Quick Summary
We walk through the cash flow forecast for small businesses, emphasizing the importance of creating a realistic forecast that considers both potential cash shortfalls and surpluses. We also outline the steps to create a forecast, including gathering data, making assumptions, and building the forecast. Cash flow forecasts are valuable business tools for preparing for seasonality fluctuations, securing financing from lenders, and reducing operating costs.
Cash Flow Forecast: Understanding Your Numbers
A cash flow forecast is a vital financial analysis tool for growing your business. When done well, cash flow projections will help you understand whether your company will have enough cash or working capital to keep operating and growing at your desired pace over time.
A cash flow forecast helps businesses plan ahead to ensure continuity by anticipating cash flowing into and out of a business in the future. Cash flow statements, on the other hand, show how much cash a business currently has on hand. Cash flow statements are one of the 3 key financial statements you need to be aware of as a business owner. The balance sheet and income statement are the other two critical financial statements.
What is a Cash Flow Forecast?
A cash flow forecast looks at projected accounts receivables and accounts payables to help businesses understand where and when they might run out of cash, clarifying the company's operating future.
- Account Receivables: Accounts receivables are how much money customers owe a business for goods or services it has already provided. It is essential to consider how quickly your clients generally pay you and the possibility of missed or late payments. It is also important to look at whether clients who default are part of a highly similar group or if they are a more heterogeneous group.
- Account Payables: Accounts payable are money due to vendors or suppliers for goods or services a business has received but has not yet been paid for. You'll need to track all upcoming payments in specified periods accurately.
Some business owners make the mistake of overestimating their ability to collect on receivables. A strong accounts receivable function takes time and effort to build and usually involves a dedicated effort to track and reconcile payments. In many businesses, especially small ones, there is little automation in place to help drive this function. Manual processes relating to accounts receivable slow things down and contribute to an efficient process. When forecasting cash flow, it is vital to be realistic with revenues and expenses, and factor in your organization's ability to realistically collect on receivables. It is helpful to remember that a forecast is an educated guess at your business's future financial picture.
These projections are not guaranteed to be entirely correct, so building in different scenarios—or scenario planning is helpful. Consider your best-case and worst-case scenarios. Scenario planning with best and worst cases obliges you to plan on what to do if you have more, or much less, cash than you expected in a specified period. You might be surprised how varied your projections may be, so having a plan for cash shortfalls or unexpected cash surpluses helps ensure financial continuity through periods of revenue shortfalls.
A cash flow forecast will also incorporate your forecasted operating expenses. Remember that non-cash charges like amortization are not included in the cash flow forecast as these are, as the name implies, non-cash items. While non-cash charges are excluded from the forecast, making provisions for longer-term cash expenditures such as GST/HST payments in your projections is essential.
We have seen companies try to use a projected cash flow statement as a cash flow forecast, which can create challenges. A cash flow statement is a type of financial statement focused on how much money and cash equivalents a company has on hand at a given time. A cash flow forecast, on the other hand, is forward-looking and uses analysis and insights to predict how an organization's cash flow will perform over time. The format of the cash flow statement prepared by accountants tends to be less user-friendly to non-accountants, especially with the indirect method of the cash flow statement.
The indirect method records payments when the goods or services are provided – not when the payments are received – which could result in an inaccurate estimation of the future cash inflow. As we described above, many companies overestimate their ability to manage receivables and, as a result, payments from customers can be delayed and significantly impact cash flow. Yet, many business owners suffer from 'optimism bias' and see their cash flow forecast with rose-coloured glasses. This can lead to overbuying inventory, hiring too many people or taking on more debt than you can pay off in a reasonable timeframe. It is best not to mix your cash flow statement and your cash flow forecast, and to prepare a cash flow forecast solely for planning purposes.
The direct method of generating a cash flow statement uses actual cash coming in and going out of the business and only uses those inflows and outflows to generate the cash flow statement. The direct method is also referred to as the income statement method. This approach can be seen as more time-consuming because it requires listing all cash disbursements and receipts. It's generally agreed that the direct method provides a more detailed view of where a company's cash comes from and how it's disbursed (employee salaries, operating expenses, cash paid to vendors, etc.).
Generating a Cash Flow Forecast
There are a few ways to generate a cash flow projection. If you are an Enkel client, this is something we can help you with. If you’re doing it yourself, there are a few tools you can use:
Accounting Software
Some accounting software for bookkeeping will allow you to create a cash flow projection using your data. These tools are generally simple but are not the most accurate projection tools. However, they are a good starting point if you are beginning to grow your business.
