How to do Cash Flow Forecasting

You found the Rigits guide on how to do cash flow forecasting!

Cash flow forecasting is about predicting your cash inflows and outflows over a certain period, enabling you to plan for future growth, manage debt, and ensure you can cover your expenses. 

This guide is designed specifically for small business owners, breaking down the complexities of cash flow forecasting into manageable, actionable steps. 

This guide is also related to our articles on understanding gross vs. net profit, how to read a cash flow statement, and how to calculate burn rate.

This guide covers:

• Understanding Cash Flow
• The Basics of Cash Flow Forecasting
• Creating a Cash Flow Forecast
• Managing Cash Flow
• Common Mistakes

By the end of this guide, you’ll not only grasp the importance of cash flow forecasting but also know how to implement it into your regular business planning.

Let’s get started!

Introduction to Cash Flow Forecasting

Cash flow forecasting represents the process of estimating the flow of cash in and out of your business over a specified period. 

At its core, cash flow forecasting involves compiling a detailed projection of all expected cash receipts (inflows) from sales, loans, investments, and other sources against anticipated cash payments (outflows) for expenses, loan repayments, purchases, and other financial commitments. 

The aim is to calculate your beginning and ending cash for each period, be it weekly, monthly, or quarterly, giving you a clear picture of your financial reserves at any given time.

Effective cash flow forecasting hinges on accurate and realistic assumptions about your business’s future. This includes a thorough understanding of your 

• market
• sales cycle
• payment terms offered by suppliers
• payment behavior of your customers

It also requires a grasp of any seasonal variations in your business or external factors that could impact your cash flow, such as economic downturns or changes in industry regulations.

Understanding Cash Flow

A common confusion among small business owners lies in distinguishing cash flow from profit. While both metrics are essential for evaluating your business’s financial performance, they serve different purposes. 

Profit, or net income, is the amount remaining from your revenues after all expenses have been subtracted. 

In contrast, cash flow focuses on the actual amount of cash available to your business at any given time. It’s possible for a business to be profitable on paper yet struggle with cash flow if revenues have not yet been collected or if there’s heavy investment in fixed assets or large debt repayments required.

Cash flow can be categorized into three main types: Operating, Investing, and Financing.

• Operating Cash Flow reflects the cash generated or spent in the course of regular business operations. It’s determined by taking revenues from selling goods and services, subtracting operating expenses, and adjusting for changes in working capital (such as inventory and accounts receivable/payable). 
• Investing Cash Flow pertains to cash used for or generated from buying and selling assets, like equipment, property, or investments in other businesses.
• Financing Cash Flow involves cash moving between a company and its owners, investors, or creditors. It includes cash from issuing shares, borrowing, or bank loans and cash used to pay dividends, repay loans, or buy back shares.

Cash inflows encompass all sources of incoming cash, such as cash sales, receivables collections, loans, and investment income. These inflows ensure your business has the funds necessary for day-to-day operations and growth initiatives. 

Cash outflows, on the other hand, represent money going out of the business. This includes expenses like rent, salaries, utility bills, loan payments, and purchasing inventory or assets. Managing these outflows is critical to maintaining a healthy cash balance.

The Basics of Cash Flow Forecasting

There are various approaches to cash flow forecasting, each with its advantages, depending on your business needs. Understanding the basics, including the differences between short-term vs. long-term forecasts and direct vs. indirect forecasting methods, is essential. 

Short-term vs. Long-term Forecasts

Short-term cash flow forecasts typically cover a period of up to 90 days and are detailed, focusing on the immediate cash flow needs of the business. 

This type of forecast is crucial for managing daily operations, ensuring there’s enough cash on hand to cover expenses like payroll, supplier payments, and other operational costs. It helps in identifying potential cash shortfalls in the near future and allows for timely decision making.

Long-term forecasts look beyond the immediate future, often spanning one to three years, and sometimes even longer. 

They help in assessing the viability of long-term projects, expansion plans, and investments. Long-term forecasting supports decision-making on matters such as funding requirements, growth strategies, and risk management.

Tools and for Cash Flow Forecasting

Numerous tools and software solutions are available to assist small businesses with cash flow forecasting. Choosing the right one depends on your business size, complexity, and specific needs. Some popular options include:

• Excel or Google Sheets: The workhorse of financial analysis tools, good ol’ Excel or Google Sheets offers tons of flexibility and ease of use. However, it can get cumbersome to update if you don’t have a good grasp of excel formulas and shortcuts.
• QuickBooks: Widely used by small businesses, QuickBooks offers robust cash flow forecasting features, integrating seamlessly with other financial reporting functions.
• Fathom: Fathom integrates with Quickbooks or Xero and offers detailed cash flow forecasting with added scenario planning and micro-forecast options. 

