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The Value of Optimizing Your Cash Flow Forecasting Process for Future Success

March 16, 2021
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Businesses talk a lot about budgets, revenue projections, and actuals. However, having a solid grip on your cash flow forecasting and reporting is one of the most important factors for any business to track. And given the current climate, paying attention to cash flow has become even more vital than ever.Even profitable businesses can be hurt if they don’t have the cash flow to support day to day operations. That’s why businesses need to know how to best forecast their cash flow as much as any other planning you do.

What Cash Flow Forecasting Is – and What it Isn’t

Cash flow forecasting is building a plan to ensure that you have the liquid assets you need to maintain business operations. It’s the cash and liquid assets available to you to pay your bills, plus your estimated inflows and outflows.It isn’t your revenue. While revenue is also an important number to understand for the health of your business, it doesn’t represent cash that you can use to pay bills like rent, inventory, and salaries. Revenue is what your company has earned on the sale of your goods or services, but depending on how and when your clients pay, may not be immediately available to you to keep the lights on. cash flow is both what is coming in and what is going out.

Two Methods of Forecasting Cash Flow

There are two methods of forecasting cash flow – the indirect method and the direct method. The indirect method tends to give you a longer view of your cash flow and is used for capital projects and longer-term growth. The projections are pulled from the profit and loss and balance sheets and balance sheet items, like purchases or depreciation, are added or subtracted.The direct method, however, is better for shorter to medium term forecasting. It takes the known operating inflows and outflows and uses these actuals to create the forecast. It makes short-term predictions highly accurate but requires a lot more guesswork for longer term forecasts.

Three Important Elements of Cash Flow Forecasting

Regardless of which method you use, you’ll still need to know some elemental pieces of information to produce a useful forecast.

How much cash will be coming in?

Obviously, to forecast your cash flow, you’ll need to understand first how much cash you’ll be bringing into the business. The best place to turn for this information is the past. Your past sales performance should be an excellent source of knowledge on the topic. It will tell you not only volume, but trends, ebbs, and flows.If you’re using spreadsheets, it might be more difficult to extract complete, accurate data that shows these trends and changes over time. Cash flow forecasting software that can easily produce a cash flow statement that reports on historical numbers can simplify this step, and all the steps, of the forecasting process.

What are your clients’ payment terms?

Even when you make a sale, the cash is not immediately available to you for use in running your business. Even for the smallest business, there is a delay between purchasing the materials to make a product or pay salaries and realizing the cash from the sale.For many companies, clients pay thirty or more days after a sale. Even if your sales history shows a big month in March, you may not realize the funds from those sales until April, or later. It’s critical to a positive cash position that you take into account payment terms when forecasting your cash flow.Be sure to also review your collections frequency. If ten percent of your sales are paid late, you should account for that in your forecast, as well. Again, clear historical reporting can make this step easier and much more accurate.

What are you spending money on, and when?

Knowing what your company spends is the last piece of the cash flow forecast puzzle. Some of your spend is predictable, some is fixed, and as much of it as possible needs to be accounted for in your projections.Fixed spends are generally easy to gather and fit well into your forecast. These are things like rent, software licenses, and salaries. Predictable, but perhaps not fixed, expenses are things like utilities, property taxes, and regular equipment purchases, like when a new employee is hired. Variable expenses include repairs for broken equipment, changes in costs for sales and marketing needs, and fluctuations in inventory and supplies.The fixed and predictable expenses are fairly straightforward to add to your forecast, whereas, again, your historical expenditures should help to formulate predictions on irregular expenses.

How to Improve Your Cash Flow Forecast - 3 Tips

Having an accurate cash flow forecast can help to avoid potential cash flow problems, predict end of year profits (or debt), and set realistic goals for the upcoming quarters and year.

However, there are many companies that are still not getting accurate cash flow data. Not only does this make accurate forecasting nearly impossible, but it can have a negative trickle down effect on other reports, rendering them inaccurate as well.

Tip #1 - Plan for Seasonality in Your Cash Flow Forecasts

Many businesses will see their cash ebb and flow during different points of the year. This can be due to factors such as seasonal sales and seasonal employee costs. While for some businesses, say Christmas tree farms or swimming pool installers in New England, typically have that seasonality baked into the cake, many others can still experience this to a lesser extent.

You can start by investigating reporting from previous years to determine if your business does have predictable cash flow swings. While one quarter or month might not stand out as the biggest sales month, you might notice an uptick or downswing as the year goes along. This information can be crucial in budget planning and forecasting for the upcoming year.

Create a cash flow forecast that highlights the seasonality in your budget. Doing this can help you plan your expenditures for any low period. And, it can also help create contingency plans for any potential issues that might arise.

Tip #2 - Evaluate Fixed and Variable Costs

When it comes time to work on budgeting and forecasting for a new year, don’t forget to audit both your fixed and variable costs. In general, it’s good practice to evaluate these costs every year or six months.

Variable costs such as office supplies or utilities can often fly under the radar when the time comes to take a hard look at expenditures. The same can be said for fixed costs such as rent and insurance. Typically, a handful of these costs can be reduced by re-negotiating a contract or making slight adjustments to the budget.

It’s also important to remember recurring variable costs as well. These would include tax payments as well as other employee expenses such as months with additional pay periods.

These potential savings can have a positive overall impact on your monthly or quarterly cash flow, especially during a down period.

Tip #3 - Plan Out Scenarios

While no CFO or budget manager wants to think about the worst, preparation is always a good strategy to lean on, especially when it comes to cash flow. Sales is one of the most difficult figures to estimate consistently, especially months down the road.

As cash flow is tied directly to sales, incorrectly projecting sales in either the positive or negative, is going to have an impact on cash flow projections as well. Being effective at cash flow forecasting means doing what you can to mitigate uncertainty over the long run, that’s where planning out multiple scenarios can come into play.

An easy way for you to approach this is to take your current sales forecast and then project the numbers with 10% more sales and 10% fewer sales. This won’t be a catch all for every variable, but it can be a very good place to start in helping you get a handle on any potential cash flow issues if your original projections aren’t met.

Hopefully, these three tips will help you untangle the sometimes complex world of cash flow forecasting.

Without cash to handle expenses, a business will flounder and potentially close it’s doors. Understanding your business’s cash flow needs, and staying on top of them, will help keep your operations and your overall organization running along smoothly. The more accurate your reporting from previous years is, the better your cash flow projections will be in the coming year. Revisit your cash flow forecast frequently to keep your business running smoothly.

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