What is Cash Flow Forecasting?
Cash Flow Forecasting is a financial tool to identify future forecasted cash position over a specific timeline. It helps determine whether the future cash position will be sufficient to cover financial liabilities. It also helps determine whether the future cash position will sufficiently cover investment in business growth. Cash flow forecasting is a key financial management component.
Introduction
This comprehensive guide will show you everything you need about cash flow forecasting. It is for entrepreneurs and business owners.
First, I will share the importance and tangible benefits of creating a cash flow forecast.
Then, I will share how to build a solid foundation for preparing a cash flow forecast. I’ll cover choosing different methods and models.
Then, I will share step-by-step instructions on creating a cash flow forecast with you and its limitations.
Did you know?
82% of businesses fail because of cash flow problems. One of the reasons why it happens, from my experience, is business owners do not have cash flow clarity on their short-term funding needs.
This is where cash flow forecasting comes into play.
Who am I to guide you?
I’m a Fellow Chartered Certified Accountant (FCCA) and Cash Flow Expert, with over 20 years of experience. I’ve helped hundreds of clients create cash flow forecast in various sectors. These sectors include dental practices, retail, marketing agencies, fine arts, and e-commerce. Their annual revenues range from £40k to £53.8m.
I have been featured in leading media sites like Independent and global brands like QuickBooks Online, Zoho, and Float app.
I am the founder of Hungry Cash Flow software. I am also the creator of The Cash Flow Hub, the world’s most comprehensive cash flow resource online. I serve my clients through my consulting company, Hungry Cash Flow Ltd.
I am sharing these credentials to make you feel comfortable that you’re learning from someone who does this for a living all day, every day.
For example, using a cash flow forecasting tool, I helped a seven-figure dental practice owner buy another dental practice.
I also helped a tech startup secure business funding of £475k
I helped a retail client pass through dry periods to maintain working capital from June to August every year for 12 years of working with him.
All of these results are achieved by using a cash flow forecasting tool.
So, wherever you are in your business journey, this will help you.
Before you go further, I encourage you to download this cash flow forecast template.
Why?
Then, you can implement the information I share in this guide for business owners who want to master cash flow forecasting.
KEY TAKEAWAYS
- Critical for Strategic Decision-Making: Cash flow forecasting is vital for businesses to anticipate future financial positions, ensuring they can cover liabilities and invest in growth effectively.
- Proactive Financial Health Management: It enables businesses to foresee and address potential cash flow issues, facilitating better-informed, strategic decisions to maintain financial stability.
- Foundation for Business Planning and Funding: A robust cash flow forecast supports strong business proposals, aids in securing funding, and integrates seamlessly with strategic business planning, highlighting its importance in overall business success.
So, let’s dive in!
I want to start by providing an example so that it is easier for you to grasp the concept.
Cash Flow Forecast Example
In 2023, I worked with a £1.2m annual revenue business in a retail space selling luxury handbags. Let’s call it Company A.
I’ll explain how I managed to do a cash flow forecast for them.
Let’s say we are at the beginning of January 2024, starting with the actual beginning cash balance of £19,500.
Estimate operational cash flow
Example: Company A expects to earn £100,000 from selling handbags. It also expects to receive £10,000 in cash interest.
Operating expenses such as wages and equipment maintenance are part of operating activities. Company A has £30,000 in wages, £35000 for marketing, £10,500 for premises, paying PAYE/NI for £3500 and buying handbags to sell for £55,000.
Operating cash flow: £100,000 + £10,000 – £30,000 – £35000- £10,500- £3,500- £55,000= -£24,000
Estimate cash flow from investing activities
Example: Company A has no investing outflows but expects to earn money from selling equipment. It expects to get £25,000 and £15,000 from this.
The cash flow from investing activities is £25,000 + £15,000 = £40,000.
Estimate cash flow from financing activities
Example: Company A expects to gain £20,000 and lose £5,000 from financing activities.
The cash flow from financing activities is £20,000 – £5,000 = £15,000.
