Introduction
One of the most critical measures of a business’s condition is its cash flow, which is simply because even a profitable business can have a problem if it lacks adequate cash flow when obligations such as bills, salaries, suppliers, taxes, loan payments and others fall due. Profit is an indication of the accounting period in which a business is earning more revenue than spending, and cash flow reveals the actual flow of cash into and out of the business. The difference turns out to make cash flow forecasting a key management tool for entrepreneurs, small business owners, finance managers and accountants. An effective forecast can provide information about when cash shortages might happen, when there will be too much cash, help the business make better spending decisions, and provide business owners with time to react in advance of a cash problem becoming a crisis. Knowing and using the various forecasting methods enables businesses to enhance liquidity, reduce risk in their financial planning and make better short and long term choices.
Cash Flow Forecasting: What It Is and How to Use It for Your Business Planning.
The process of predicting the amount of cash inflow and outgo that will occur in the near future is called cash flow forecasting. Normally, the forecast looks at the cash that is expected to flow in, such as customer payments or sales receipts, loans and investments, refunds, and any other cash inflows, and the cash that is expected to flow out, such as payroll or rent, utilities, payments to suppliers, taxes, debt payments, purchases of inventory, and capital expenditures. It does not have to be an accurate forecast of the future, but rather a realistic financial picture for the benefit of management in preparing for potential problems and opportunities. When a business is aware of its probable cash flow situation, it can make decisions regarding deferring discretionary expenditures, arranging supplier terms, speeding up customer collections, financing the surplus cash or investing the excess cash. The forecast is not just another accounting document, but rather it is an early-warning system and a decision-making tool.
Why Cash Flow Forecasting is important for Small Businesses.
One of the problems facing small and medium sized businesses is that they may have less money available for them to use when they need it, that’s why it’s especially important for these types of businesses to have great cash management. When the unexpected strikes, a large corporation could have several financing options or it might have a good cash reserve; a smaller company could be at serious risk of disruption with a modest shortage of cash. In the case of a business, for instance, a number of sales can be profitable but there may be a lack of cash flow for paying employees due to the fact that customers have not paid their invoices. Likewise, a sudden equipment failure, tax bill or a rise or a drop in sales can suddenly put pressure on working capital. Familiar with the situations can be avoided with regular forecasting. It will also allow the firm to have a stronger foundation for budgeting, buying, hiring, expansion, debt management, and investment opportunities. For when forecasts are regular, management is less reliant on guesswork and can better adjust to varying financial circumstances.
Different Types of Cash Flow Forecasting Methods
There are various ways of forecasting cash flow that a business can use depending on the size of their business, their goals, the amount of money they have available and the time they have in which to forecast. The most popular methods are direct forecasting, indirect forecasting, rolling forecasts and the 13 week cash flow forecast. All the above-based techniques do not necessarily need to be competing systems; on many businesses they may complement each other. Either a direct forecast or an indirect forecast can be helpful for cash flow monitoring purposes or financial planning purposes. A rolling forecast enables management to be able to continually adjust its forecasts to reflect any new information, and a 13-week forecast offers a good short-term forecast of liquidity. The technique selected depends on the information needed to the management, the credibility of the information available, and the speed of the business environment.
1. Direct Cash Flow Forecasting Method
Direct cash flow forecasting is the process of obtaining a forecast of the actual cash receipts and payments that will be generated within a specific time frame in the future. The direct method rather than starting with accounting profit and adjusting it for future events, concerns the time that money is anticipated to be received or paid out in the business bank account. Sources of cash can be things such as sales, customer payments, collections, deposits, sales of assets, and loans, and inflows of cash could be repayments of loans, repayments of debts, and operating expenses, among others. The forecast can be done weekly, monthly or even daily, especially if a business is under a lot of pressure regarding liquidity. The direct method focuses on cash flow and is especially helpful for the short-term management of cash. It aids business owners in figuring out difficult issues that they may have to face like is there sufficient cash next week to pay employees or should the supplier’s payment be postponed.
