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Cash-flow forecasting is a forward-looking process that could help businesses anticipate future cash positions and understand how much cash they might have readily available to run their operations.
Cash-flow forecasting could be a natural extension of cash-flow analysis, which is the process of measuring a business’s cash flow during a certain period of time. By projecting future cash flow, businesses may better anticipate surpluses and deficiencies, make financial planning decisions, and invest in future growth.
Learn how to forecast cash flow, potentially avoid common forecasting mistakes, and prepare your projections to help fuel business success.
Key takeaways:
- Cash-flow forecasting is the process of projecting cash inflows and outflows based on historical business data and future activities.
- Cash-flow projection may help with managing risk, making informed financial decisions, securing funding, and preparing budgets for potential cash surpluses and shortages.
- Businesses may use a four-step framework to forecast cash flow: determine a forecasting period, choose the direct or indirect method, gather necessary financial data, and complete the calculations.
Cash-Flow Projection: What It Is and Why It’s Important
Cash-flow forecasting, or cash-flow projection, is the process of estimating future cash inflows and outflows based on historical data and expected business activity. With cash on hand, businesses may be better prepared to keep inventory stocked, make payroll, and cover other critical business expenses.
Cash-flow forecasting may be important because it helps companies anticipate gaps before they occur and plan accordingly. With a predicted positive cash flow, for example, a company might plan to pay down debt or evaluate potential investment opportunities. Conversely, if a negative cash flow is on the horizon, a company might plan in advance for alternative capital, such as financing, selling some assets, or even changing strategic course.
Cash-Flow Forecast vs. Cash-Flow Analysis
Cash-flow forecasting and cash-flow analysis both involve evaluating business data and activity to understand cash flow. The difference is that cash-flow analysis is retrospective while forecasting looks forward.
A business might use cash-flow analysis, for example, to identify past trends in customer payments and expenses. Meanwhile, a business might use cash-flow forecasting to predict future inflows in advance of an upcoming investing opportunity or busy season.
Both cash-flow forecasting and analysis could be key elements of effective financial management.
Are Cash-Flow Forecasts Necessary for Profitable Companies?
Cash-flow forecasts may be helpful for profitable companies because profitability may not guarantee liquidity. In other words, cash flow is not the same as business profit. Profit is a measure of how much money your business has left after all expenses, such as payroll and utilities, have been paid. Cash flow, on the other hand, is a measure of how much money moves in and out of your bank account during a certain period of time.
The difference is largely about timing. Say you’re evaluating profit and cash flow for the same quarter. Your profit and loss statement might show you made a profit because you delivered work and invoices during that quarter. But your cash-flow statement might show a shortage of cash because those invoices have not been paid yet. So even though you technically earned a profit, you might not have liquid cash on hand.
As such, poor cash management could create financial challenges even for profitable businesses. That's why it may be important to measure both cash flow and profit for a comprehensive view of financial health.
How to Create a Cash-Flow Forecast
Businesses may consider this framework to help create a cash-flow forecast. Just remember that the accuracy of your forecast depends both on data quality and realistic assumptions.
Consider these four steps to help calculate and project cash flow for your business:
1. Determine the Forecasting Period
Businesses may first decide how far into the future their forecast could extend. The choice of forecasting period may depend on factors like cash volatility, growth stage, and operational complexity.
Common forecasting timeframes may include:
- Weekly forecasts: May be useful for tight cash management or early-stage businesses experiencing rapid growth and frequent changes.
- Monthly forecasts: May be used for some businesses, providing a baseline to anticipate operational needs and financial performance.
- Quarterly forecasts: May be beneficial for strategic planning and long-term decision-making.
2. Select the Appropriate Method
There are two main methods to consider for developing a cash-flow forecast:
- Direct method: Projects actual cash inflows and outflows; based on expected receipts (sales) and payments (expenses); may be useful for short-term forecasting and operational planning. Many small-to-mid businesses may use the direct method for day-to-day planning.
- Indirect method: Starts with net income and adjusts for non-cash items and working capital changes; may be used for longer-term or financial reporting alignment.