Add the three amounts
The final step is to add the three subtotals.
Example:
-£24000 + £40,000 + £15,000 = £31,000
According to this estimate, Company A will have a net positive cash flow forecast of £31,000 at the end of January 2024.
The closing forecasted cash flow balance is £50,500 at the end of January 2024.
If you follow the cash flow forecast, the company will have an overdrawn bank closing balance of £1,000 and £53, 000 in February and March 2024.
How does this help?
At the beginning of January 2024, the business will have a cash forecast position. It shows that the business will run out of money at the end of February 2024. The business can then take actions to stay cash flow positive.
Functions and Uses of Cash Flow Forecasting
What Is a Cash Flow Forecast Used For?
If you want to know how much cash your business will have or need in the future, you’ll need a cash flow forecast. Cash flow forecasting is used as a cash flow tool for:
Optimizing Cash Position
It can help you plan how to spend your cash in the smartest way possible. You can avoid wasting money on unnecessary expenses. Instead, you might spend the money on projects that will increase your income.
Preparing for Future Cash Flow Problems
A cash flow forecast can help you spot a cash shortage or surplus before it happens and take action accordingly.
Making Better-Informed Decisions
From what I have seen working with my clients, it can help you see how different choices will affect your cash position in the future.
- A positive cash flow means you have cash coming in rather than going out in a specific period. A negative cash flow means that you have more money going out than coming in. Positive cash flow is important for your business because it gives you enough money to cover your costs.
- It also helps you grow your business and save for emergencies. Having a negative cash flow can be risky for your business. This can lead to cash shortages, debt problems, and missed opportunities.
- A cash flow forecast is useful for you and others who care about your business’s financial performance and health. Some of these stakeholders are:
- Lenders: An individual, organization, governmental or private, or financial institution that lends money to a person or company that expects to be returned. Lenders want to know if you can repay your loans and interest on time.
- Shareholders: A limited company’s owners are its shareholders. They want to know if you can make enough money to reward them for their investment and risk.
Integration in Strategic Business Planning
From my experience working with small business owners who either sell a product or provide a service, I have learned that cash forecast is integral to business planning. When you make a business plan, money is also involved. You need to hire a professional to do market research or buy inventories from vendors; you need to estimate future cash going out.
This is where the integration of cash flow forecasting with strategic business planning comes into play.
How To Build a Foundation of Cash Flow Forecasting?
Building a solid foundation of cash flow forecasting requires you to be aware of these areas.
1. Where does it fit in?
It is a part of financial management. It is prepared alongside profit and loss, balance sheet, and cash flow statement to provide a comprehensive financial position of the business.
2. How does it work?
To work out how cash flow forecasting works, you need to be aware of the following:
- Formula
- Key aspects
The Formula
Let’s start with the formula first:
There is one simple formula to calculate the cash flow forecast. It uses very simple mathematics to estimate how much you expect to earn and spend over a certain period, usually 30 or 90 days. The formula is:
Cash Flow Forecast = Beginning Cash + Forecasted Inflows – Forecasted Outflows = Ending Cash
Let’s Break it Down
Beginning Cash- This is the amount of cash your company has on hand at the start of the period. You can find this on the Statement of Cash Flows.
Forecasted Inflows– The money you expect to receive during the period includes outstanding and future payments.
Forecasted Outflows– The costs and payments you expect to make during the period.
Suppose you have the following:
- Forecast outflows for the next 30 days = £5,000
- Forecast inflows for the next 30 days = £40,000
- Beginning cash = £40,000
Here’s what your cash flow forecast will look like: (£40,000) + (£40,000) – (£,000) = £75,000
Key Aspects to Consider
Things To Consider When Creating A Cash Flow Forecast
A cash flow forecast helps you plan your finances and avoid cash shortages or surpluses. To create a cash flow forecast, you need to include the following things:
Opening balance: This is the amount of cash you have at the start of the period. For a new business, this is usually zero. This is the closing balance from the previous period for an existing business.
