07 Apr The importance of cash-flow forecasting
Cash-flow forecasting is something that every business should have at all times and not just during a crisis. Though, a major crisis, such as a market disruption or a global health pandemic is when a cash-flow forecast is needed the most and can potentially save your business.
Moreover, your financial forecasting should be as dynamic and easily updated as possible, so you could quickly adapt it to the ever-changing business world. This article will outline why a cash-flow forecast model is necessary for your business and how to create one.
Why does my business need it?
Cash is the king of every business and running out of it leads to insolvency. Cash-flow forecasting is therefore necessary to see if your business is stable enough to survive in the future. It is especially important to always be prepared for the worst and make sure that you have enough funds for a rainy day (or a global Coronavirus pandemic). Here are some of the main things that financial forecasting can help you with:
- It shows you if your business is meeting your expectations - whether your actual revenue and expenses are similar to the ones forecasted for the time period. If you notice that your company is underperforming, you can find the possible issues that may be causing low numbers, which leads to...
- Seeing what changes your business needs to implement. Perhaps you decide to cut on the expenses, as they seem to have got out of hand. On the other hand, you might want to start a hiring process and therefore change your current forecast for employer wages to match these changes.
- It also tells you how long your business is able to meet the payroll and suppliers obligations for as well as how liquid its assets are. For instance, if your company had to shut down today, how long would it still be able to survive on the cash that it has?
- It monitors whether there are any problems with customer payments, such as your debtors taking too long to pay.
- Having a financial forecast can also save you in times when you need to seek financing. Most of the banks or investors require cash-flow forecasting before they agree to lend you money, as they want to be aware of any potential risks.
How to create one
First of all, you should decide what software you want to use for this. A lot of people use Excel spreadsheets for their cash-flow forecasting - this is especially common for self-employed people. Now this works perfectly fine, though keep in mind that it will be more time consuming and it is easy to make mistakes in the formulas.
Otherwise, it is always recommended for businesses to use a professional forecasting software that will be error-proof and will do a lot of the work for you. A great one to choose is BRIXX and they offer a free trial as well.
Choose an approach
There are a few approaches to a cash-flow forecasting, depending on the required depth and frequency of information. You should decide whether you want to review your forecasts monthly, weekly or even daily. This leads to two main ways of cash-flow forecasting:
- Direct method - This takes into account the upcoming receipts and debtors as well as payments and creditors. It is all about short-term forecasting and focuses on funding working capital.
- Indirect method - This is constructed with income statements and balance sheets (with adjusted changes in the accounts). The cash is required to fund long-term growth strategies and capital projects.
The choice between these two approaches is often dependent on how well the business is doing. If your company is struggling, it’s likely you will prefer the short-term forecasting to ensure survival during a crisis. Ideally, every business should utilise both, short-term and long-term cash-flow forecasting.
What to include
Your cash-flow forecast should only include the most important information and should be easy to understand for the whole team (as it is usually reviewed together with the whole leadership team). So, make it robust and straightforward. Follow these steps to create an efficient forecast:
- Start with the past. Before jumping into the future forecasts, you need to look into the historical accounting data of all the income and expenses details. This will provide you with insights of your typical sales trends or the timing of expenses and act as a benchmark indication for your forecasting.
- Start with your current cash balance. Each period should start with documenting the cash balance that you had at the end of the prior period.
- Predict your revenues. You should forecast how much cash your business will be receiving in the upcoming period. This includes the revenues for your sales of goods and services as well as any additional income your business has. Don’t forget to think about any potential risks to your future inflows as well.
- Estimate all expenses. Write down all the payments that will be done during the time period, including any new or changed cash outflows. Try to separate different expenses based on their nature to make it easier to analyse. This includes the operational costs (raw materials, distribution costs), non-operational costs (rent, utilities, marketing), financing (interest, legal/financial payments) or people (salaries, benefits, taxes).
- Calculate Net cash. The opening balance and revenue less the outflows will make your Net cash. This is the number that will be your opening balance for the next period.
Prepare the “what if” scenarios
It is extremely important that your business is prepared for any unknown circumstances that may influence its sales. Therefore, you should create multiple iterations for a variety of scenarios. This will act as a fire extinguisher during an unexpected situation, as you will be prepared to quickly take action and make a contingency plan based on your forecasting.
Keep your team involved
It is important that the cash-flow forecast models are shared with the team, especially the key leaders. This could be done in a form of key insights through an understandable, effective model. It doesn’t only involve the finance professionals in your company, as it is important that other, non-financial members of your team understand what is happening in the company. For example, cash-flow forecasting shows employees where the business is heading, what are the expectations for different departments, what sort of changes the company will be undergoing and so on.
Need any help?
While we hope that this guide will help you get started on your cash-flow forecasting, we understand that it might not be as easy as it sounds. If you are finding that something in your cash-flows does not add up or your business is underperforming, we are happy to help.
At ASfB we specialise in helping businesses of all sizes achieve their growth ambitions. We offer the best financial and strategic solutions tailored specifically to your company’s needs. If you’d like to discuss more, contact us on 01202 755600 or email email@example.com.