pandemic extends for another year. The worst-case scenario sees a 70% sales decline, while a best-case scenario sees zero growth in sales.
In such a perspective, operational costs would remain comparatively stable as rent, and utilities and other fixed costs remain stable (assuming that landlords do not revise their rates during the pandemic)
This base case scenario is modified to include changing ground realities to analyze the current drivers and linkages between events and results in a better way. For instance, the shop owner may find that the shoe repair business is thriving as people look to fix their existing shoes, and the casual flip flop business is booming.
As a business looking to sustain its cash flows, the owner can decide to promote the repair services. The repair department can be expanded to get more business from other shops that do not offer repair services. Flip flops can also be promoted or expanded to cater to higher demand during the pandemic.
In light of these findings, the shoe shop owner can plan out a strategy for the future holiday season to gain some growth in sales.
Interpreting Base Case Results
Base case evaluations act as a foundation for evaluating different outcomes over differing situations. They work to ground the financial perspective of a business to keep managers and analysts in touch with reality. The financial results of the base case are supposed to be better than that of the worst case but worse than the results from the best case scenario.
This is the reason why there is so much emphasis on the base case and assumption planning. It is advisable to make and assess multiple scenarios to understand finances better.