The Pros and Cons of Direct Cash Flow Forecasting Method
The major benefit of making direct cash flow projections is the simplicity and practicality of the concept. A business owner can check against the bank balance on their expected receipts and determine if the business is likely to have sufficient cash and quickly check their payments. It can be a very useful approach for SMEs, for whom immediate visibility is needed, without the need for complex long-term financial modeling. It can also identify the impact of late payments by customers, unexpected payments by suppliers, seasonal sales trends, and significant one-off costs. But detailed transaction level data may be necessary for direct forecasting and the accuracy of the forecasts largely depends on the quality of the forecasting assumptions, including when customers will settle and when expenses will be paid. It may also prove tedious if a business has numerous transactions and/or several accounts. Such limitations should not detract from the fact that the direct method is one of the most valuable ways to manage short-term liquidity.
2. Indirect Cash Flow Forecasting Methods
The indirect method is a different way to forecast. It does not usually include all cash receipts and payments expected but instead starts with the forecasted profit (or some other accounting figure) and then accounts for non-cash receipts or payments, and changes in working capital. Depreciation does not reflect any cash flow, and the changes in accounts receivable, inventory, accounts payable and other working-capital items can impact the cash flow available to the business. This can be helpful if the management already has financial statements, budgets and income forecasts and they can use them as the basis for the calculation. It creates a link between profitability and liquidity and helps business owners to gain insight into how a business can generate high accounting profits and low cash flow. The indirect approach is therefore of great value for broader financial planning and strategic analysis.
The Pros and Cons of the Indirect Cash Flow Forecasting Method
The indirect method is useful because it could be used to incorporate cash flow forecasting into other financial planning activities. Establishing cash flow forecasting may be easier for businesses that already create income statements, balance sheets, budgets and financial projections. Also, it can aid management review the impact changes in profitability, working capital, financing, and investment decisions can have on cash. For business owners, however, this approach may not be as straightforward as they’d like when they want to see in their bank account how much money will be available at a specific time. It could also lead to inaccurate forecasts if the projected profit or working-capital figures are not realistic. Therefore, it is advisable that the indirect forecast should not be used in place of careful cash monitoring. It should be used in addition to real cash information and frequent checks of collections, payments and bank balances, however.
3. Rolling Cash Flow Forecasts
A rolling cash flow forecast is a way of keeping the forecast up-to-date by constantly lengthening the forecast period as it goes. A business can have a 12-month forecasting horizon for instance. After the first month, the first month gets dropped from the forecast and another month in the future is added. This provides an on-going picture of anticipated cash flow, instead of a forecast that is produced only once at the start of the financial year. Rolling forecasts are particularly beneficial in sectors that experience quick changes in sales, costs, customer behavior, exchange rates or economic conditions. They push management periodically to re-evaluate what was previously believed, rather than holding on to stale estimates. This process also enables companies to get a head start on trends. The rolling forecast can show the impact of late customer payments and enable management to take action if there is a recurring problem, for instance.
How to make Rolling Forecasts Effective
How frequently a rolling forecast is updated and the seriousness with which management conducts the forecasting process is key to its effectiveness. The companies should have some regular review plan (e.g. weekly, monthly) and check their results against previous forecasts. If there are significant differences, they should not be ignored, but investigated. If sales were on a regular basis below predicted, the company must examine the possibility of the sales figure being misjudged, or if it was the result of seasonality, loss of customers, pricing problems or any other factor. Likewise, when costs are typically higher than they are expected to be, management should determine which cost categories are to blame. As time passes, it can get better at forecasting and making fewer errors due to the company’s learning. New information such as contracts won, expected customer payments, purchases, tax liabilities, and changes in operating costs should also be taken into account when using rolling forecasts.
