Have you ever checked your bank account to make sure that your next paycheck will land before your rent is due? Or maybe you’ve splurged on something pricey on an installment plan, strategically spreading your payments over several credit card statements?
If so, you’ve already participated in cash flow forecasting.
In the accounting world, cash flow forecasting is a tool that allows companies to estimate net income over a given period of time, helping business owners to meet obligations, monitor expenses, and plan for growth.
What is cash flow forecasting?
Cash flow forecasting is the process of estimating the amount of cash that will enter and leave a business over a given period.
Let’s say that an interior design consulting business wants to run a 12-month cash flow forecast. If this company anticipates an inflow of $80,000 and an outflow of $30,000 over the next 12 months, it can forecast a net cash flow (or net income) of $50,000 for that period of time.
Direct vs. indirect cash flow forecasting
There are two different methods of cash flow forecasting: the direct method, which deals with known income and expenses, and the indirect method, which deals with projected income and expenses.
- Direct cash flow forecasting. Direct forecasting deals with known costs and this method is generally appropriate for short-term forecasting. A business might use direct cash flow forecasting at the beginning of a month, for example, to make sure that it will have enough working capital to pay end-of-month bills.
- Indirect cash flow forecasting. Indirect cash flow forecasting is the method used to make long-term predictions, and it involves using projected balance sheets (also known as pro forma balance sheets) and projected income statements. The indirect method also accounts for factors that affect profitability but don’t affect cash balance, such as depreciation on buildings and equipment.
How to forecast cash flow in 4 repeatable steps
Cash flow forecasting follows a repeatable process.
Step 1: Set a forecasting period
Cash flow forecasting always specifies a period of time, and the first step is choosing your forecasting period. Short-term cash flow forecasting might look at a period of 30 days (or even several weeks), while longer-term forecasting will look at a quarter, a year, or even multiple years.
Step 2: Choose a forecasting method
The next step is to choose a forecasting method. If your forecasting period is relatively short (say, 30 days), you can use the direct method, consulting known income and expenses to figure out how much cash you will have on hand at the end of that period of time. If you are looking at a year, on the other hand, the indirect method will allow you to make projections beyond the timeframe for which you have concrete flow data.
Step 3: Calculate cash inflow, outflows, and cash balance
The next step is to calculate estimated cash inflows, outflows, and starting cash balance.
To calculate inflows, sum up all the gains you expect during your forecasting period. This can include anticipated sales revenue, anticipated investment revenue or interest to be earned, and the disbursement of any loan funds previously secured by the company.
Next, do the same with outflows, including anticipated expenses such as loan payments, vendor expenses, payroll, and estimated taxes in your calculations.
Finally, determine your starting cash balance or the amount of cash in your bank accounts at the start of the forecasting period.
Step 4: Calculate net cash flow and closing cash balance
Once you’ve calculated inflows, outflows, and starting cash balance, you’re ready to create your cash flow forecast.
First, calculate net cash flow by subtracting outflows from inflows. This formula reads inflows - outflows = net cash flow. Positive net cash flows represent a business gain over the period of time in question, and negative cash flows represent a loss.
Next, calculate your closing cash balance, or how much cash your business is expected to have in its bank accounts at the end of the forecasting period. This number is calculated using the formula starting balance + outflows - inflows = closing cash balance.
Cash flow forecasting software can automate large parts of this process, both improving the accuracy of your forecasts and making it quick and easy to consult updated cash flow projections.
Advantages of cash flow forecasting
Cash flow forecasting provides many strategic advantages, from helping businesses pay off debt to maximizing returns on current assets.
- It can help businesses make informed decisions about cash outflow. Business owners are constantly prioritizing potential investments. Whether you’re targeting a new hire, a planned marketing expenditure, or an investment in facilities, predicting net cash flow can help you time expenditures strategically.
- It can help businesses identify cash outflow patterns. By tracking outflows, cash flow forecasting can help you identify potential opportunities to eliminate unnecessary expenses. It can also help you ensure that all of your bills don’t come due on the same day, which would require you to carry an unnecessarily large amount of cash on hand.
- It can help businesses project growth or manage debt repayment timelines. Being able to anticipate profits and losses over the course of a quarter, a year, or more can help businesses plan for the future. For example, if your business took out a start-up loan, cash flow projections can help you develop a repayment timeline, and reviewing monthly cash flows can help you evaluate if you’re on target to meet that goal. The same is true of accrued profits. You might not be able to make a new hire today, but cash flow forecasting can tell you at what point it might be wise to add to your team.
- It can help you put your funds to work. Businesses should operate with enough working capital that they are able to cover all planned expenses. Most also keep some cash in reserve. Beyond this, letting cash pile up in your business bank account is unwise. That cash is better invested—either in markets or in the growth of your business. Cash flow forecasting can help you free up funds for income-generating activities.
Disadvantages of cash flow forecasting
Keep these caveats in mind 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. And, just like a weather forecast, cash flow forecasts can be wrong. This is particularly true for seasonal forecasts made under the indirect method. Even direct cash flow forecasting, however, can be inaccurate, as this method assumes that your debtors will pay their bills on time and that you won’t incur any unexpected expenses during the forecasting period.
- It doesn’t account for unforeseen events. Cash flow forecasting doesn’t account for a tree falling on your workshop or your cat tipping a glass of water onto your keyboard. Businesses tend to keep extra cash in reserve to deal with these surprise expenses.
- It can be a time-intensive process. Even if you already operate on an accrual accounting method, your forecasting process will involve taking a close look at accounts receivable, accounts payable, and your balance sheet and either partitioning or extrapolating on these numbers to isolate your forecasting period—all before you begin your calculations.
Cash flow forecasting is a valuable tool in your strategic business development arsenal, making it possible for you to plan for the future and evaluate your performance relative to your predictions.
Investing in an accounting method (or accounting software) that makes generating cash flow projections possible is wise. Just remember not to mistake predictions for certainty—and keep a little cash around for those (proverbial) rainy days.