Cash Flow Forecasting
What is Cash Flow Forecasting?
Cash flow forecasting is a central part of a company’s financial management and operations. A cash flow forecast projects where a company stands based on anticipated revenue, payments, and receivables. The importance of a cash flow forecast is to ensure that a business has enough money to cover their expenses and stay operational. Without it, a business cannot function and could quickly go into debt or out of business.
There are two types of cash forecasting: direct and indirect. Whichever method you use depends on what your company needs to calculate, either short-term or long-term cash flow, and who you need to share the findings with.
Direct forecasting is the best method for short-term projections. It’s very accurate because it uses known cash flows from receipts and disbursements to produce concrete numbers. It calculates the actual cash that is coming into the business, transaction by transaction.
The downside to this method is that it’s difficult to create, especially for larger companies, since they have many transactions. Most bankers, accountants, and investors do not like forecasts in this form. Accuracy also decreases as the time period in question lengthens.
The formula is:
Cash Flow = Cash Received - Cash Spent
To forecast cash received, you must include the four primary sources:
Sales of products and services: cash paid immediately by customers
Loans and investments: new loans or investments
Sales of assets: selling cars, property, equipment all result in cash received
Income and sales tax: money made from savings accounts or sales tax
To forecast cash spent, include these types of spending:
Cash expenses and bills: money spent on petty cash or paying bills
Loan payments: repaying your principal must be included (but not interest)
Purchasing assets: investing in property, cars, equipment
Indirect forecasting works best for a long-term view of your cash flow, and is more commonly used by companies. It’s straightforward to calculate because it begins with net income on an accrual basis, and most companies keep their records on an accrual basis.
Although this method is less accurate, particularly for short-term calculations, it is great at predicting long-term growth by using data that already exists, like the income statement and balance sheet.
The formula is:
Cash Flow from Operations = Net income (or loss) ± non-cash revenue and expense items
Changes in accounts receivable: sales that weren’t paid in cash up-front, but still ended up in the bank
Changes in accounts payable: purchases that you plan to make but have not paid for yet
Taxes and depreciation: add back depreciation and taxes since the money is still in the bank account, and doesn’t impact cash flow
Loans and investments: add cash received from loans or investments, and subtract loan payments
Assets purchased/sold: add the assets you’ve bought or sold
Best Tips for Accurate Cash Flow Forecasts
Cash flow varies from business to business, therefore no forecast is the same. However, every cash flow forecast should follow these three tips:
Cash Flow ≠ Revenue
You should immediately distinguish the difference between cash flow and revenue, because they are indicators for different things. Cash flow measures the success of a company’s money management, which includes sales revenues and other sources of money. Whereas revenue shows how well sales, marketing, and advertising is doing by the influx of money. Ultimately, cash flow will determine if a company can function or not.
Determine Inflows and Outflows
The main question to ask yourself is: how much money is being brought in, and from where? You should calculate what is being collected for the goods and services you are selling. Part of determining the inflows in cash is to anticipate surges in sales (for the release of new products or seasonal demand) and declines in sales (recalls, negative consumer perception, economic downturn).
Calculating outflows involves fixed and variable costs. Overhead like rent, payroll, insurance, and utilities are fixed. Variable expenses include things like taxes, cost of goods sold, and seasonal changes in inventory. You must also identify one time expenses, like purchasing assets, employee training, or bonuses.
Make Adjustments to the Forecast
Think of a cash flow forecast like a weather forecast, they are adjusted as more information is learned. Cash flow forecasts should not be rigid, because there are a lot of variables that go into calculating them. However, they shouldn’t be so far off that they’re entirely unreliable. You should have a predetermined variance goal to hit with your cash flow forecast.
Assembling a cash flow forecast can be tricky because of how many variables and moving parts there are. A reliable, accurate cash flow forecast should show you when your company will be short on cash, and give you enough time to make the necessary adjustments. Regardless if you use the direct or indirect method, a cash flow forecast makes planning ahead possible, so that when your company encounters periods of negative cash flow, it can stay afloat.
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