Cash inflows: These are the sources of cash that come into your business. These include sales, tax refunds, funding, grants, and investments. You need to estimate how much and when you will receive these inflows based on your sales forecasts, contracts, invoices, and payment terms.
Cash outflows are the expenses that you pay out of your business. Examples include salaries, rent, raw materials, marketing, taxes, loans, and other bills. You must have projections on how much and when you will pay these outflows based on your contracts, invoices, payment terms, and budget.
Total inflows and outflows: These are the sums of your cash inflows and outflows for each period. You can calculate these automatically using a spreadsheet or an application software tool.
Frequency of Use To determine the frequency, we need to consider the following factors:
- Industry
- Characteristics of business
- Regulation requirements
- Purpose
If you want to go deeper on this topic, check out how frequently cash flow forecasting should be used
How Does Cash Flow Forecasting Help Business Owners?
Cash flow forecasting can help business owners with :
- Strategic Business Planning
- Business Proposal
- Business Funding
- Working Capital
Let’s look into them, one by one, in detail, with real-life examples of my clients in different industries and business sizes.
1. How Can Cash Flow Forecasting Help with Business Planning?
Cash flow forecasting is a helpful tool for business planning. It is also useful for strategic decision-making. By predicting future cash flows, you can see if there might be any gaps or surpluses in your cash flow and adjust your operations accordingly.
It reminds me of one of my clients, a seven-figure dental practice owner based in Guildford looking to expand. We sat down to tackle the numbers, diving deep into the heart of their financial operations.
We found a bit of a mixed bag – solid income, but the cash flow could choke on a toothpick.
From my experience, I knew we needed a clear view of the cash coming in and out, especially with expansion on the horizon.
Creating a 13-week cash flow forecast was our first step. We took the last six months of actual cash flow data and, based on creating the next 13-week cash flow forecast.
From what I have seen, this kind of detailed forecasting is a game-changer. It helped us pinpoint exactly where the cash was getting stuck and what moves we needed to make to keep the practice’s financial health in top shape.
What improved was, frankly, everything.
We identified key areas where the practice could optimize spending and improve cash collection processes. This wasn’t just about surviving; it was about setting the stage for growth.
The result?
The practice stabilized its financial footing and successfully funded its expansion to a new location, Farnborough while maintaining a healthy cash flow.
It was a testament to the power of proactive financial planning and the kind of success story I’m proud to be a part of.
2. How Can Cash Flow Forecasting Help with Strong Business Proposal?
Cash flow forecasting is a crucial aspect of a strong business proposal.
A well-designed cash flow forecasting model can provide a potential lender or investor with a clear and accurate picture of your business’s financial health, both now and in the future.
I worked with a startup keen on breaking into the tech industry. Their idea was solid but needed a robust business proposal to secure funding.
What we found through detailed cash flow forecasting was eye-opening.
It allowed us to pinpoint exactly how much investment was needed and when. This precision turned their proposal from good to irresistible.
In my experience, a strong business proposal not only shows visionary ideas but also a clear path to financial stability and growth. Our cash flow forecast did just that, showcasing a well-thought-out plan for managing finances.
What improved was not just their proposal’s quality but also investor confidence. They could now see a clear, calculated financial trajectory. This significantly boosted the proposal’s credibility. This case is a testament to how crucial cash flow forecasting is in laying down the financial groundwork of a compelling business proposal, bridging dreams with reality.
3. How Can Cash Flow Forecasting Help With Business Funding?
Cash flow forecasting can help with business funding by identifying potential investors, preparing loan applications, and providing data for investors or banks to evaluate your business’s financial viability.
It is very important for you to have a thorough understanding of your business’s funding needs. Cash flow forecasting is one of the best tools for achieving this.
I once advised a client looking to raise £500,000 for their innovative tech startup. We identified a precise breakdown of the funds’ allocation over the next 12 months through meticulous cash flow forecasting. We pinpointed £300,000 for product development, £100,000 for marketing, and £100,000 for operating expenses.
