Cash flow projections, a guide for small businesses

If cash flow isn’t monitored closely, it can result in a business running out of operating cash - the second most common cause of business failure (1) – which can result in closure.

What is cash flow?

Cash flow is the net amount of cash and cash equivalents being transferred in and out of a company. Cash received represents inflows, while money spent represents outflows.

Positive cash flow indicates a company's liquid assets are increasing. Thus, enabling it to cover its obligations, reinvest in the business, pay dividends to shareholders, pay expenses, and build contingency against future economic challenges.

Companies with strong financial flexibility fare better in an economic downturn because they avoid the financial distress.

Cash flows are analysed via the cash flow statement, which is a standard financial statement reporting a company's cash source and use over a given period.

Corporate management, analysts, and investors use the cash flow statement to determine how well a company can manage its operating expenses.

The cash flow statement is a crucial financial statement for a company, along with the balance sheet and income statement.

What is a cash flow forecast?

Otherwise known a cash flow projection, a cash flow forecast is similar to a budget in that it estimates incoming cash and outgoing cash based on past performance.

It can be common for a business to suffer cash flow difficulties even when sales are high. This typically occurs when credit terms are offered to clients, such as when a client is allowed to pay for the goods after delivery.

In a business that operates this way it is vital that cash flow management is tight. If a business’s clients experience cash flow problems, then the business could struggle to chase in the money it is due, which can impact on its growth plans and its ability to pay suppliers and employees.

With a cash flow forecast a business ignores sales on credit, accounts payable, and accrued expenses, and focuses on the money it expects to collect and the expenses it will pay in that period. From this, many business owners and financial controllers can use the information provided to estimate expenses for that period.

Cash flow forecasting benefits

Cash flow forecasting is essential for businesses:

You can predict future cash – Being able to predict the months when your business might experience a cash problem gives a business owner the opportunity to make the necessary changes to ensure there will be enough inflowing cash.

Minimise the impact of a cash shortage – Cash flow forecasting can help inform of you of steps you could take to mitigate potential issues caused by a weak cash flow. As a business, putting more money aside in advance to help cushion the blow of a cash shortage, or establishing a line of credit with the bank for working capital can mean the difference between thriving and surviving.

During an economic period where costs are sharply rising, such as in 2023, saving extra cash can be difficult. In this situation it could be more effective to cut costs from non-essential areas in the business.

Make life easier for your staff – Forward planning and making contingency for a period of weak cash flow, will help make your employees’ jobs easier by ensuring there is cash available to pay suppliers and place orders, which helps to maintain those valuable relationships.

Putting measures in place to ensure you have enough reserve capital can help your business meet your payroll obligations.

What are the best practices for cash flow projections?

For a business to track cash flow effectively it must work to a proper system for managing the calculations and for regular and consistent reporting.

The following best practices can help you ensure your projections are accurate:

1. Know your short-term and medium-term plans in detail – Knowing exactly what finances you are going to need for marketing campaigns, investment plans - such as for new hardware and software - even acquisition plans are important before you can start to plan how to use your cash.

2. Perform a situation analysis of your current cash flow – Distinguish the categories for all your incomings and outgoings into a simple to understand format, whether that be in an Excel spreadsheet or in cash flow software so that the business owner or senior manager can identify the ‘current debtors and creditors situation’.

3. Be consistent in your reporting – Committing to cash flow forecasting involves consistency in your reporting and communication. Your information should be kept up-to-date and delivered on a consistent reporting day. If the person responsible is on holiday or on sick leave, then someone else should cover the task in their absence and not let it slide.

4. Forecast future cash flows for 3, 6, and 12 months, based on different scenarios – Categorising your cash flows and setting up your regular reporting will enable you to anticipate future cash flow. You should always consider short-term and longer periods of cash flow.

Recurring forecasting can be adopted for predictable and regular obligations, such as rent, salaries, insurance, for which you can set up a recurring forecast.

Fluctuating forecasting is ideal for irregular payments, such as supplier invoices and payments from clients. You could model your forecast based on your future plans, including any anticipated payment delays.

5. Simplify and automate your cash flow management – Manual forecasting and reporting can be onerous and time consuming and is only as good as the data that is available.

Human error can throw your cash flow projections out of line, which can stifle growth and in a worst-case scenario leave a business without cash when it is forecast to be cash rich.

Adopting automation tools and forecasting software can significantly reduce errors being made, whilst also speeding up the whole forecasting process.

What should be included in a cash flow forecast?

There are three key elements involved in a cash flow forecast:
1. your likely sales (inflows).
2. projected payment timings.
3. and your estimated costs (outflows).

1. Likely sales (inflows) – Your historic sales can help you estimate your sales for the time period your cash flow projection will cover. Remember to note any campaigns and promotions you have run in the past and factor in seasonality, and bear in mind that markets shift on a regular basis.

When estimating your sales, look at the state of the market you’re in and any trends, as these will likely have an impact on your business’s sales, as will any plans you have for sales promotions …and don't forget the activity of your competitors.

2. Projected payment timings – Once you know your estimated sales, you can add in the dates you expect to receive payments. Remember to factor in contingency for late payment.

3. Estimated costs (outflows) – At this point you should know what income you’re expecting. You now need to list all your expected outgoings for the period.

Included both your fixed costs and variable costs in your forecast, such as rent, salaries, utility bills, memberships and other fees, and tax payments.

Variable costs including for stock and raw materials and for delivery of your goods, can be determined from your past invoices, and from your projected sales of your products that require delivery.

What methods of cash flow forecasting are here?

There are two methods for cash flow projections, Direct forecasting and Indirect forecasting. Understanding the differences can help you determine which is right for your business.

Direct forecasting is easier to calculate than indirect and is based on the obvious formula:

Cash flow = receivables – expenditure

However, the method is less commonly adopted because it can be difficult to gather the required information, especially if a company uses accrual accounting. Accrual accounting is when transactions are recorded before money actually changes hands.

Indirect forecasting is more complex yet more widely used. This method begins with net income (net income = revenue – costs of goods sold – expenses), and accounts for items that can affect profit rather than cash flow.

Indirect forecasting adjusts the accounts receivable and accounts payable for the actual cash flowing in and out of the business. Money set aside to cover tax payments, but not yet spent, is added back in. Money from funding or paid back to funding sources, plus money from assets bought or sold, are also accounted for.

Access to funding

If your projections indicate your business plans will need extra funding, then your business could benefit from additional finance to help it survive a lean period and help it continue its growth.

Regular forecasting will tell you when you might need extra funds so you can prepare your application for an overdraft extension or for a business loan in good time.

Top tips to keep cash flowing

The following tips could help you keep your cash flowing strongly:

1. Ensure your staff are aware of cash flow – Educate your staff and ask them to inform you if they discover anything that could alter your cash flow, for better or for worse.

2. Regularly compare your cash flow projections with your actual finances – Do your projections match your actual cash position? If so, you're on the right track. If not, you will need to revisit your forecasts to ensure you avoid any potential future cash shortfall.

3. Set up alerts – If your business is approaching the last 10% of its overdraft limit, then you'll know you need to draw on cash that you might have set aside in another account. Alternatively, you’ll know it's time to seek external financial assistance. Setting up alerts such as this can help you avoid a cash shortage.

Accessing forecasting templates

Microsoft Excel has a range of business management templates included in its files that can be customised and rebranded to suit your business needs.

Sources:
1. https://bench.co/blog/operations/cash-flow-forecasting/