Introduction to Cash Flow Forecasting
Cash flow forecasting is a process of creating an estimate of a business's future cash levels over specified periods. Maintaining a company's cash flow predictions is a vital part of financial management for companies of all sizes.
A cash flow forecast estimates the timing and amounts of cash inflows and outflows over a set timeline, usually broken-down month-by-month. It includes all expected sources of cash receipts like sales revenue, collection of receivables, and financing. It also incorporates all foreseeable expenditures such as payroll, taxes, inventory purchases, capital spending, and loan payments.
By forecasting cash flows, companies can ensure they will have sufficient cash on hand to pay their obligations. Cash flow forecast reports allow businesses to take proactive steps if they foresee issues on the horizon, such as obtaining credit lines, delaying major purchases, or adjusting financing plans.
Overall, cash flow forecasting provides critical visibility that helps businesses effectively manage their cash position. It is an essential financial planning tool that allows companies to anticipate their liquidity needs and make strategic decisions accordingly. With a detailed forecast in hand, businesses can confidently pursue opportunities for growth.
What is in a Cash Flow Forecast
A cash flow forecast accounts for all the money flowing in and out of business over a set period.
The revenue or sales forecast estimates the amount of money expected to come from sales of products and services. Since revenue is the primary source of cash flow, this is one of the most essential parts of the forecast. The forecast can be broken down by product, service, customer segment, and sales channel. Historical sales data, current sales pipeline, seasonality, promotions, and economic conditions all impact the revenue forecast.
The expense forecast tallies up all the cash a business expects to spend over the forecast period. Examples include recurring operating expenses like payroll, rent, utilities, and inventory purchases, as well as non-recurring or intermittent expenses such as loan payments, taxes, maintenance and repairs. Examining historical expenses and factoring in new plans/needs informs the expense forecast.
Capital expenditures (CapEx) refer to investments in assets like equipment, hardware, and facilities that require significant upfront cash outlays but provide value over the long term. While not a regular operating expense, CapEx needs to be incorporated into the cash flow forecast as it represents a significant cash outflow.
For companies with debt like loans or lines of credit, required debt repayments represent an important recurring cash outflow. The cash outflows include principal payments and interest owed. Accounting for debt obligations ensures cash is available when payments come due.
Taxes also result in material cash outflows, whether income taxes, payroll taxes, or sales taxes. The tax forecast should account for estimated tax liabilities based on profits and taxable transactions.
Having accurate forecasts for all sources of cash inflows and outflows allows businesses to anticipate their future cash position and make proactive decisions. This core information forms the foundation of an effective cash flow forecast.
How Far Ahead to Forecast
When creating a cash flow forecast, businesses need to determine how far into the future they want to forecast. There are a few standard timeframes used:
Monthly Cash Flow Forecasts
Monthly cash flow forecasts project inflows and outflows on a month-by-month basis. These are useful for getting a detailed view of your cash flow needs in the short term. Monthly forecasts are often done for the next 3, 6, or 12 months.
Having the monthly cash flow figures allows you to monitor your cash position closely. You can see potential cash shortfalls well in advance and act to fix the situation if needed. Monthly forecasts require more work to maintain but give your business greater visibility into its near-future cash needs.
Quarterly Cash Flow Forecasts
Quarterly cash flow forecasts show your projected cash flow for each financial quarter ahead (three-month periods). You can forecast quarterly for the next year or two-three years.
Quarterly forecasts strike a balance between detailed monthly projections and big-picture annual forecasts. Looking at the three-month periods smoothes out some of the month-to-month variability while still allowing reasonably accurate forecasts.
Annual Cash Flow Forecasts
Annual cash flow forecasts project your inflows and outflows for the entire year ahead. Forecasting annually is helpful for budgeting and planning purposes. It gives you a big-picture view of your cash flow needs and surpluses for the next 12-month period.
The downside of only doing an annual forecast is that it needs more precision and early visibility into potential cash shortfalls. Monthly fluctuations get lost in the annual figures. For most businesses, doing quarterly or monthly forecasts is recommended. However, a yearly forecast can supplement more frequent projections.