This forecasting clarified the funding requirement and demonstrated the startup’s prudent financial planning to potential investors. The detailed forecast included in their business proposal illuminated a path to revenue generation and profitability, significantly enhancing their funding appeal.
The result?
The startup secured the funding. Investors praised the clarity and foresight of the financial projections. This success story underscores how critical cash flow forecasting is for startups. It is essential when seeking funding. It provides a solid foundation for their financial strategy and bolsters their case to investors.
4. How can cash flow forecasting help with working capital needs
Working Capital is the difference between a company’s current assets and liabilities. It represents the funds available to cover short-term obligations. Working capital can be either positive or negative. A positive balance indicates current assets exceed current liabilities, while a negative balance indicates the opposite.
The cash flow forecasting statement provides the future forecasted cash position of the business. This means that it identifies whether the current working capital requirement is covered.
Why is this important to you as a business owner?
In my experience, businesses must monitor their working capital, cash flow, and accounts payable to ensure everything runs smoothly. On a day-to-day basis, managing cash flow is crucial.
From what I have seen examining my client’s financials, the level and changes in working capital are more relevant when evaluating the company’s operational success at the end of the year. Income is used to pay off cost.
So, when there’s a positive cash flow, working capital increases, and you can use it to pay off accounts payable, creating a negative cash flow.
That means there’s always a relationship between cash flow and working capital that must be carefully managed so the company can meet its obligations and keep growing by making investments.
I will share how I helped a retail client meet his working capital needs using a cash flow forecasting document.
Working with a retail client generating over £1.5m in revenue, we identified a need for £250,000 in additional working capital to support inventory expansion and marketing efforts for the upcoming holiday season.
We demonstrated how this investment could boost sales by 20% through cash flow forecasting. This would achieve a return within six months. This forecast, detailed in their financial plan, enabled them to secure favourable credit terms with suppliers and a short-term loan, optimizing their cash flow and supporting strategic growth without disrupting operational liquidity.
Limitations of Cash Flow Forecasting
While cash flow forecasting has its benefits, it also has some limitations. These include:
- Fails to convey net income
- It needs further analytical tools
- It is not comparable to an income statement
- It is not possible to compare across industries
What Are the Common Challenges of Cash Flow Forecasting?
Here are the most common challenges that I come across businesses face when it comes to cash flow forecasting:
1. Lack of a Dedicated Team: You need a dedicated team, a bookkeeper or an accountant, and a cash flow specialist who can handle cash flow forecasting. Most business owners cannot access an accountant who will provide cash flow forecasts as an added service. Primarily, they are engaged only in preparing final accounts and filing tax returns.
2. Non-Involvement of Departments: You must involve all the departments with data relevant to cash flow forecasting. You can’t do this alone or with just one person. So, you will need honest, accurate, and transparent communication. If even one person or department refuses to participate or acts carelessly, it can affect the whole process.
An energy provider servicing company recently approached me to guide their cash flow situation. I noticed that there was hardly any communication between the sales team and the procurement team. The management accountant was receiving an unattainable sales forecast. Meanwhile, the procurement team was spending excessively for a business that was far from cash positive.
The result?
A business that had been running profitably with a healthy cash flow for two decades went into a severe cash crunch in a few months. Things were so bad that the company had to reduce the workforce by half.
3. Using Wrong Data
Inaccurate data is the quickest way to ruin cash flow forecasts. There is a saying in our world of accounting and finance. Garbage in and garbage out. The cash flow forecast will be wrong if the transactions are not categorised correctly. In addition to this, regular bank reconciliation should be performed to ensure debtors’ and creditors’ balances are correct to prepare the cash flow forecast.
4.Ignoring Historical Data
A cash flow forecast that doesn’t use past performance is just a guess. You should always include historical data like variable costs and unexpected expenses in your cash flow forecasting, no matter how much you can access it.