Float
Float is a cash flow forecasting and scenario planning tool that integrates with cloud-based accounting software like Xero and Quickbooks Online. Float exports data from your accounting software, which is excellent if you want to run different scenarios or have a complicated cash flow forecast. You can also input your current budgets and track your progress against them.
Excel Templates
Projecting your cash flow forecast using programs like Excel or Google Sheets is an excellent way to get intimate with your financial data. It’s important to be vigilant when manually setting up a model as it leaves much room for human error, and beware that the continuous upkeep of these documents can be time-consuming. If you’re set on projecting your cash flow with these tools, free templates available on both Microsoft Office and Google Sheets.
What Can I Use My Cash Flow Forecast For?
If you have your cash flow forecast ready to go, let’s review how you can use your financial data to help plan for your future.
Identifying Potential Shortfalls in Cash Balances in Advance
You need to be able to pay your expenses, manage employee payroll – and, of course, pay yourself – and know what you have for investing in growth activities. By forecasting, you can spot potential cash shortages far before they become problems.
Conversely, businesses should always have extra cash on hand. Sometimes, when it rains, it pours, so having some additional money in the bank will help you get through tough times.
But if too much money is piling up without any planning on how you’ll reinvest it within the company, you may be missing out on opportunities. It is helpful to determine how much cash you need for operations over a specific period and to use that as a benchmark for how much cash to set aside. Once you have more than the benchmark amount, you could invest in developing or launching a new product offering, expanding marketing programs, hiring new talent, or investing in capital such as equipment or property.
Preparing for Seasonality Fluctuations
You'll want a forecast if your industry experiences extremely busy and quiet seasons. Seasonal businesses often experience fluctuations—for example, ski resorts are busier during the peak winter season and slower during the summer.
You can use your cash flow forecast to budget your expenses for slower months and know how much earnings you’ll need to set aside to cover these expenses.
Stronger Loan Applications
When you apply for a small business loan, you’ll need to come prepared with your financial reports, but a cash flow forecast is also extremely valuable in the loan application process. You’ll come across as forward-thinking and prepared; lenders will better understand your growth potential. Buying into your growth story will make them more confident in lending you money.
Reducing Operating Costs
Cash flow forecasts estimate future revenues and expenses. Forecasting expenses can help reduce future operating costs by estimating cash outflows before they occur. Are your employees generating enough revenue to justify their salaries? Is your business ready to expand into that second location? Your cash flow forecast is your closest financial tool to a Magic 8 Ball.
Forecast Cash Flow in Four Steps
Cash flow forecasting follows a process that can be repeated. Follow these steps to forecast your organization's cash flow:
- Set a forecasting period: Short-term forecasting might involve looking at a shorter period (ie: 30 days) whereas longer-term forecasting could look at 3 months, a year, or more.
- Choose a forecasting method: If looking at a short forecasting period (30 days), the direct method is recommended to look at known income and expenses for that period of time. The indirect method works better for a longer timeframe as it allows you to make projections without concrete data.
- Calculate cash flows and cash balance: This step involves calculating cash inflows (sales revenue, investment revenue or interest to be earned) and cash outflows (vendor expenses, loan expenses, payroll and estimated taxes). Don't forget to account for the cash balance in your bank account at the start of the forecasting period.
- Look at net cash flow and closing cash balance: Net cash flow is calculated by looking at inflows (cash coming in) minus outflows (cash going out). The closing cash balance would factor your starting balance into the equation. (Starting balance + inflows - outflows = closing cash balance.)
Final Thoughts
The first step to building an accurate cash flow forecast is to have an up-to-date set of books and accurate financial data. At Enkel, we provide business owners and not-for-profit organizations with monthly bookkeeping and other accounting services so they can be confident in the quality and reliability of their books. We would be happy to assist you with generating a cash flow projection for your small business. Contact us today to learn more about our bookkeeping services for small businesses.
How We Select and Evaluate Our Software Recommendations
We thoroughly research and test the apps we include in our regular workflow for Client bookkeeping services. After deciding on criteria for evaluating the software and then researching the app itself, we tested the app, noting its strengths and weaknesses. We then work with the app for at least a few weeks before deciding whether to recommend it to our readers. We use the software as it was designed for its intended tasks. For a detailed walk-through of how we select and evaluate software, please see the details of our process.
