Businesses talk a lot about budgets, revenue projections, and actuals. However, one of the most important planning tools for a business of any size is cash flow forecasting — especially in times of uncertainty.
Knowing your cash flow position has never been more important:
How much is really in the bank?
How much is available on short notice?
What revenues are coming in, and when?
What resources are going out?
Managing your cash flow as tightly as possible is perhaps the most important tool you have to withstand a down economy and come out on the other side intact and poised for growth.
Your ability to produce accurate and timely cash flow statements — and to perform analysis based on those accurate and up-to-date reports — is critical for assessing the current health of your organization and for making key business decisions. Knowing the timing, amount, and predictability of future cash flows with cash flow forecasting should be an essential component of your budgeting and planning process.
What is cash flow forecasting?
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.
Cash flow forecasting is not about your revenue. While revenue is also an important number to understand for the health of the 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, whereas cash flow is the money coming in and the money going out.
There are two methods of forecasting cash flow:
The indirect method tends to give you a longer view of your cash flow, and is used for capital projects and longer-term growth. These projections are pulled from the profit and loss and balance sheets. Balance sheet items, like purchases or depreciation, are added or subtracted.
The direct method is better for short-term and medium-term cash flow forecasting. It takes the known operating inflows and outflows and uses these actuals to create the forecast. This cash flow forecasting method makes short-term predictions highly accurate, but requires a lot more guesswork for longer-term forecasts.
Important elements of cash flow forecasting
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 forecast cash flow in parallel with the other planning that you do.
Regardless of which method you use, you’ll still need to know some basic pieces of information to produce a useful forecast:
How much cash will be coming in?
To forecast your cash flow, you’ll first need to understand how much cash you’ll be bringing into the business. The best place to turn for this information is the past. Your historical sales performance should tell you not only volume, but also trends, ebbs, and flows.
What are your clients’ payment terms?
Even after you make a sale, the cash is not immediately available for use in running your business. Be sure to review your collections frequency. If 10% of your sales are paid late, you should account for that in your forecast. It’s critical to a positive cash position that you take into account payment terms when forecasting your cash flow.
What are you spending money on, and when?
Knowing what your company spends is the last piece of the cash flow forecast puzzle. Some 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. Predictable expenses are things like utilities, property taxes, and regular equipment purchases, such as equipment for a new hire. 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, and historical expenditures should help to formulate predictions on irregular expenses.
Understanding your business’ cash flow needs and staying on top of them will help keep your operations running smoothly. The more accurate your reporting from previous years is, the better your cash flow projections will be.
How to build stronger cash flow forecasts
Here are three tips to help you build stronger cash flow forecasts:
1. Plan for seasonality
Many businesses will see their cash ebb and flow at different points of the year. This can be due to factors such as seasonal sales and seasonal employee costs. To start, look into reporting from previous years to determine whether or not your business has predictable cash flow swings. Create a cash flow forecast that highlights this seasonality in your budget. Doing this can help you plan your expenditures for any low period and help create contingency plans for any potential issues that might arise.
2. Evaluate and potentially reduce fixed and variable costs
Don’t forget to audit all of your fixed and variable costs. 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. Some of these costs can be reduced by re-negotiating a contract or making slight adjustments to the budget.These potential savings can have a positive overall impact on your monthly or quarterly cash flow, especially during a down period.
3. Plan out scenarios
Planning for the worst is always a good strategy to lean on when it comes to cash flow. Sales is one of the most difficult figures to estimate consistently. One way 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 catchall for every variable, but it can be a good place to start in getting a handle on any potential cash flow issues if your original projections aren’t met.
Cash flow forecasting software: Case study
Wakeland Housing and Development is a housing non-profit based in San Diego. Its major revenue stream is the developer fees it collects, which are built into the financial structure of each development. Fees are earned based on trigger mechanisms, such as when the development team completes construction or closes permanent financing.
“It’s imperative that we know when the developer fees are going to come in,” explains Wakeland CFO Joan Edelman. “Our biggest asset is our cash, which means I need to ensure we have adequate cash to fund our operations as well as fund the developments.”
The nonprofit had a pro forma budget built in an Excel spreadsheet, which was very difficult to update and manage on an ongoing basis. “It was archaic; we weren’t having any fun with it, and it wasn’t giving us the analytic information we needed.”
With Centage, Wakeland has been able to streamline their cash forecasting. “I can update our cash flow, income statement, and forecast out five years really easily. I can do a five year model and see how much cash we’ll have, which is pretty critical to our existence. And because of the flexibility of Centage, I can change forecasts and get new information faster and without extra headaches... It used to take a week to do that.” Now that forecasting is so streamlined, Wakeland reforecasts on a monthly basis.
How cash flow forecasting helps manage economic downturn
The one thing finance executives can count on for the year ahead is that the business environment will continue to change dynamically. Cash flow forecasting is a powerful tool that your organization can use to evolve along with the market. By deploying a modern FP&A solution that can manage even the most complex cash flow requirements, you will have the ability to assess the financial health of your organization today and plan for its ongoing survival, even in the face of ongoing uncertainty.