3. Gather the Necessary Data
An accurate forecast may rely on specific data inputs from various sources, including:
- Historical cash-flow data: Identify inflow and outflow trends from past months, quarters, or years.
- Sales forecasts: Calculate expected revenue timing and amounts.
- Accounts receivable: Determine when customer payments may be received.
- Accounts payable: Determine when bills are expected to be paid.
- Fixed and variable expenses: Account for repeated and changing expenses, such as rent, payroll, utilities, and marketing costs.
4. Calculate Projected Cash Flow
Once you’ve gathered your data, you may use it to build your cash-flow model and help finalize your forecast. You may do this manually using spreadsheets or through an automated software program.
Here’s how to calculate projected cash flow:
- List all expected cash inflows by period
- List all expected cash outflows by period
- Calculate net cash flow (inflows – outflows)
For the forecast period, if projected cash outflows exceed inflows, the business is projected to have negative net cash flow. Conversely, if in a forecast period projected inflows exceed outflows, the business is projected to have positive net cash flow.
Instead of relying on one calculation, you might also consider forecasting cash flow for different types of scenarios, such as:
- Baseline scenario: The most-likely outcome based on current and historical financial data.
- Best-case scenario: An optimistic outcome based on higher-than-expected revenue, rapid customer payment periods, and minimal expenses.
- Worst-case scenario: A conservative outcome based on slow sales, late customer payments, and higher-than-usual expenses.
Benefits of Cash-Flow Forecasting
Cash-flow forecasting is not just a financial exercise or a task to cross off your list of management tasks — it could help improve business performance and resilience.
By projecting cash flow, businesses might be more prepared to:
- Manage risk: For periods of negative cash flow, consider setting up supplemental sources of cash to remain operational.
- Set budgets: Be aware how much you might spend on payroll, equipment, and utilities going forward, such as when heading into a seasonal lull.
- Maintain relationships: Aim to sustain solid business relationships with vendors and supply chain partners by paying bills on time.
- Secure funding: Provide potential lenders with information about projected cash flow when applying for loans.
- Invest in growth: Identify periods with surplus cash and make advanced, informed decisions about business spending.
- Optimize business strategies: Pinpoint internal processes that may need improvement, such as collections of accounts receivable.
Common Cash-Flow Forecasting Mistakes to Avoid
Inaccurate forecasts could create financial planning challenges. When projecting cash flow, consider common mistakes and risks, such as:
- Making overly optimistic assumptions: Overestimating revenue could leave you unprepared to cover future expenses and bills.
- Ignoring seasonal trends: Remember to account for seasonal fluctuations in revenue, such as summertime rushes or slow winters.
- Not updating forecasts regularly: Just like cash-flow analysis, forecasting should be a standard and repeatable part of your financial management workflow, not a one-off exercise.
Power Financial Decision-Making with Cash-Flow Forecasting
Cash-flow forecasting could help business leaders prepare in advance for periods of surplus cash or cash shortages, so they may make more informed financial decisions. Forecasting could also help businesses identify potential risks, improve processes, and prepare their budgets. Business leaders may calculate their cash-flow conversion ratio, for example, to measure how efficiently they might turn revenue into liquid cash for future growth.
Cash-Flow Forecasting FAQs
What is cash-flow forecasting?
Cash-flow forecasting is the process of projecting future cash inflows and outflows for a business over a certain time period, such as a week, month, or quarter. It may be used to help anticipate surpluses or deficits before they occur, so businesses can plan accordingly.
How is forecasting different from cash-flow analysis?
Cash-flow forecasting is forward-looking while cash-flow analysis is retrospective. Cash-flow analysis involves identifying trends in past payments and expenses while forecasting involves predicting expected cash flow. Both processes use historic data to better understand a company’s financial standings and help inform decision-making.
How far ahead should you forecast cash flow?
Choosing how far ahead to forecast cash flow may depend on each business’s objectives, growth stage, and operational complexity. The standard forecasting period may vary by business. However, early-stage businesses might conduct weekly forecasts as they grow, and larger businesses might conduct quarterly forecasts for long-term operational planning.
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