Money makes the world go round- and no entity lives, breathes and talks money more than businesses do. The primary function of any regular business is wealth creation. Regulating, monitoring and predicting cash flow in and out of business is imperative for all business leaders. This is why companies do cash flow forecasting.
What is Cash Flow?
Cash flow is the total amount of money coming in and out of your business. Cash flow is the behaviour of the inflows and outflows of Cash, i.e. effective liquidity. The movement of funds can be virtual or real.
The cash flow statement details the company’s earnings and expenditures over time. The primary cash inflows of the company come from sales, debt repayments, interest on investments etc. The significant outflows of the company are its various operating and non-operating expenses.
There are three types of cash flows-
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financing activities
Cash flow from investing activities is the funds spent on capital expenses and are long-term investments. Flow from financing activities represents the flow of Cash from the company’s creditors, investors and owners. Cash flow coming in because of operating activities is the money received via customer sales minus the operating expenses.
What is Cash Flow Forecasting?
Cash flow forecasting is the process of predicting and estimating the value of future sales, investments and expenses over a specific period. It helps businesses predict the future cash performance of the companies, probable risks, cash shortages, earnings and surpluses and eventually allows the business leaders to make informed financial decisions.
The company’s finance team usually performs cash flow analysis and forecasting. However, the process of cash forecasting is tricky and necessitates collaborative efforts from multiple departments, leaders and stakeholders.
Why Is Cash Flow Forecasting Crucial for a Company?
In cash flow forecasting, the finance teams analyse the expected sales performances and purchase activities and consider all upcoming business costs, opportunities and risks to develop an insightful and actionable forecast report. These forecasts become crucial for risk aversion and help businesses prepare for probable crises.
Recovery from debt
Cash flow forecasting helps finance officers get detailed insights into the cash on hand and future spending. This allows them to ascertain if they have enough resources to make debt and interest payments when they are due.
When businesses are in debt, lenders often place certain financial restrictions on them. Lenders want firms to maintain a certain level of financial standing to ensure that the company can repay the debt without delays or issues. These restrictions are called debt covenants. Cash flow forecasting helps the finance teams detect cash flow bottlenecks that may violate the debt covenants early and take necessary actions.
Execution of growth strategy
Cash flow forecasting helps businesses know when they can expect cash surpluses and, in turn, plan their growth phase strategy.
How Does Cash Flow Forecasting Work?
The process of cash flow forecasting differs among businesses. It depends on what you want to achieve from the forecast, your business objectives, management and workforce requirements and your company’s data availability and transparency. However, no matter the end goal, the following steps will help you in your forecasting process.
Step 1: Setting your objectives
The first step in cash flow forecasting is outlining your business objectives and aligning them with the goals of the forecast. Cash flow forecasting can be used for several reasons, including short-term liquidity planning, debt reduction, risk management, and growth planning.
Step 2: Set forecast period
Depending on your cash flow forecasting objectives, decide on the time duration for which you want to perform the cash flow forecast. Selecting the suitable forecast period can affect the accuracy of the forecast as the further into the future you estimate the values, the higher will be chances of inaccuracy and data contamination.
Step 3: Opt for the suitable forecasting method
The forecasting method you choose depends on your forecasting objectives and period. Majorly there are two types of forecasting methods: the direct forecasting method and the indirect forecasting method.
The direct method is for short-term forecasting and shows cash needs and working capital fund requirements. It is done by analysing the upcoming payments, receipts, credits and debts.
The indirect method is for long-term forecasting and shows the money required to pay for long-term projects and growth strategies. It is done by analysing income statements, pro forma balance sheets, etc.
Step 4: Forecast your cash inflows
To forecast the sales for a specific period, look at the sales data from previous years. Try to find a pattern and pinpoint the influencing variables and factors against which the sales increased, decreased or stayed the same.
You can also forecast your income by estimating how much cash inflow is needed to sustain the business’s profitability. If any assets are set to be sold, you must account for those earnings in the forecast and any other atypical gains that the company incurs.
Remember that sales predictions can never have 100% accuracy because sales have many variables like sales personnel’s performance, customer needs and attitude, changes in economic conditions, competitor’s activities etc.
Step 5: Estimate your cash outflows
To estimate your cash outflows, you need to ensure you are aware of all kinds of expenses that your business incurs. While a company’s cash inflows are limited, the expenses seem almost endless. Make sure you account not just for the cost of goods sold and operating expenses but also for non-operating expenses and depreciation on capital expenses.
Learn about the different types of expenses that a business incurs here.
Step 6: Compile the data for the cash flow forecast
Cash flows are time-sensitive. While compiling the final data, start with the cash you have at hand. Now, you can add cash inflows and minus cash outflows for specific periods. At the end of each period, you will get an amount that will be the closing cash balance, which will be the opening balance for the following period.
Free Cash Flow = Net Income + Depreciation- Change in WC – CE
Operating Cash Flow = Operating Income +Depreciation – Tax +Change in WC
Cash Flow Forecast = Beginning Cash + Projected Income – Projected Expenses = Ending Cash
Step 7: Review and revisit the forecast report
The last and most crucial step is to revisit the forecast report whenever you get new information or data. You can supply new data to the report and improve the accuracy of your forecast. It can also help you analyse your forecasting methods and highlight the differences between the actual cash flow and your expectations.
Challenges Faced During Cash Flow Forecasting
As discussed above, investing in cash flow forecasting is more than worth it. It consumes a lot of resources from the company. However, it does not nullify that it comes with a set of challenges.
Although forecasting software and different revenue/expense management platforms have made life easier, many companies still rely on manual processes for their forecasting needs. Manual cash flow forecasting is an even longer and more tedious process which may lead to the following problems.
- Time and effort: Finance teams are already overstretched. Cash flow forecasting then makes them source, centralise, standardise and organise data from multiple departments. When done manually, cash flow forecasting requires long hours with excel spreadsheets making the process even more time-consuming.
- Data contamination: Manual data collection can lead to errors and inconsistencies during data inputs and lead to data contamination. This can skew the final forecast reports.
- Delayed collection of data: While the finance teams understand the importance of cash flow forecasting well, other stakeholders in the company may not be able to understand the time sensitivity of data. This may mean that they will provide data later than required or in a format that is not optimal.
Embrace Technology for Cash Flow Forecasting
Cash flow forecasting requires a trustworthy repository of a company’s financial data. Using automation-empowered platforms like revenue management tools or expense management software can give you access to accurate live and historical data.
Leverage the power of technology to produce accurate and effective cash flow forecasts and push your organisation towards a more innovative financial future.