This way, you can glimpse the future by looking at the past. You can make accurate forecasts better when you combine them with careful analysis.
5.Forgetting Tax Liability
Your tax obligations and sales, revenue, and cash flow change. For example, if your revenue increases, your business might have to pay more taxes. On the other hand, if your revenue decreases, your tax burden might go down.
TIP: Most business owners cross reference the word projection with the forecast. They are not the same. Think of the weather forecast. Have you heard of weather projection? I haven’t.
Why ?
Because we can forecast what the weather will be? However, we cannot project how to have specific temperatures on a given day.
Similarly, projecting cash flow is about maintaining a certain level of cash flow balance at a certain period, whereas forecasting cash flow is about the future cash position at a certain period.
Methods and Models of Cash Flow Forecasting
Cash Flow Forecasting Methods
Two types of Cash Flow Forecasting Methods
Cash flow forecasting can be done using either the direct or indirect method, both valid options. You need to know their differences to choose the best method for your business.
1) Direct Method: The direct method is much simpler to calculate but is less commonly used. Cash flow equals receipts minus payments, which is exactly how it works in the direct cash flow forecasting method.
As you can see, this method uses the actual cash inflows and outflows to generate its result. This method is less frequent because it can be hard to get the data, especially for businesses that use accrual-basis accounting instead of cash-basis accounting. Mostly, you use the direct forecasts method for short-term cash flow forecasts.
Short Term cash flow forecast- You can use short-term forecasts to project the cash flows for a shorter period. This is usually less than a year. They can be as short as 30, 60 or 90 days.
These forecasts help you monitor your cash flow situation and identify any liquidity issues that may arise soon. You can use short-term forecasts to plan your financial resources. They help you fulfill short-term objectives.
2. Indirect Method
The indirect method starts with net income and adjusts for factors that affect profit but not cash flow. Transactions are recorded in accrual-basis accounting before money changes hands. Accounts receivable and payable must be adjusted to reflect the actual cash flow.
The same goes for funds that have been set aside for taxes but have not yet been paid. You must also consider any assets bought or sold and any money borrowed or repaid from financing sources.
There are three methods of performing the indirect methods
- ANI- which stands for adjusted net income
- PBS- which stands for pro forma balance sheet
- ARM- which stands for accrual reversal method and is similar to ANI
ANI is the most commonly used among the three of them. ANI process starts from operating income (EBIT) and then adds or subtracts balance sheet movements to arrive at the cash flow forecast position.
The indirect method is mostly used to do long-term cash flow forecasts.
Long Term cash flow forecast- You can use long-term forecasts to estimate the cash flows for longer. They can be divided into several 12-month cycles or span multiple years. These forecasts help you evaluate your long-term financial performance. They also help you spot potential investment opportunities.
You can use long-term forecasts to assess the viability of your business model and the return on your current investments. You can also use them to adjust your credit policies and strategies.
Cash Flow Forecast Direct vs Cash Flow Forecast Indirect Methods
Below are the key differences between Cash flow forecast direct vs cash flow forecast indirect:
Cash Flow Forecasting Model
You can create cash flow forecasting models depending on your needs/capacity to prepare regularly.
- Daily
- Weekly
- Monthly
- Quarterly
- Annually
The most common cash forecasting model is monthly. This way, you know your cash flow position month to month to make it more manageable for you.
Practical Steps in Cash Flow Forecasting
Creating a Cash Flow Forecast
How do you create a cash flow forecast?
There are several ways to create the forecast. Here’s a simple approach:
- Choose a timeframe, such as six months from now, and calculate the value of your transactions during that period.
- Determine the money you expect to receive. Start with a sales forecast, especially for regular invoices that you can reasonably predict. Include other inflows such as investments, asset sales, grants, and tax refunds.
- List the money you expect to spend separately, including future overhead costs such as personnel, rent, software, hardware, and taxes.
- Use the Net Cash Flow calculation to determine if you will have positive or negative cash flow during the selected period. The formula is Cash Received – Cash Spent = Net Cash Flow.