Methods of Cash Flow Forecasting
There are a few main methods companies use to create cash flow forecasts:
Use of Historical Data
One approach is to start with historical cash flow data as a baseline. The company can take its actual cash flow from prior periods and use that as a starting point for estimating future cash flows. Using the historical data approach involves analyzing sales, expenses, capital expenditures, debt payments, and other inflows/outflows from previous financial statements. Past cash flow patterns and seasonality can help inform the projections. The historical data provides a grounded estimate, which can then be adjusted based on expected changes in business conditions.
Percentage of Sales
Another method is to forecast cash inflows as a percentage of projected sales revenue. For example, suppose a company expects $1 million in revenue over the next year. In that case, they may estimate their cash inflows at 95% of sales, or $950,000. This technique assumes that the historical relationship between sales and cash collections will stay consistent. Companies can further break this down, predicting cash inflows from specific customers or sales channels as a percentage of those subtotals.
Bottom Up Build
For a more detailed approach, companies build cash flow forecasts from the bottom up. This approach involves making itemized estimates of all expected cash inflows and outflows. The projections start at the transaction level for invoices, payrolls, taxes, inventory purchases, equipment investments, and debt repayments, for example. The cash effects of each transaction are modeled week-by-week or month-by-month. Granularly projecting each cash flow driver provides a higher accuracy forecast compared to the top-down percentage of sales or historical data methods. However, bottom-up build requires comprehensive knowledge of all business operations.
Using Cash Flow Forecasts
Cash flow forecasts are an essential planning tool for businesses of all sizes. They allow companies to get a clear picture of their short and medium-term cash position so they can make informed financial decisions. Here are some of the key ways businesses use cash flow forecasts:
Identify Future Cash Shortfalls
One of the main benefits of forecasting cash flow is that it can highlight times in the future when expenses will exceed income. The shortfalls may occur due to seasonal fluctuations, large one-off expenditures like equipment purchases, or due to an unprofitable period for the business. By forecasting future cash flow deficits in advance, companies can plan accordingly. For example, they may decide to build up cash reserves or secure a business loan to cover the expected shortfall. Having a plan prevents unexpected cash crunches that could threaten the financial health of the business.
Plan Timing of Large Expenditures
Cash flow forecasts help companies schedule large outlays of money appropriately. Significant investments like acquiring a competitor, purchasing expensive equipment, or moving into a larger site can weaken companies if not adequately budgeted for. By mapping out when these significant cash outflows will occur well in advance, businesses can build up sufficient reserves or arrange financing. This prudent financial planning allows companies to fund growth and expansion without jeopardizing day-to-day operations.
Manage Debt Levels
Forecasting future cash flow also enables businesses to manage their debt wisely. Taking on too much debt can be dangerous, especially if upcoming expenses exceed income for an extended period. By projecting future cash flow deficits ahead of time, companies can limit borrowing to sensible levels. They can also plan the timing of loan repayments to avoid cash crunches. Proactive debt management ensures businesses only take on what they can reasonably afford to repay, keeping financing costs down and preventing possible insolvency.
In summary, cash flow forecasts let companies foresee their upcoming cash position. This allows them to identify future shortfalls, plan major expenditures, and manage debt sensibly. Using cash flow forecasts is vital for making informed financial decisions and ensuring the business remains liquid. It provides an invaluable long-term view that promotes stability and growth.
Automating Cash Flow Forecasts
You do not need to create cash flow forecasts manually. There are various software tools available to automate and streamline the process. Some key benefits of using cash flow forecasting software include:
The software connects to accounting systems and imports data: Rather than manually gathering all the figures needed for the forecast, the software can sync directly with your accounting system or other business platforms. This automated data import saves significant time.
Real-time tracking of cash flow: We update the forecast dynamically in real-time, allowing you to monitor the forecast against actual results and quickly see when projections are off.
Customizable forecasting models: The software allows you to set up a forecasting methodology that fits your business. You can customize the timing intervals, line items, formulas, and layout.
Scenario planning: Many tools have the functionality to run different scenarios for "best case" and "worst case" projections, providing valuable insights for contingency planning.
Collaboration: Modern systems allow multiple users to access and update forecasts, enabling collaboration across teams.
Reporting and analytics: Software can generate reports and visualizations from the forecasts to quickly summarize and glean insights.
Overall, using a purpose-built cash flow forecasting software automates much of the grunt work involved. It provides efficiencies, richer models, collaboration, and insights to enhance data-driven decision-making. Evaluating options to find the right solution for your organization can take cash flow forecasting to the next level. West to East Business Solutions uses state-of-the-art software to give you the most accurate view of your future projections.