4. A 13-Week Cash Flow Forecast
One of the most helpful short term liquidity management tools is the cash flow forecast, which offers about three months into the future. Typically, it should report cash receipts and cash payments net of each other by week, starting with the weekly cash balances and forecasting the weekly cash balances which should be reported at the end of each week. They can be divided into inflows, such as collecting cash from customers, receiving sales receipts, financing proceeds and any other cash expected to be received, and outflows, which include payroll, suppliers, rent, taxes, debt repayments, utilities, and capital expenditures. The weekly format can be helpful in determining the specific time of the week that cash may be scarce. It is particularly relevant for companies that have an unpredictable cash cycle, seasonal cash flow, heavy debt payments or slow customer payments. The short time horizon of the forecast may allow more certain assumptions to be made than in long-term forecasts.
Why Businesses should use a 13-week Forecast?
The best part of the 13-week forecast is that it converts a general liquidity concern to a specific timeline. The statement that a company could have a cash shortage during the next few months can be turned into a statement that the company would have a cash shortage that week or on a specific date. This provides the business with a chance to react. Management could speed up the collection of receivables, negotiate for longer payment periods, defer non-essential purchases, trim marginal costs, and utilize an existing credit facility or setup new financing. Another advantage to having a forecast is that it can be revised regularly when actual results occur in periods of financial uncertainty. While it’s a process commonly found in companies that are experiencing financial strain, it can also be a sound liquidity management strategy for healthy companies.
Effective ways of Anticipating the Cash Shortage
In order to predict a cash shortage, more than just sales can be estimated. It’s essential to know the timing of both inflows and outflows as there can be a significant liquidity gap between the time the revenue is earned and the time it’s collected. The initial step is to set up a correct opening cash balance and then to take an estimate of expected receipts from the invoices, but not their date of invoice, but realistically their date of receipt. The next step for the company is to draw out the billable expenses that they must pay – these include payroll, rent, taxes, supplier invoices, loan repayments, and other essential operating expenses. These numbers get entered into the forecast and management can then calculate what the cash balance is expected to be in each of the periods. The warning should be issued when the balance is going to be near or less than the minimum cash reserve of the company. It’s also important for businesses to run other scenarios, including customers paying 15 or 30 days late, sales doing worse than anticipated or if an extra expense arises.
How to Identify and Manage Cash Surpluses
Most cash surpluses are positive, but it is important to manage the excess cash with care as it simply might be a case of a large amount of idle money being placed in a low-yielding account. A forecast can indicate when there is likely to be excess cash flow in the business for normal day to day activities and minimum reserves. Surplus can then be considered for the appropriate uses that can be made by management, whether it be the purchase of essential equipment, the ability to reduce the cost of debt, the ability to build up emergency reserves, the ability to invest in growth opportunities or the ability to improve working capital. But businesses should not presume that predicted surpluses are going to be in their pocket for discretionary expenditure. There may be some obligations that are already funded for future taxes, suppliers, loan repayments, seasonal costs, or planned capital costs. As such, it is essential to consider a surplus within the context of future commitments and a company’s desired liquidity buffer. Forecasting can be used to differentiate between cash available and cash that is temporarily unavailable.
Using Scenario Analysis to Improve Forecast Accuracy
It is important to recognize that no cash flow forecast can give an absolute guarantee for the future and, as such, should be complemented by scenario analysis to form part of effective financial planning. A business can come up with one forecast versus a “base case”, a “best case” and a “worst case” forecast. Base case is the most realistic case that can be made with available information. The best case could be for higher sales, quicker payables, reduced costs, etc., while the worst case would be for slower sales, slower collections, higher costs, etc. These scenarios can be compared to give management an understanding of the sensitivity of the business to changes in assumptions. Even in the base case scenario, management might have to act in advance of a worsening situation, if there is a small cash margin. The value of scenario planning to SMEs is that they are able to plan ahead before financial issues do arise, instead of reacting in an adrenocorticotropic hormone rush to solve a financial problem.
