What’s cash flow forecasting, and why is it important?

Acclaimed entrepreneur Richard Branson once famously said: “Never take your eyes off the cash flow because it’s the lifeblood of business.”  This quote quickly communicates why the survival of your business depends mostly on cash flow.

What is cash flow?

In simple terms, cash flow refers to the net amount of cash coming in and going out of your business. Think of money coming in as representing inflow, and money spent reflecting outflow.

Typically, the sale of goods or services is what results in an inflow of cash, but other sources might include debt repayments and interest from deposits. Wages, supplier payments, rent and taxes are among classic examples resulting in outflow of cash.

What is cash flow forecasting, and how does it relate to a cash flow statement?

Your business’s cash flow can be measured and predicted through a technique called cash flow forecasting. The cash flow forecast is often represented through a cash flow statement, which is essentially a document showing the business’s cash inflow and cash outflow in a set period, prepared in accordance with generally accepted accounting principles.

Businesses with more money coming in than going out during the period are considered to have a positive cash flow statement. Those with more money going out than coming in during the interval are considered to have a negative cash flow statement.

A negative cash flow isn’t always bad

A negative cash flow isn’t always cause for concern. Some businesses may experience a significant outflow of cash if they are completing an acquisition or financing a new venture, for instance.

But a negative cash flow statement does warrant further investigation. To provide context, companies issue a cash flow statement in conjunction with the income sheet and the balance sheet.

Some businesses with a negative cash flow will need to plug cash outflow holes before it’s too late. In entrepreneurial terms, this refers to revisiting the cash burn rate — the amount of money needed monthly to cover all expenses.

The lower the burn rate, the better the indication that your business has a strong cash position. To reduce burn rate, businesses must take measures aimed at increasing revenue and cutting costs.

Why is cash flow forecasting key?

A cash flow forecast is a valuable tool for businesses because it:

• Accurately reflects money coming in and going out.
• Shows unanticipated cash flow shortages so you can make backup plans.
• Allows you to base decisions on data rather than assumptions.
• Informs strategic planning and day-to-day operational planning.

The utility of cash flow forecasting

Cash flow forecasting helps estimate a company’s future cash balance, and it’s usually performed for the short, medium and long terms. However, the further into the future the forecast goes, the more it is based on assumptions and the less dependable it becomes.

Businesses use cash flow forecasting so they can be better prepared. It will tell you when you’ll have sufficient cash to run the company or expand it, as well as when more cash is going out than in.

Investors and banks also rely on cash flow forecasting, in part, before deciding whether to fund a business. It also helps position business owners to ask investors for more funding.

The basics of forecasting cash flow

Because business cash flow is dependent on time, aim to be as accurate as possible regarding the timing of your inflow and outflow predictions when following these broadly outlined steps.

1. Choose a forecast period (such as monthly or annual).

2. Forecast income or sales for the period.

Established businesses can do this by reviewing last year’s figures for any trends. You can adjust based on whether sales or income went up, went down or stayed the same.

Newer businesses without past numbers to look at can begin by estimating all their cash outflows to get an idea of how much money they need to bring in to cover it.

3. Estimate cash inflows.

Estimate your inflow of cash from sources other than sales of goods and services. This will vary by business, but examples could include:

• Loan being repaid to you.
• Asset sale.
• Tax refunds.
• Grants.
• Royalties or franchise fees.

4.  Estimate cash outflows and expenses.

Estimate your expenses for administration and operations, such as wages, taxes and rent. You may also need to factor in the cost of making goods available.

If applicable, add other cash outflows that separate from normal running expenses, such as loan repayments, purchasing new assets, one-off bank fees, and payments to the owner.

5. Compare your estimated cash flow against actual cash flow.

Review what you estimated against your actual cash flows for the chosen period. This will show any differences between estimated and actual to see why cash flow deviated from your projections. 

Want more? In addition to accounting, bookkeeping and CFO services through its FinOps, Escalon’s Essential Business Services include PeopleOps (HR, benefits, recruiting and payroll) and Risk (business insurance). Talk to an expert today.