Cash Flow Forecasting: What It Is & How To Do It?

Jacqui Coombe

What is cash flow forecasting? Why is it important for your business? How do you go about it? This article provides the answers to the most important questions regarding making the best use of your company’s financial resources.

What is cash flow forecasting?

Cash flow is the movement of money through a business, from cash in (via sales and payments) to cash out (via bills, wages, and other expenses). When cash in is greater than cash out, a business is said to have liquidity (enough cash on hand to meet all obligations).

Cash flow forecasting is the process of calculating the flow of cash into and out of your business over a set period of time. This process can help you to predict the future financial position of the business, avoid financial shortfalls, and to put surplus cash to the best possible use.

While in larger companies this is typically the domain of the Finance Department, in a small business with limited resources, cash flow forecasting depends on input from a variety of different sources across the business.

The time period attached to cash flow forecasting can be:

  • Short-term (2-4 weeks) – this is best suited for short-term liquidity planning
  • Medium-term (2-6 months) – this is useful for debt reduction
  • Long-term (6-12 months) – this is used for long-term strategies or
  • Mixed term – this is a blend of all three of the above time periods and is commonly used for liquidity risk management

Why forecasting is important?

Cash flow forecasting offers a number of benefits to a business. These benefits include:

  • Debt management – By planning ahead, a business can ensure it has the finances it needs to cover current and future debt repayments and meet its financial obligations with regard to loans, taxation, and interest payments.
  • Growth strategy – Planning ahead also allows a business to execute a more predictable future growth strategy by using resources such as surplus cash rather than relying solely on investment capital.
  • Early warning – Accurate cash flow forecasting can give your business a heads up on potential future cash shortages, giving you time to change direction to avoid them. Cash flow forecasting can also give you an early warning of instances where extra cash will be needed, such as seasonal inventory and upcoming maintenance or repairs of plant and equipment.
  • Creditworthiness – Many lenders require a business to perform regular cash flow forecasting in order to qualify for loans. Cash flow forecasting is also used by potential investors when assessing the health of a business.

Forecasting Components & Steps

There are three components to accurate cash flow forecasting. These are:

  • Estimated future sales – This can be calculated using sales figures from previous years, taking into consideration any patterns (i.e. sales and seasonal promotions).
  • Estimated receivables – This involves calculating when payments are likely to be received, with a margin for the inevitable late payments.
  • Estimated outgoings – These include fixed (regular payments) and variable (unexpected expenses) costs.

The key steps to accurate cash flow forecasting include:

Step 1: Work out your business objective (i.e. debt reduction, liquidity, growth planning).

Step 2: Set a time period (the longer the time period, the less accurate the forecast is likely to be).

Step 3: Select a method (direct or indirect)

Step 4: Collect the data (your opening cash balance, your cash inflows, and cash outflows for the forecasting period)

Forecasting Methods

The two main methods of cash flow forecasting are direct and indirect. Direct forecasting involves using available data to make predictions, whereas indirect forecasting is about making predictions based on projected data.

Direct forecasting is the most accurate method, but typically only for 90 days or less, and can be very time-consuming as it involves collating a large amount of data from a variety of sources. While tedious, it is a particularly important process for small to medium enterprises that need to keep a close watch on their finances.

Indirect cash flow forecasting is about obtaining a long-term and larger scale picture of the future of your business. It involves periods longer than 90 days and uses calculations based on common best-practice projection methods. This method is more useful to large companies that have the resources to allocate to such forecasting.

As with any predictive process, there are certain obstacles to obtaining an accurate forecast. These can include: failing to capture all the data, inaccuracies in the data, failure to report changes, and unexpected shifts in the marketplace.

But despite these potential drawbacks, cash flow forecasting is something that every business should be practicing. Most small businesses fail within the first few years and this is largely due to poor cash flow management. So, it makes sense that cash flow forecasting should be an essential tool in every financial toolbox whether it’s a small start-up business or a multinational corporation.

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Jacqui Coombe has been a prolific reader since childhood, and now channels her love of the written word into writing content on a range of topics from business, marketing and finance to travel and lifestyle.

Santa Monica, CA
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