So you’ve picked your long-term or short-term forecast and your tools. Let’s dive into setting up your cash flow forecast.

Preparing for Cash Flow Forecasting

This process includes gathering necessary financial data, understanding your business cycle, and identifying your cash flow drivers. 

Gathering Necessary Financial Data

Essential financial documents include historical income statements, balance sheets, and cash flow statements. You’ll also need detailed records of past sales, expenses, accounts receivable, and accounts payable. 

Additionally, gather information on any upcoming expenditures that are not part of your regular expenses, such as equipment purchases, loan payments, or planned investments. 

For a more accurate forecast, include all known future incomes, such as confirmed sales or contracts that will generate cash inflows. 

The more comprehensive and detailed your financial data, the more accurate your cash flow forecast will be.

Understanding Your Business Cycle

Every business has its unique cycle, influenced by seasonality, market trends, and operational factors. For instance, retail businesses might experience high sales volumes during the holiday season, while construction companies may see a downturn in winter months. 

Consider how your sales, expenses, and cash flow have varied in the past during different seasons or economic conditions. 

Knowing your business cycle also helps in planning for inventory purchases, staffing levels, and marketing efforts to align with your cash flow needs.

Identifying Your Cash Flow Drivers

Cash flow drivers are the primary factors that affect the movement of cash in and out of your business. Common cash flow drivers include 

• sales volume
• pricing strategies
• payment terms given to customers
• credit terms negotiated with suppliers
• production cycles
• debt obligations
• interest rates

Understanding your cash flow drivers allows you to pinpoint areas where adjustments can significantly impact your cash flow. 

Creating Your Cash Flow Forecast

Creating a cash flow forecast is a structured process that requires attention to detail and a deep understanding of your business’s financial rhythms. The goal is to anticipate the flow of cash in and out of your business.

Here’s a step-by-step guide tailored for small business owners to craft a comprehensive cash flow forecast.

1. Establish the Time Frame. Decide on the period your cash flow forecast will cover. Short-term forecasts might span a month or a quarter, while long-term forecasts could look ahead to the next year or beyond.

2. Project Sales and Revenue. Start by estimating your future sales. This projection should be based on historical sales data, considering any expected changes in market conditions, your business capacity, and marketing efforts. Factor in seasonality and any upcoming events or promotions that might impact sales volumes.

3. Estimate Cash Inflows. Cash inflows extend beyond just sales to include all sources of incoming cash, such as loan proceeds, investment income, or tax refunds. Be realistic about the timing to avoid overly optimistic forecasts.

4. Forecast Cash Outflows. List all expected cash outflows, including costs of goods sold, operating expenses, loan payments, and capital expenditures. Remember to account for periodic payments like taxes, insurance, or any subscription services.

5. Adjust for Unexpected Expenses. No forecast can be 100% accurate, so it’s important to build in flexibility for unforeseen costs or unexpected cash injections. These could stem from emergency repairs, legal disputes, or sudden opportunities requiring quick investment.

6. Use Historical Data in Forecasting. Your business’s past performance is a valuable guide for predicting future cash flows. Analyze historical financial statements to identify patterns or trends in sales, expenses, and cash flow movements.

What your cash flow forecast should look like

Your forecast should start with your beginning (actual) cash balance. This should only factor in liquid assets (cash or short-term investments that can be quickly converted into cash).

Then, estimate all your inflows and outflows for the period (usually a month), which should end in your projected (estimated) ending cash balance. 

That ending cash balance then becomes the next month’s beginning cash balance and the process is repeated.

Monitoring and Updating Your Forecast

To get the most out of your forecast, you should compare them to actual performance, and adjust future projections accordingly. Here’s how to make forecasting a dynamic management tool for your business.

Frequency of Review and Update

First, establish a routine for how often you will review and update your forecasts. This doesn’t mean you need to do it daily; however, the frequency should match the pace at which your business environment changes. 

For many small businesses, a monthly review is a good starting point. This allows you to capture enough data to see trends without getting lost in daily fluctuations. However, in fast-changing sectors or during critical growth phases, you might need to review and update your forecasts more frequently, perhaps on a weekly basis.

Adjusting Forecasts Based on Actual Performance

When it comes time to review your forecasts, compare your actual performance against what you had predicted. Look for areas where you’ve underperformed or overperformed, and analyze why. 

If your actual revenues are consistently lower than forecasted, it might indicate an overly optimistic sales projection or perhaps an external market shift you haven’t accounted for. Conversely, if expenses are running higher than expected, it could signal inefficiencies or rising costs.