Updating and Revising
Cash flow forecasts should be considered living documents that require regular review and updating. The value of a cash flow forecast diminishes if it is not regularly revised to reflect changing business conditions.
Here are some best practices for keeping your cash flow forecast up-to-date that we use at our firm:
Review the forecast regularly: Set a schedule, such as monthly or quarterly, to formally revisit your cash flow forecast. Review actual cash flows compared to the projections and analyze any variances.
Update with actual cash flow amounts: As you progress through the forecast period, update the model to reflect real operating cash flows. This improves the accuracy of future period projections.
1. Review the key assumptions underlying your projections.
2. Update assumptions to reflect changes in expected sales volumes, prices, expenses, timing of receivables/payables, capital expenditures, or any other inputs.
3. Revise forecasts accordingly.
Keeping your cash flow projections current will ensure they remain valuable tools for managing your small business finances and cash flow. The forecast will retain relevance if regularly reviewed and updated to reflect your latest expectations and operating conditions.
One of the most important aspects of cash flow forecasting is effectively communicating the forecasts to key stakeholders in your business. There are several options for presenting cash flow forecasts:
Charts and Graphs
Visualizing cash flow forecasts using charts or graphs can make the data easier to digest. Bar charts are commonly used to show forecasted cash inflows and outflows over time. Line graphs can illustrate projected cash balances over the forecast period. Use clear labeling, legends, and data highlighting to ensure your visuals are easy to understand.
In addition to detailed forecasts, create summarized versions highlighting key numbers and trends and present key takeaways upfront before diving into specifics. Executives often appreciate condensed overviews they can see at a glance.
Customizing for Stakeholders
Think about what cash flow details matter most to each stakeholder and tailor forecast presentations accordingly. For example, managers may want departmental breakdowns, while accounting is concerned with overall cash position. Consider stakeholder needs and positions when formatting and emphasizing elements.
Effective forecast presentation ensures your hard work creating projections also pays off in practical use, driving operations, strategy, and decision-making. Apply best practices to transform cash flow data into insightful, actionable information.
Cash flow forecasting is an essential practice for businesses. Still, it does come with some potential pitfalls to be aware of:
Overly optimistic forecasts: It's easy to get carried away and make overly optimistic assumptions about future cash flows. However, forecasts should be based on historical data and trends. Setting realistic targets for revenue growth and expenses is important.
Not updating regularly: Cash flow forecasts quickly become outdated and irrelevant if they are not updated on a regular basis. As business conditions change, the forecasts need to be revised. Failing to do so reduces their usefulness for planning.
Limited visibility: Most cash flow forecasts only cover a three-to-six-month horizon. Trying to predict much further out than that with accuracy is difficult. Businesses should be aware of large expenses and debt repayments coming due in the more distant future.
Avoiding these common pitfalls will lead to more accurate and valuable cash flow forecasts. Building in regular reviews and updates and keeping assumptions conservative are good practices. With realistic forecasts, businesses can better manage their cash and avoid potential shortfalls.
Cash flow forecasting is a critical practice for any business. By planning out your expected cash inflows and outflows over a future period, you can identify potential cash shortfalls or surpluses ahead of time. This gives you the lead time to avoid cash flow problems.
Some key points to remember about cash flow forecasting:
- Forecast far enough into the future to anticipate fluctuations - generally 3-12 months out or more. The further out the forecast, the more room for error.
- Use historical data and future projections to estimate your cash inflows from sales and cash outflows from expenses each month. Consider seasonal patterns and trends.
- Continually update your forecasts with actual cash flow and revise projections. Cash flow forecasting is an ongoing process, not a one-time task.
- Present easy-to-understand forecasts to stakeholders using graphs and charts. Cash flow forecasts are an important communication tool.
- Automate forecasting using accounting software, when possible, for efficiency. But always verify computer-generated forecasts.
- Avoid common pitfalls like overlooking upcoming large payments or relying on overly optimistic sales projections. Stay grounded in reality.
Cash flow forecasting takes effort but pays major dividends for businesses in visibility and control over their financial future. With diligent forecasting and monitoring, you can proactively manage your business's cash flow.