Common Mistakes made in Cash Flow Forecasting
The worst error in forecasting is being overly optimistic about how much revenue and customer payments are going to be. In some cases, businesses may book expected sales when the customer has credit terms or a history of late payments; this is an artificial approach that inflates sales. Occasionally, businesses may record expected sales as if the cash will arrive the same day that the sale is recorded, when customers might have credit terms or have a history of late payment; this is a fake approach which inflates sales. Another common mistake is that people don’t take into account any expenses that are not regular. While there are monthly expenses to consider, there are also other expenses that can sneak up on you, such as insurance premiums, taxes, annual subscriptions, equipment repairs, loan repayments and other seasonal purchases. However some businesses don’t re-evaluate their forecasts when the situation changes, which leads to old assumptions affecting decisions. Forecasting can also become unreliable when owners are not separating between business and personal expenses, they aren’t reconciling bank accounts or the financial records are incomplete. These errors can be avoided by keeping the books in a disciplined way, making realistic assumptions, keeping the books up-to-date, and comparing the cash flow forecast with the actual cash flow on a regular basis.
Best Practices for Effective Cash Flow Forecasting
If businesses set clear procedures and designate someone to take responsibility for keeping the forecast up to date, they can enhance their forecasting process. Any forecast should be accompanied by the true financial position of the company with current bank position, outstanding invoices, obligations to suppliers, payroll obligations, schedules of debt and expected operating expenses. The assumptions should be documented to enable management to understand how the projections have been calculated. Forecasts should also be made on a frequency that is suitable to the company’s risk level. For a stable business, you may want to check your forecast monthly, and for a business that’s growing quickly or is under liquidity pressures, you may need to update it weekly. It is also useful to compare forecasts with the actual results, as this will bring to light where assumptions were incorrect. Last but not least, management should set an acceptable minimum cash level and establish its response when the cash forecast indicates that it is on the verge of reaching the level. These practices mean a new way of forecasting in a passive financial activity becomes a tool for active financial management.
Choosing the Appropriate Cash Flow Forecasting Method
No single forecasting method is a cure all for all businesses. Appropriate solution will be based on the size of the enterprise, number of transactions, financial complexity, cash cycle and aims of planning. One of the best types of forecasts for a small business owner who wants to know if he will have enough cash on hand to pay the bills next week would be a direct cash flow forecast. The indirect method might be more suitable for a company that has a good financial reporting framework in place and wants to incorporate cash flow into overall financial planning. Rollings forecasts can work for businesses in unpredictable environments as they can always adjust their expectations. A detailed 13-week forecast could be of great benefit to companies experiencing liquidity problems, or those with a narrow working capital. In many instances, a combination of techniques will be the best course of action. A business could have a rolling forecast of 40 weeks or more for strategic planning and a forecast of 13 weeks for detailed weekly liquidity management.
Conclusion
Cash flow forecasting is more than just a bookkeeping activity, it is a concrete management tool which can make or break a business’s ability to have financial flexibility to face challenges and seize opportunities. Direct forecasting gives insights into the real expected receipts and payments, while indirect forecasting links profitability and variations in working-capital to future cash positions. Rolling forecasts maintain up-to-date financial projections and the 13-week forecast gives a detailed short-term outlook which can be particularly useful for liquidity management. Key cash parameters such as minimum cash levels, sensitivity testing of various scenarios, prediction of cash shortages and surpluses and regularly reconciling forecasts with actual results are some additional indicators that businesses can track to reinforce their forecasting. Businesses and SMEs that have cash flow forecasting as part of their regular business management process are more likely to pay their bills on time, avoid unnecessary cash emergencies, manage working capital and make well-informed financial decisions. The ultimate aim is not to forecast all transactions accurately but to provide the decision makers with sufficient accurate information for taking actions in time prior to cash problems becoming an emergency and to take advantage of surplus liquidity in judicious manner when it arises.
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