Cash flow forecasting is the process of estimating how much cash will flow in and out of a business over a specified time period.
Cash flow forecasting is a crucial financial management tool that enables businesses to predict and analyze their future cash inflows and outflows. It involves estimating the timing and amount of cash that will be received and disbursed over a specific period. This proactive approach helps businesses anticipate potential liquidity issues, make informed decisions, and plan for growth effectively.
By providing a clear picture of the company's financial health, cash flow forecasting allows businesses to identify trends, manage working capital efficiently, and ensure timely payments to suppliers and employees.
Additionally, it aids in securing external funding by demonstrating the company's ability to meet its financial obligations.
Overall, cash flow forecasting empowers businesses with the foresight needed to navigate challenges, seize opportunities, and maintain financial stability in an ever-changing market landscape.
Direct vs. indirect cash flow forecasting
There are two distinct cash flow forecasting methods: the direct method, which involves known income and expenses, and the indirect method, which involves projected income and expenses.
Direct forecasting of cash flow. Direct forecasting involves costs that are already known, and this technique is generally suitable for short-term forecasting. A business may use direct cash flow forecasting at the beginning of the month, for instance, to ensure it has sufficient working capital to pay end-of-month expenses.
Indirect forecasting of cash flow. Long-term predictions are made using indirect cash flow forecasting, which involves using projected balance sheets (also known as pro forma balance sheets) and projected income statements. The indirect method also accounts for factors, such as depreciation of structures and equipment, that affect profitability but do not affect cash balance.
How to predict cash flow in four simple stages
The procedure of cash flow forecasting is a repeatable process.
First, establish a forecasting period
In cash flow forecasting, a period of time is always specified, and the first stage is to select the period. Short-term cash flow forecasting may consider a period of 30 days (or even several weeks), whereas longer-term cash flow forecasting may consider a quarter, an entire year, or even multiple years.
Select a forecasting technique
The following stage involves selecting a forecasting method. If your forecasting period is relatively short (say 30 days), you can use the direct method to determine how much cash you will have on hand at the conclusion of the period by referring to known income and expenses. In contrast, the indirect method will enable you to make projections beyond the timeframe for which you have concrete flow data if you are considering a year.
Calculate cash inflow, cash outflow, and cash balance in Step 3.
The subsequent phase is to estimate cash inflows, outflows, and the beginning cash balance.
To calculate inflows, add all expected benefits during the forecasting period. This may include anticipated sales revenue, anticipated investment income or interest, and the disbursement of any previously secured loan funds.
Include anticipated expenses such as loan payments, vendor expenses, payroll, and estimated taxes in your calculations for disbursements.
Determine the beginning cash balance or the quantity of cash in your bank accounts at the beginning of the forecasting period.
Calculate net cash flow and ending cash balance in the fourth step
After calculating cash inflows, cash outflows, and the opening cash balance, you can construct a cash flow forecast.
First, net cash flow is determined by subtracting outflows from inflows. The formula is inflows minus outflows equals net cash flow. Positive net cash flows indicate a business profit for the period in question, whereas negative cash flows indicate a loss.
Calculate your closing cash balance, or the amount of cash you anticipate your business will have in its bank accounts at the end of the forecasting period. This is determined using the formula beginning balance plus outflows minus inflows equals ending cash balance.
Cash flow forecasting software can automate a significant portion of this procedure, thereby enhancing the accuracy of your forecasts and facilitating access to the most recent cash flow projections.
Positive aspects of cash flow forecasting
Cash flow forecasting offers numerous strategic benefits, such as assisting businesses with debt repayment and maximizing returns on current assets.
It can help enterprises make informed cash flow decisions. Entrepreneurs continually prioritize potential investments. Whether you're aiming for a new employ, a planned marketing expenditure, or a facility investment, predicting net cash flow can help you strategically time expenditures.
It can help businesses identify patterns of cash outflow. Cash flow forecasting can help you identify opportunities to eliminate superfluous expenses by monitoring outflows. It can also help you ensure that not all of your bills are due on the same day, which would otherwise require you to carry an excessive quantity of cash.
It can assist businesses with growth projections and debt repayment schedules. Businesses can better plan for the future if they can anticipate profits and losses over the course of a quarter, a year, or even longer. For instance, if your business has taken out a startup loan, cash flow projections can help you establish a repayment schedule, and reviewing monthly cash flows can help you determine if you're on track to meet this objective. The same applies to accumulated profits. You may not be able to make a new employ today, but cash flow forecasting can indicate when it would be prudent to do so.
It can assist you in investing your funds. Businesses should maintain sufficient working capital to cover all anticipated expenses. Most also maintain cash reserves. Beyond this point, it is imprudent to allow cash to accumulate in the business bank account. This cash should be invested in markets or in the expansion of your business. You can liberate up funds for income-generating activities with the aid of cash flow forecasting.
Negative aspects of cash flow forecasting
Consider these caveats when developing cash flow projections.
It can be inaccurate, especially when utilizing indirect methods. Similar to a weather forecast, a cash flow forecast represents the best estimate of what future conditions will likely be based on current conditions and existing models. Moreover, similar to weather forecasts, cash flow forecasts can be inaccurate. This is especially true for indirect method-derived forecasts. However, even direct cash flow forecasting can be inaccurate, as this method implies that your debtors will pay on time and that you will not incur any unforeseen expenses during the forecasting period.
It does not account for unexpected occurrences. The forecasting of cash flow does not account for a tree toppling on your workshop or your cat spilling water on your keyboard. In order to cover these unforeseen expenditures, businesses usually maintain a cash reserve.
It can be a time-consuming procedure. Even if you already use accrual accounting, your forecasting process will involve a close examination of accounts receivable, accounts payable, and your balance sheet, as well as the partitioning or extrapolation of these numbers in order to isolate your forecasting period prior to performing any calculations.
Cash flow forecasting is a valuable instrument for strategic business development, as it
enables you to plan for the future and assess your performance in comparison to your projections.
It is prudent to invest in a method of accounting (or accounting software) that enables cash flow projections. Remember not to confuse predictions with certainty, and keep some cash on hand for those (metaphorical) rainy days.