Cash flow forecast: How to manage your finances today and in the future
Tired of cash flow guesswork? Cash flow forecasting predicts shortfalls before they happen, helps secure funding, and turns financial insights into action.
As all business owners know, cash is king. Businesses can rise and fall based on how much cash they have at any given time, so improving your cash flow knowledge is essential to ensuring your business succeeds.
It’s estimated that over 20% of small and medium-sized businesses (SMBs) in the US fail within the first year, and cash flow mismanagement is a key culprit.
Cash flow forecasting helps businesses anticipate money issues before they happen, prevent cash flow disruptions and shortfalls, and make the most of financial opportunities when they arise.
Let’s explore what a cash flow forecast is and how it can save your business.
What’s cash flow forecasting?
Imagine you’re a small company that receives a lot of telephone calls. To handle this, you may consider a modern tool like interactive voice response or IVR solutions.
You know that the automated telephone service could help your team accommodate more traffic and satisfy increased customer interactions. The question is, can you afford it? You might ask yourself whether you should invest in IVR now (and reap the rewards later), or wait until you have more money. Should you choose stability or attempt to grow?
That’s where cash flow forecasting, or a cash flow projection, can be helpful.
It’s a financial management method that helps businesses predict their potential cash inflows and outflows; or, in other words, the money coming in or out of a business during a given period. By monitoring this, managers can anticipate future cash shortages and weigh the costs of their decisions.
What is the purpose of a cash flow forecast?
The importance of a cash flow forecast cannot be understated. It enables business owners to predict the inflow and outflow of cash during a given time period, ensuring the business has enough liquidity to meet financial obligations such as payroll, operating expenses, and vendor payments.
Every business faces lean times, when demand is lower and sales are slow. Cash forecasting methods help to anticipate these shortfalls, and alert the business to potential cash shortages. This allows time to secure financing or minimize spending to adjust to the reduced cash supply.
Cash flow forecasting also provides insights into the business’s current and future financial health, making it easier to decide wisely about budgeting and spending.
In short, cash flow forecasting is a proactive way to manage cash flow, helping businesses to prevent crises, and make the most of financial opportunities on the horizon.
How cash flow projection works
The basic formula for how to forecast cash flow begins with your opening cash balance.
Add any money coming in (inflows), then subtract money going out (outflows). The resulting figure is called your free cash flow (FCF). This is how much money you predict you’ll have left to work with.
While the premise is simple, there are several things that can complicate this figure. For instance, what time period are you hoping to forecast? Are there any unforeseen expenses that might arise? Maybe the information you gathered describes a single month, but can it truly be applied to the next two, three, or six months?
A cash flow forecast will look radically different depending on a multitude of factors, all of which can and may change over time. To accurately predict the state of your business, you’ll need good information and clear objectives.
Types of cash flow forecast
There are several types of cash flow forecasting that determine a business’s financial projections from different angles. Each has a different purpose and varying timeframes.
Let’s explore and compare the key cash forecasting types:
Short-term vs. long-term forecasting
Short-term forecasting focuses on cash flow over a shorter period, typically two to eight weeks. It helps to ensure that the business can meet immediate financial obligations, such as rent, payroll, and vendor payments. Short-term forecasting is more detailed and precise than longer-term methods, and is designed to help manage day-to-day liquidity.
Long-term forecasting predicts cash flow and financial performance over a longer period, from 6 to 12 months, or even two years or more. It is less detailed than short-term forecasting, but broader in scope, helping to identify long-term funding needs and opportunities for reinvestment. It is designed to support strategic planning and identify growth opportunities and initiatives.
Operational vs. financial forecasting
Operational forecasting predicts the needs and performance of a business from an operational standpoint. This can include things like production, inventory, and staffing. It aims to ensure that the business has the capacity and resources to meet customer demand while maintaining efficient operations.
Operational forecasting is a short to medium-term approach that considers day-to-day operations and tactical planning. It uses forecasting metrics such as sales volume, production schedules, labor needs, and supply chain data to help optimize workflows and prevent over- or under-production.
Financial forecasting is focused on predictions about the business’s financial performance, including revenue, expenses, profit, and cash flow. This may include revenue projections, expense trends, and requirements for capital, providing insights into profitability and liquidity that support budgeting and strategic planning. Financial forecasting can be a short, medium, or long-term approach.
Cash forecasting methods
The most common cash forecasting methods include:
- Direct method: Tracks expected cash inflows and outflows to calculate net cash flow over a specific period, usually short term (ie, daily, weekly, or monthly).
- Indirect method: Determines cash flow projections from financial statements, such as profit and loss statements and balance sheets, used for longer-term forecasting.
- Historical trend analysis: Uses past patterns in cash flow data to predict future cash flow trends, such as seasonal fluctuations or recurring expenses.
- Scenario analysis: Predicts cash flow in various hypothetical scenarios, such as “best case” or “worst case”, helping businesses to manage risk in uncertain markets or economic conditions.
- A/R and A/P forecasting: Analyzes the timing of accounts receivable and accounts payable to forecast cash flow, and aligns incoming and outgoing funds to prevent shortfalls.
- Rolling forecast: Updates cash flow predictions continuously over a set period of time (ie. 12 months) and adjusts the forecast regularly to reflect the situation.
Each business must choose the best cash flow forecasting method for them, depending on the business size, industry, market situation, and timeframe. Many businesses use a combination of methods to suit their short and long-term financial goals.
