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A cash flow model helps owners and managers calculate cash expected from certain business activities. These models are often different for each situation, as few activities in business are exactly the same. To create a cash flow model, steps include selecting the time frame to measure, using a formula to estimate cash inflows and outflows, deciding whether or not to use a discounted cash flow model and comparing positive cash flows to previous projects. These steps are similar for each model situation.
Measureable time frames are a must when measuring cash flow. In a project management type of system, owners and managers will often break down models to each project and specific time lines within each project. For example, a cash flow model is common in construction companies. Individuals in these firms must complete projects on a timeline; this provides an opportunity for measuring cash flow on a particular basis. Using a specific time frame helps companies create a deeper analysis for measuring the company’s overall cash flow process.
Formulas for estimating cash flows will most certainly vary. A common practice for this process is to estimate the total revenues a company will receive, and then deduct the expenses necessary to earn these revenues. For example, if each member in a sales force delivers an average of $25,000 US Dollars (USD) monthly, then a company would compare how much it costs to hire, train and pay for this new team member. The remaining figure is then the cash flow left to the company for paying expenses and rewarding owners or shareholders with a profit.
Using a discounted cash flow model helps estimate future cash flows for multiple years. The value of these estimates needs to be based on current dollar values for accurate comparison to money spent on new projects. Owners and manages will estimate cash flows and discount them back to the current dollar amount using a discount rate, such as the cost of capital related to borrowed funds. This process is common because it gives a quantitative analysis to the model that can eliminate the subjectivity of human error.
Business models allow for comparison between one or more projects. Although each project is different, comparing the effectiveness of models can help the company refine their business modeling process. Comparisons also help companies discover which projects result in the highest cash returns. Owners and managers can also help the company diversify by taking on projects that have low risk and low cash returns, which can offset riskier projects with questionable cash returns.