Adjusting your forecasts based on this analysis is crucial. If you see a persistent trend, revise your forecasts to make them more realistic. This might involve lowering sales projections, adjusting your budget to account for higher costs, or both

Managing Cash Flow

Your forecast is meant to help you manage your cash flow. If your forecast is showing you scary numbers, it’s time to make decisions that will fatten up your cash cushion.  

Strategies to Improve Cash Inflow

• Improve Invoice Management: Prompt invoicing and follow-ups can significantly reduce the time it takes for your business to receive payments. You might need to shorten your collection periods.
• Offer Multiple Payment Options: By accepting various payment methods, including credit card payments, you make it easier for customers to pay promptly. Convenience can lead to getting paid faster.
• Implement Early Payment Discounts and Late Payment Penalties: Encourage your customers to pay early by offering discounts. Discourage late payments by implementing penalties for overdue invoices.
• Focus on High-Margin Products or Services: Analyze which of your offerings bring in the most revenue after costs. Prioritizing these can improve cash inflow with the same or even reduced effort.
• Lease Instead of Purchase: When possible, lease equipment rather than purchasing it outright. This strategy can free up cash that would otherwise be tied up in assets.

Techniques to Minimize Cash Outflows

• Negotiate Better Terms with Suppliers: Longer payment terms with suppliers can keep cash in your business longer. Don’t hesitate to negotiate terms that are more favorable to your cash flow situation.
• Reduce Overheads: Regularly review your overhead expenses to identify areas where you can cut costs without impacting your business operations. Even small reductions can add up to significant savings over time.
• Inventory Management: Keep inventory levels in line with your sales forecasts to avoid tying up cash in unsold stock. Consider just-in-time inventory systems to minimize the cash locked in stock.
• Optimize Staffing: Labor costs are a significant expense for many businesses. Utilize part-time staff or contractors during peak periods to avoid the financial burden of full-time salaries during slower times.
• Control Discretionary Spending: Limit expenses that are not essential to your business operations. Discretionary spending should be the first area to cut back on when cash flow is tight.

The Role of an Emergency Fund

A contingency fund, or emergency fund, is a reserve of cash set aside to cover unexpected expenses or financial downturns. 

The size of the fund will vary depending on your business’s specific risks and financial situation, but having three to six months’ worth of operating expenses is a common recommendation.

To build a contingency fund, start by setting aside a fixed percentage of your monthly revenue until the fund reaches your target amount. Treat contributions to this fund as a non-negotiable expense, similar to rent or salaries. Having this financial safety net can give you peace of mind and the ability to navigate challenges with confidence.

Common Mistakes in Cash Flow Forecasting

Common mistakes in this process can lead to serious financial difficulties. Here’s how to recognize and avoid these pitfalls.

Overly Optimistic Revenue Projections

One of the most common errors is being overly optimistic about future sales. It’s natural to be hopeful about your business’s potential, but unrealistic revenue projections can lead to spending more money than you actually have. 

This optimism often stems from the best-case scenarios like a major deal closing or a marketing campaign yielding high returns without considering the mid or worse case scenario.

Underestimating Expenses

Expenses often grow faster than anticipated, especially in a small business environment where scale doesn’t yet offer cost efficiencies. Unforeseen costs such as emergency repairs, increases in rent, or rising material costs can quickly throw off your forecast.

To guard against this, include a buffer in your expense forecasts for unexpected costs. Additionally, regularly review your actual expenses against forecasts to identify and understand any discrepancies. 

Failure to Adjust Forecasts Regularly

Cash flow forecasting is not a one-time task but a continuous process that requires regular updates to remain useful. A forecast made at the beginning of the year, or even the quarter, can quickly become outdated as new information becomes available. 

Make it a habit to review and adjust your cash flow forecasts regularly—at least monthly. This doesn’t mean you need to start from scratch each time. Instead, update your projections with actual figures as they come in and adjust future months based on what you’ve learned. 

Conclusion

Cash flow forecasting is vital for managing a small business. 

But, it’s easy to slip up being too optimistic about how much money you’ll make, not guessing your costs right, or not updating your forecasts can hurt your business. To avoid these mistakes, be realistic about your income, plan for unexpected costs, and keep your forecasts up to date.

This way, you can help your business stay flexible and ready for whatever comes your way, setting it up for long-term success.

Next, take a look at our related articles on top 10 ecommerce platforms, understanding nonprofit accounting, and cash vs. accrual accounting.

Let Rigits help you

Grow confidently Sleep better at night

Get stuff off your plate

Let's chat!

Author: Julia Kelly

Co-founder at Rigits

I write about how small business owners can better understand and utilize their financials for growth.

Julia Kelly