The advantages of cash flow forecasting
The benefits of a cash flow forecast can be felt in the short and long term, and across the business, from operations to strategy. Here are the key advantages of cash flow forecasting:
- Helps to ensure liquidity and sufficient cash to cover day-to-day expenses.
- Identifies potential cash shortfalls in advance, allowing time to secure funding or adjust spending.
- Supports smarter decision-making based on data and insights about expenses, revenue, and growth opportunities.
- Helps to align financial resources with long-term goals and growth strategies.
- Demonstrates financial organization and discipline, making it easier to secure financing from lenders.
- Enables business owners to allocate cash more effectively, giving priority where needed and making the business more efficient.
- Prepares businesses in advance for economic downturns, market disruptions, or unexpected expenses.
- Increases financial control by tracking and identifying trends in incoming and outgoing cash, helping to reduce wasteful spending and improve the accuracy of the budget.
How to improve cash flow forecasting
Here are the main things you need to do to ensure your forecast is accurate and helpful.
Select your time frame carefully
Your objectives as a company dramatically alter the period of time your forecast should cover. When it comes to strategically managing your cash flow, time is always of the essence.
Are you short on cash and therefore worried about the day-to-day liquidity of your business? In that case, short-term forecasting is probably the most useful.
But if you’re planning to expand or pay off large amounts of debt, then medium to long-term forecasting could help you time larger expenditures for when your business is cash rich.
When choosing what period to cover in your projection, consider the following:
- Short-term forecasting is good for your business’s nitty-gritty payments and receipts but isn’t a useful tool when you’re planning for the future.
- Medium-term forecasting is great for planning toward key date visibility, such as quarterly reports, but lacks the scope for planning expansions.
- Long-term forecasting tends to be used for annual budgeting and forward planning. But little attention is given to the day-to-day inflows and outflows that affect a struggling business.
Finally, there’s also the option of performing a mixed forecast, which balances future-facing visibility and day-to-day detail. An example could be a forecast that begins with a weekly overview to manage short-term liquidity risks, before moving on to monthly forecasts once the heat is off.
Gather data across all areas of your company
A reliable projection cannot be created if you don’t have accurate data about how much money you’re making and what you’re spending it on. Only when you have all the facts can you make the necessary changes for your business to thrive.
Useful data for cash flow forecasting may include revenue from sales, operational expenses, one-off purchases, and debt repayments. Gathering it often requires input from various stakeholders and data sources within the company.
All of this information comes together to create an accurate representation of your free cash flow. It can also provide valuable insights into your business’s strengths and weaknesses.
For example, if you find that your company’s inventory is increasing, you should include efforts to increase sales in your projection. Likewise, if your current sales are not generating as much profit as expected, maybe you should look into potential waste or inefficiencies that are hurting your bottom line.
Be ready to adapt to change
Let’s return to the earlier example cited above: the company is flooded with phone calls. Following the success of implementing IVR, productivity has gone up. But now there’s a new problem. Customer calls have increased exponentially, and they require more operators, more phones, and more office space. The problem? This expansion was not factored into the original forecast.
Looking to solve this, you read an article about the value of VolP (Voice over Internet Protocol). You now realize that by replacing your existing business phone system, employees can make or answer customer calls from any location using the internet.
But while VoIP may be a beneficial tool for your business, any new platform or investment will require major changes to your forecasting model.
Unfortunately, cash flow forecasting can be inflexible, because its predictions are based on data from previous months and years. This makes it short-sighted regarding both external changes and anticipating new challenges, such as changes to customer demand.
To avoid these shortfalls, try the following:
- Keep all your data as up-to-date as possible. This entails carrying out frequent stock takes or simply updating the forecast regularly.
- Constantly compare the forecast against your free cash flow.
- When discrepancies arise, ask yourself what changed, and what inaccuracies or unforeseeable events contributed to this gap between expectation and reality.
- Update your forecasting period to reflect your evolving situation. In the VoIP example, maybe a mixed forecast would help understand the short and medium-term impacts of the new strategy.
Common cash flow forecasting mistakes to avoid
When carrying out your cash flow forecasting techniques, here are the top three mistakes that are most common and easily avoided:
- Overestimating revenue or underestimating expenses
If the projection for future sales is overly optimistic, or expenses are ignored or underestimated, this can lead to cash shortages and financial strain.
- Not updating forecasts regularly or ignoring seasonal trends
Business is dynamic, and cash flow forecasts must be updated to reflect changing conditions and ensure maximum accuracy. Seasonal trends should also be considered in the forecast, as they can have a huge impact on performance.
- Relying mainly on past data without considering the bigger picture
Past trends and historical data are important, but they don’t cover the broader financial landscape. Be sure not to ignore market conditions, customer demand, economic changes, and fluctuations in raw materials or supplier costs, all of which are subject to change and affect the accuracy of the cash flow forecast.
The bottom line
Your job as a business owner is to turn insights into action. In fact, research from McKinsey shows that businesses that react quickly to changes see a 20% to 30% improvement in financial performance.
Cash flow forecasting gives business owners the opportunity to be proactive about change by effectively planning for the future and managing day-to-day liquidity at the same time. But, ultimately, every business owner must use their best judgment and decide which types and methods of cash flow forecasting are most useful.
Looking for more ways to improve your cash flow? Consider using an online payment platform like Melio to manage your cash inflows and outflows. You get more insights, more control, and more payment methods and options. The best part? There are no subscription fees or strings attached, so sign up for Melio today.
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