A Guide to Cash Flow Forecasting
In my last article, I identified excuses I often hear for not forecasting cash flow. Hopefully, those reasons were compelling enough for you to ask, “so how do I prepare a forecasted cash flow?”
The short answer is…with lots of input from your team. Perhaps the primary reason most accountants are not able to prepare a meaningful cash flow forecast is that input is required from so many people in your organization and the thought process is quite different from bookkeeping.
Cash is flowing through your organization everyday either coming in – “Source” – or flowing out – “Use.” In most organizations which have no CFO, there is no one person responsible or able to accurately identify this money flow.
Preparing a cash flow forecast can be complicated, but I’d like to share the process I use with clients. I keep the initial forecast very simple and then develop detailed calculations over time.
My starting point is to review the current financial statements and operating budgets. Typically, with small businesses, the forecasted cash flow has not been developed because operating budgets are non-existent.
First, I identify all the “sources” of cash. These sources are usually easily identified because there are only a handful of them:
- Sales
- Deposits
- Collections of accounts receivable
- Note receivable payments
- Capital injections
- Loan proceeds
I conduct a sales projection review to ensure it is realistic, and then ask, “How and when is the sale converted to cash?” We need to understand the timing of when cash is received.
- Is cash received at the time of sale or is there a difference in timing? Even with e-commerce sales, there is a two-to-three-day difference plus payment of merchant account fees before cash is received.
- If you sell on account, how long does it take on average to collect?
- What percentage of receivables are never collected?
Developing a spreadsheet for forecasting the timing of cash from sales is challenging but essential because it depicts the main sources of cash flow. If you don’t understand how cash flows from sales, then forecasting is very difficult. I will similarly go through all the other sources of cash and understand the timing of receipt of each one.
To forecast the “Use” side, review the Income Statement, beginning with the Cost of Goods Sold section. If the business is product based, I will ask questions until I understand how inventory is purchased, processed, and delivered. Like sales, this is typically a challenging area, yet most important because it is typically the largest use of cash in the business. If the business is service based, then understanding the timing of payments to employees and subcontractors is critical. Owners of service businesses are often surprised by the amount of cash they have expended before they receive payments from sales.
After the Cost of Goods Sold, I review each operating expense and its timing. The next step is to review the Balance Sheet – both assets and liabilities – to determine additional future cash outlays. Examples of these include purchase of fixed assets, sales of fixed assets, payment of accounts payable, credit card payments, loan payments, dividends, or distributions to owners.
When preparing a forecasted cash flow, a summary sheet (here’s an example) is helpful, with a detail sheet for each Source and Use line. This makes the summary easier to read and provides space in the detail to document my assumptions. The last section of the forecasted cash flow provides a running balance of the projected cash balance based on this set of assumptions. While this will never be 100% accurate, I can review the projected cash balance to determine if there is a projected future shortfall. Knowing this information now allows the business owner to take action to mitigate a shortfall.
After preparing the forecasted cash flow the first time, there is almost always a change in how the business operates in the future – from a cash flow perspective – because of the insights obtained by understanding how cash flows in and out of the business.
Timing of cash flow forecasting is based on what the current cash flow tells you. If cash is tight and there are projected shortfalls, I recommend a 6-week cash flow, by day, prepared weekly. In any case, I like to see a 3-month cash flow by week, prepared monthly. And, of course, a 12-month cash flow forecast should be prepared as part of the annual operating budget.
There’s certainly much to know when it comes to forecasting cash flow, but once you start, you’ll find it to be an invaluable tool, and you’ll wonder how you ever operated without it.
Many companies feel more comfortable having a CFO handle this sometimes-tedious task. If you’re interested in discussing how I can help or have questions about forecasting cash flow yourself, contact me by phone, email, or online, for a complimentary consultation.
