While large businesses with dedicated finance teams can spend significant time and resources forecasting their future cash flow, smaller companies typically need to find ways to do it in-house. Thankfully, forecasting cash flow is simpler than one would think. You can get a good idea of your business’s future cash flow by maintaining accurate financial records, utilizing accounts payable tools, and having a clear understanding of your incoming funds.
Cash flow management is vital for businesses, and problems related to cash flow are consistently cited as one of the biggest reasons small and medium-sized companies fail. The US Bureau of Labor estimates that around 80% of small businesses survive their first year. This figure drops to a half after five years and a third after ten years. Managing your money and forecasting future cash flow properly can be the difference between success and failure.
The importance of cash flow forecasting
Cash flow forecasting is the process of predicting a business’s future incoming and outgoing cash over a fixed period. These are predictions, and their accuracy will vary. But, with reliable cash flow forecasting, you can help keep your company in great financial standing.
This offers a range of potential benefits, including:
- Avoiding periods of negative cash flow and the likelihood of missing payments.
- Identifying periods of positive cash flow where you can take advantage of cash surpluses.
- Understanding the financial performance of your business and revealing cash flow patterns by comparing forecasts to the actual figures.
- Getting your business out of debt faster after borrowing funds or missing payments.
- Facilitating sensible business growth through the effective use of excess liquidity.
Ultimately, cash flow forecasting allows businesses to plan for the future and optimize financial decision-making. So, how do you go about forecasting your future cash flow? First, you need to make two key decisions.
Choosing a forecast duration
While it can be beneficial to have long-term forecasts, there is generally a trade-off between the prediction’s accuracy and the duration. The period for which you should forecast will often be governed by your objectives and the availability of the data you have.
Typically, cash flow forecasts can be separated into four main durations:
- Short-term: Ideal for managing cash flow on a granular, day-to-day basis, short-term forecasts typically only look a few weeks ahead.
- Medium-term: Ranging from two to six months in the future, medium-term forecasts offer a more complete view of the company’s finances to help with debt reduction or liquidity risk analysis and even planning for large upcoming outlays. The most commonly used medium-term duration is a rolling 13-week forecast (quarterly).
- Long-term: Predicting cash flow between six and twelve months in advance, long-term forecasts help businesses develop annual budgets and plan for long-term growth projects.
- Mixed period forecasts: A slightly different approach, mixed period forecasts are a common tool for liquidity risk management by combining the three durations discussed above. In practice, this could look like a more granular week-to-week analysis for the first three months before extending to a monthly analysis for the next six months.
Direct vs indirect cash flow forecasting
Direct forecasting relies on known costs that are updated daily or weekly, while indirect uses past data and income statements to project the future. The method you choose depends on the duration you’re trying to forecast.
The direct method is better for shorter-term forecasts as it deals with known, upcoming bills. It’s often a good approach to monthly budgeting, ensuring your business has the funds to meet all of its immediate bills.
In contrast, the indirect method is better for longer forecasts and budgets, and planning for future expenses or growth opportunities. Direct forecasting often breaks down for periods longer than 90 days ahead, as it relies on hard data that becomes less accurate the further you project. Indirect forecasting uses projected income statements while accounting for longer-term factors affecting cash balance, such as depreciation.
Gathering the data and making the forecast
To accurately forecast cash flow, you need your opening balance and your projected incoming and outgoing funds.
Utilizing the direct method for a shorter-term forecast, you can often pull all of the data you’ll need from the software you use to manage your finances. This includes accounting, accounts payable/receivable, and enterprise resource planning (ERP) systems.
Find all of your anticipated income, including sales revenue and investments. Next, total all your upcoming expenses, including payroll, rent, raw materials, interest payments, taxes, and marketing spend.
Your net cash flow for the period in question is then simply the difference between your incoming and outgoing funds. Your closing balance is this figure added to your opening balance.
Positive cash flow means you’re earning more in the next month than all of your expenses combined, and you should determine the best way to use the additional funds. Negative cash flow means you’re spending more than you’re earning over the forecast period and may have issues covering all your accounts payable.
The indirect method, looking at longer cash flow projections, is more difficult to explain succinctly. It considers past financial results, looking at income and balance sheet items, and includes non-cash transactions. You’ll need to analyze historical financial statements and make assumptions about future performance to predict longer-term cash flow.
The most common methods of indirect forecasting include:
- Adjusted net income: Takes net income from previous financial periods and adjusts for non-cash transactions.
- Pro forma balance sheets: Uses a balance sheet with historical and predicted data to determine cash flow (often, this method can be automated using accounting software).
- Accrual reversal: Estimating cash flow from the difference between current assets and liabilities.
Make financial decisions based on all the information available
Cash flow forecasting is a valuable tool for businesses wanting to make strategic decisions about the future. Uncovering potential periods of negative cash flow allows you to determine how best to meet your financial obligations. Discovering when you have a surplus of cash available allows you to plan for growth opportunities and predict when you might be ready to expand.