A Step-by-Step Guide to Cash-Flow Forecasting

Cash flow is a primary concern for companies of all sizes and industries, and rightly so. Simply put, a company can stay in business for only so long when the amount of cash leaving its coffers exceeds the amount coming in. Managing current cash balances is critical for a company to meet its financial obligations and invest for growth – and forecasting how those balances might change in the future is equally important. While it might seem similar to forecasting revenue and profits, cash-flow projection is a different process. This guide explains what cash-flow projection is, why it’s important, and how to get it done.

Cash-Flow Projection: What It Is and Why It’s Important

Cash-flow projection is the process of forecasting future cash balances so a business can plan for a potential surplus or shortfall. A cash surplus may be the result of an accelerated collection of accounts receivable – money customers owe the company – or an increased use of trade credit for payables – money the company owes others. With a predicted positive cash flow, a company can, for example, plan to pay down debt or grow its money by investing.

Conversely, a cash shortfall may occur during months with an extra payroll cycle, periodic tax payments, or stocking up on inventory in advance of busy sales seasons. If a negative cash flow is on the horizon, the company can plan in advance for alternative capital, such as financing, selling some assets, or even changing strategic course.

Cash-flow projections are created by forecasting the amount of cash that will be flowing into and out of a business over a specific period of time. One part of forecasting cash inflows or cash sources is projecting when customers will make payments for goods and services. The other part is forecasting cash outflows or uses of cash, such as when the business will need to pay for an obligation, like rent or a supplier invoice. Managing the inflows and outflows reveals periods of positive cash flow – when cash in is greater than the amount of cash out – and periods with negative cash flow, when outflows exceed inflows and possibly jeopardize the business’s future. 

Are Cash-Flow Forecasts Necessary for Profitable Companies?

Cash flow and profitability are related financial concepts, but a fundamental timing difference between them can make or break a business. Indeed, many profitable companies succumb due to insufficient cash flow. Cash flow reflects when cash is received and when it’s paid out. Profitability, under the accrual method of accounting, counts revenue that is earned though payment has not yet been received, such as sales made on credit, as well as expenses that have been incurred but not yet paid. The timing differences are significant – a company needs cash in hand, not a receivable, to keep the lights on and pay employees and suppliers. Forecasting cash flow helps both profitable and unprofitable companies avoid a cash shortage.

4 Steps to Creating an Accurate Cash-Flow Forecast

No business is immune to the possibility of running out of cash. But generally speaking, every business that takes the time to create a cash-flow forecast is at least in a position to see a shortfall coming and take steps to avoid it. The process involves four steps, some with multiple elements. 

1. Determining the Period

Decide how far into the future the forecast should extend, based on your objectives. Short-term forecasting is helpful to manage day-to-day cash needs for the upcoming 30 to 60 days. Medium-term forecasting extends the period to up to six months and is helpful in planning for upcoming events, like seasonal inventory purchasing or large loan repayments. Long-term cash-flow forecasts range up to 12 months and are useful for strategic initiatives, such as capital projects or product launches. Short-term cash-flow forecasts tend to be more accurate because there are fewer unknowns. The most common cash-flow forecasts look at the next 13 weeks on a continuous, or “rolling,” basis.

2. Selecting the Appropriate Method

There are two methods for developing a cash-flow forecast: the direct method and the indirect method. Each method has pros and cons and is better suited for different purposes.

Direct Method

The direct method for developing a cash-flow forecast is a bottom-up accumulation of expected transactions. This method is more tedious but tends to be most useful and accurate for short-term forecasts and day-to-day cash management. The direct method involves identifying expected cash inflows and plotting out when each instance will occur. This entails estimating upcoming sales to customers and applying the typical lag in payments. The timing and amount of other inflows, like interest income, loan proceeds, and tax refunds, are also projected. A similar exercise is done for expected cash outflows – plotting payments for expenses, like payroll, inventory purchases, utilities, and taxes, to name a few.

Generally speaking, every business that takes the time to create a cash-flow forecast is at least in a position to see a shortfall coming and take steps to avoid it.

Indirect Method

The indirect method for developing a cash-flow forecast gives a high-level view of projected cash flows and is more appropriate for guiding strategy in a long-term forecast, rather than short-term cash needs. In order to use the indirect method, you must first create a forecasted income statement that covers the cash-flow forecast period and balance sheets as of the beginning and ending dates of the period. This method starts with the cash balance at the beginning of the period and adds in net income for the period from the forecasted income statement. It then adjusts for all noncash items, like depreciation, on the income statement. It also adjusts for changes in the balance of assets and liabilities because they are also sources and uses of cash. For example, a decline in the accounts receivable balance is a source of cash because it means customers are paying the amounts they previously owed. Similarly, an increase in the balance of accounts payable is a source of cash, because it means the company is making its purchases using credit rather than cash. After making all the adjustments, the ending cash balance is forecasted.

3. Gathering the Data

The data needed for the direct method of cash-flow forecasting comes from various sources, such as bank accounts, accounts receivable, payment subledgers, and accounts payable. Tapping into automated accounting and reporting systems is a good way to gather the data for cash-flow forecasting, helping to ensure that everything is caught – and accurately. Also needed: an analysis of customer payment trends, like days sales outstanding – how many days, on average, it takes customers to pay their bills – and forecasted revenue, to better inform cash inflow estimates. Additionally, margin estimates and days payable outstanding metrics, which measure the average number of days it takes the business to pay its bills, can help project cash outflows related to the revenue expectations.

Data gathering for the indirect method is significantly easier because most of the “data” is on the forecasted financial statements.

4. Finalizing the Cash-Flow Model

When all of the cash inflows and outflows have been identified, it’s time to complete the cash-flow forecast. This is done by breaking the overall cash-flow forecast period into several shorter periods, based on what best aligns with how the business runs, such as monthly, weekly, or daily. For example, if payroll is done weekly, it may be more manageable and accurate to forecast 12 weekly periods, rather than the overall 90-day cash-flow forecast period. After plotting inflows and outflows into these shortened periods, subtract the outflows from the inflows to calculate whether each period is cash positive or cash negative. Trends and fluctuations will become visible, helping business leaders to manage cash needs and keep the business running smoothly.

Benefits of Cash-Flow Forecasting

Are cash-flow forecasts worth all the effort? Given that they provide advance warning of future periods of negative cash flow, helping to avoid insolvency, and are an essential tool for guiding management decisions, the answer should be apparent. Other important benefits of cash-flow forecasts include:

• Helping business leaders set up supplemental sources of cash, such as a line of credit, for periods of negative cash flow and manage balances to avoid excess interest charges.
• Maintaining good relationships with vendors and a smooth supply chain by paying bills on time.
• Ensuring that adequate cash is on hand to pay employees timely.
• Giving potential lenders a better sense of a company’s credit-worthiness when applying for loans.
• Identifying periods of surplus cash and prioritizing business spending.
• Helping companies attract new potential investors and raise additional capital.
• Providing insight into internal processes that may need improvement, such as collections of accounts receivable.

The Takeaway

Cash-flow forecasting helps business leaders prepare in advance for periods expected to have surplus cash or cash shortages. Using either the direct or indirect method, cash-flow forecasts help business leaders make more informed decisions about how to spend or conserve a company’s cash. The benefits of cash-flow forecasting outweigh the challenges – namely, the time it takes to create a forecast.