Guide to Cash Flow Forecasting For Small Business Owners
Did you know that checking your bank account can help you make sure your next paycheck arrives before your rent due date? Perhaps you have an installment plan that allows you to spread your payments across multiple credit card statements, which can be a good way to save money.
You're likely to have participated in cash flow forecasting.
Cash flow forecasting in accounting is a tool that helps companies estimate their net income over a while. It allows business owners to plan for growth, meet their obligations, and monitor expenses.
What's cash flow forecasting?
Cash flow forecasting is a process that estimates the cash that will enter or leave a business during a specific period.
Let's suppose that an interior design company wants to forecast its cash flow for the next 12 months. This company can project a net cash flow of $50,000 if it anticipates an inflow (or net income)of $80,000 over the next 12 months.
Direct vs. indirect cash flow forecasting
There is a direct and indirect method of cash flow forecasting. This involves estimating income and expenses.
● Forecasting direct cash flow. Direct forecasting works with known costs. This method is usually suitable for short-term forecasting. Direct cash flow forecasting is used by businesses to ensure that they have sufficient working capital to pay their end-of-the-month bills.
● Indirect cash flow forecasting. This is the long-term forecasting method that uses projected balance sheets (also called pro forma balance sheets) as well as projected income statements. Indirect methods account for factors that impact profitability, but not the cash balance. This includes the depreciation of buildings and equipment.
In 4 steps, forecast cash flow, It is a repeatable process to forecast cash flow.
Step 1: Set a forecasting period
The first step in cash flow forecasting is to choose a forecasting period. A short-term cash flow forecast might focus on a period of 30 or more days, while a longer-term forecast might consider a quarter, a whole year, or multiple years.
Step 2: Choose a forecasting method
Next, choose a forecasting technique. If you have a short forecasting period (say 30 days), the direct method can be used. This involves consulting your income and expenses to determine how much cash you will have at the end. The indirect method, however, will allow you to make projections for a longer time frame than the one you have.
Step 3 - Calculate cash outflows and inflows
Next, calculate the estimated cash outflows and cash balances.
Add up the expected gains during your forecasting period to calculate inflows. This could include the anticipated sales revenue, anticipated investments revenue, or interest earned, as well as the disbursement and repayment of loan funds that the company has previously secured.
Next, calculate outflows. Include anticipated expenses like vendor expenses and loan payments.
Determine your starting cash balance, or the cash available in your bank accounts at the start of the forecasting period.
Step 4 - Calculate net cash flow and closing cash balance
After you have calculated your inflows and outflows, as well as the starting cash balance, it's time to build your cash flow forecast.
To calculate net cash flow, subtract outflows from inflows. This formula is inflows minus outflows = net Cash flow. Negative cash flows are a loss.
Next, calculate the closing cash balance. This is the amount of cash that your business should have in its bank accounts by the end of the forecasting period. This number can be calculated by using the formula: starting balance + inflows - closing cash balance
Software that automates cash flow forecasting can improve the accuracy and speed of this process. It also makes it easy to check updated cash flow projections.
The advantages of cash flow forecasting
Cash Flow forecasting offers many strategic benefits, including helping companies pay off debt and maximizing returns on assets.
● It will help businesses make informed cash flow decisions. Potential investments are a top priority for business owners. You can use net cash flow forecasting to help you plan your expenditures, whether you are targeting a new employee, marketing expenses, or investments in facilities.
● It helps businesses to identify cash flow patterns. Cash flow forecasting, which tracks outflows and helps you to identify opportunities to reduce unnecessary expenses, can be used by businesses. This can help you avoid having too many bills due at once, which could lead to you carrying unneeded cash.
● It can be used by businesses to project growth and manage debt repayments. Businesses can plan for the future by being able to predict profits and losses for a quarter, a whole year, or longer. Cash flow projections are useful for helping you plan your repayment schedule if your company took out a start-up loan. Also, reviewing your monthly cash flows can help determine if you are on track to reach that goal. Accrued profits are the same. Even though you might not be able to make a hire right away, cash flow forecasting can help you determine when it is advisable to increase your team.
● This can allow you to put your money to work. Companies should have enough working capital to cover all expenses. Many businesses also have some cash in reserve. It is not a good idea to let cash accumulate in your bank account. It is best to invest your cash in markets and the growth of your company. You can free up cash for income-generating activities by using cash flow forecasting.
Drawbacks of cash flow forecasting
These are some important points to remember when creating cash flow forecasts.
● It can be inaccurate--particularly under an indirect method. Just like a weather forecast, a cash flow forecast represents a best guess at what future conditions are likely to look like based on current conditions and existing models. Cash flow forecasts, like weather forecasts, can also be incorrect. This is especially true when seasonal forecasts are made using the indirect method. However, even direct cash flow forecasting can be inaccurate. This method assumes your debtors will pay their bills in due time and that there won't be any unexpected expenses.
● It doesn't take into account unexpected events. Cash flow forecasting does not account for the possibility of a tree falling on your workshop, or your cat spilling glass water onto your keyboard. These unexpected expenses are often covered by extra cash that businesses tend to have in reserve.
● This can be time-consuming. Before you start your calculations, you will need to look at your accounts receivable and accounts payable.
Final thoughts
Cash flow forecasting can be a useful tool in your strategic business development arsenal. It allows you to plan for future events and assess your performance against those predictions.
It is a smart decision to invest in an accounting system or software that generates cash flow projections. Don't mistake predictions for certainty. Keep a little cash on hand for those (proverbial!) rainy days.