Cash Flow Forecasting Template in Excel Spreadsheet Download
This cash flow forecasting template helps you track your business’s total cash flow (income, expenditure) for 12 months. You can see the expected and actual cash-on-hand amounts for the first day of each month. This way, you can plan ahead and ensure you have enough money to pay your employees and suppliers.
Enter your cash inflows and outflows data in an Excel spreadsheet to get your end-of-month cash balance. This template’s monthly data also show any potential cash flow problems that might affect your business.
Click here to download the template and see my step-by-step video of how it’s done.
Once you have prepared the cash flow forecast, the next step is to analyse it.
Let’s look into this in the next section.
Analyzing Cash Flow Forecasts
How to analyze cash flow forecasts
It is important to prepare an accurate cash flow forecast to rely on the presented figures. To do this, it is necessary to analyze the cash flow forecast, where you may encounter categorization or incomplete information. Once you correct these, you will have an accurate cash flow forecast.
To analyze a cash flow forecast in detail, follow these steps:
- First, review the cash flow statement to identify the sources and uses of cash during the reporting period.
- Next, calculate the cash flow, such as the cash ratio, operating cash flow ratio, and free cash flow, to see how the company performs concerning cash management.
- Then, compare the forecasted cash flows to actual cash flows for the same period to evaluate the accuracy of the forecast.
- Additionally, consider any cash flow prediction challenges and how they may have affected the forecast.
Lastly, analyze the impact of the cash flow forecast on important business decisions, such as funding or investment opportunities.
Tools for Cash Flow Forecasting
Cash Flow Forecasting tools
Cash Flow Forecasting Software /AI
Cash flow forecasting software or AI automates gathering financial data from various sources. These include accounting systems, invoices, bank statements, and other relevant documents.
By integrating this data, the software generates comprehensive cash flow reports and projections, allowing businesses to clearly understand their cash position in the short term and long term.
The software uses advanced algorithms and analytical techniques. It analyzes historical data and identifies patterns and trends. To provide accurate and reliable cash flow forecasts, they consider factors such as sales revenue, expenses, accounts receivable, accounts payable, loan repayments, and investment activities.
So, in this day and age, it’s of the utmost importance for you to use such software to greatly improve the efficiency and accuracy of making your cash flow forecasts.
If you want to know the top cash flow forecasting software list, here is the link.
Limitations of cash flow software
Although cash flow forecasting software speeds up and prepares cash flow forecast reports, it has its limitations. It relies heavily on historical transactions to make forecasts. Business may be operating at a new level, or significant big changes may happen to the business sector it is associated with. The software doesn’t consider this, and human intervention is required.
Spreadsheet
A spreadsheet, however, is most commonly used to prepare a cash flow forecast. It is easy and simple to use. Google Sheet version of the spreadsheet is free. For a simple cash flow forecast, it does a good job. When the forecasting starts to get complicated as the business starts to build scenarios and has to get data from different variable sources, then the spreadsheet is prone to errors and becomes unreliable.
So, the lesson for you is to keep the cash flow forecasting as simple as possible to use a spreadsheet as a cash flow forecasting tool.
Interactive Cash Flow Forecasting Quiz
If you are concerned about cash flow forecasting, you can take this quiz- how healthy is your cash flow ? It points out the areas you need to fix and step-by-step guidance on how to do it.
Summary
Cash flow forecasting is a critical component of financial planning. It helps businesses make informed decisions about allocating and saving their financial resources. By estimating future business growth and predicting cash inflows and outflows, companies can avoid cash crises and ensure they are sticking to their budget.
Manual forecasting can be challenging, but using an online accounting solution to automate the process offers many advantages. A real-time overview of incoming and outgoing cash is essential for accurate forecasting.
It’s also important to monitor your cash flow forecast results by subtracting costs from available cash at the end of each period. This helps identify warning signs of trouble ahead and allows businesses to avoid financial difficulties proactively.
