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Cash flow forecasting: How to manage your finances

A carpenter working on a cash flow forecast in front of a laptop in his workshop.
Portrait of Scott Rigdon, marketing copywriter.
Scott Rigdon Guest Author
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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 is successful.

It’s estimated that over 20% of small and medium-sized businesses (SMBs) in the U.S. fail within the first year, and cash flow problems are the main culprits.

Cash flow forecasting helps anticipate money issues before they happen so you can make the most of financial opportunities.

This article will look at how cash flow forecasting works and how it can save your business.

What’s cash flow forecasting?

Let’s imagine you’re a small company that receives a lot of telephone calls. To combat 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?

Enter cash flow forecasting.

Cash flow forecasting is a financial management method that helps businesses predict their potential cash inflows and outflows. In other words, the amount of 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.

In essence, a cash flow forecast, also known as cash flow projection, is a roadmap for how the months ahead are going to look financially, for your business. Armed with this knowledge, a company can adjust its strategies, anticipate challenges, and exploit potential opportunities.

How cash flow projection works

The basic formula for creating a cash flow forecast 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?

As you can see, cash flow forecasting is not fortune-telling. To accurately predict the state of your business, you’ll need good information and clear objectives.

Failing to have sufficient cash flow reduces the number of buffer days in which a business can afford to pay its expenses without any extra inflow of cash. Naturally, this kind of situation radically alters the objectives of those businesses and, therefore, the kinds of forecasting that will help.

In short, proper cash flow forecasting should help prepare your business to meet its particular needs and avoid incurring liabilities.

3 crucial steps for an effective cash flow forecast

Here are the main things you need to do to ensure your forecast is accurate and helpful.

1. 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.

As a rule of thumb, short-term forecasting extends between two to eight weeks. Medium-term forecasts cover up to six months, while long-term forecasts cover 6-12 months. Each of these options has its strengths and weaknesses. 

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 balance between future-facing visibility and day-to-day detail. One example of this would 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.

2. 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.

3. Adapt to change

Let’s go back to our previous example, the company 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 your original forecast. 

Looking to solve this, you read an article about the value of VolP, or 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.

The bottom line

In the end, your job as a business owner is to turn your new 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 presents business owners with an opportunity to effectively plan for the future and manage their day-to-day liquidity. But, ultimately, every business owner must use their best judgment and decide which kinds of forecasting are most useful.

Looking for more ways to improve your cash flow? Consider using an online payment platform like Melio to manage the money coming in and out of your company. This gives you better oversight, more control, and a choice of payment methods and technological solutions for deferring payments and preserving your cash flow. The best part? There are no subscription fees or strings attached, so sign up for Melio today.

Scott Rigdon is a senior marketing copywriter with over two decades of experience helping brands across the tech, financial services, manufacturing, and other sectors.

*This blog post is intended for informational purposes only and is not intended as financial advice.
**Melio does not provide legal, tax or accounting advice, and you should consult with a professional advisor before making any financial decisions.