What is a cash flow forecast and how to create one?

Revolut Contributor

 · July 29, 2020  · 07/29/2020

Cash flow forecasting is a process which helps a business to predict what it expects its cash position to be in the near future. The goal is to preempt problems (i.e. running out of cash or dips in balances) by noticing any looming liquidity crises in advance. This horizon scanning should enable the business to set-up new arrangements, such as extend its short-term credit or raise finance. That’s the idea.

Another upside of keeping a close eye on cash-flow forecasts is to spot if a cash surplus is likely to be available and prepare for the opportunities this creates. The business can choose whether to invest in more stock, hire staff, plump for some shiny new equipment, or place funds in a high-interest account.

The bottom line is that by predicting cash flow, a business improves its ability to make sensible plans.

What is a cash flow forecast?

The cash flow projection (i.e. another way of saying forecast) is an educated best-guess of how liquid the business is likely to become over a given period. For instance, the upcoming quarter or financial year. The forecast aims to quantify how much cash the business will have access to in this timeframe.

The cash flow forecast achieves this feat by creating a projection of what the business expects its cash inflows and its cash outflows will be and calculates a series of estimates for its net cash position.

Some businesses prepare regular forecasts for each of the three primary financial documents (see below) to gain a full picture. Unlike its two siblings, a cash flow forecast is mostly for internal use and not as readily shared with investors as its income statements. This is the ‘dirty-laundry’ of a business.

  • Cash flow statement
  • Income statement (i.e. profit-and-loss statement)
  • Balance sheet

What is the difference between cash flow and cash flow forecast?

The cash flow statement of a business shows its cash position at a specific moment. By contrast, the cash flow forecast is a guesstimate, primarily based on its historic data, with a spoonful of assumptions to make it palatable. For example, a forecast will include an expectation of when clients who purchased goods on credit will settle the invoices. In reality, some sources of financial information are more reliable than others. A stable business might well have regular customers and consistent expenses that will enable it to project its cash flow accurately for an extended period.

Invariably, though, the dark art of financial forecasting will involve blending multiple flavours of data to concoct a credible plan for the future. We cover the premise of financial forecasting in full here but have also provided a few examples of potential data-sources below:

  • Historic business data (i.e. previous financial statements of the business)
  • Economic indicators (e.g. inflation or unemployment rate)
  • Regulatory changes (e.g. Brexit or Open Banking)
  • Industry trends (e.g. sector growth or margins contracting)

How do you prepare a cash flow forecast?

When you think about how to do a cash flow forecast, there are several options. Because any forecast is an estimate, its sophistication will naturally depend on how many variables it opts to incorporate, how it computes these, and how reliable the source-data prove to be.

The mature business is likely to base its cash flow forecasting on the style of its regular cash flow statements, which show all the cash inflows and outflows within three sub-categories:

We cover how to calculate a conventional cash flow statement here and reveal the two core methods for preparing one (i.e. the direct and indirect) here. If this sounds scary, the good news is that the cash flow template which you adopt for your forecast can be reasonably simple.

There are sound reasons why an SME with straightforward finances might be wiser to adopt a more streamlined cash flow forecast. For one thing, it’s smarter to work with a modest document which gets regularly updated than to swim against the tide with a more complex one that is rarely ever refreshed.

So long as the core building blocks are in place (see below), then your forecast will be a useful tool.

  • Show the cash balance at the beginning of the time-frame to be forecasted
  • Record the effect of predicted cash inflows for each sub-period of the forecast (e.g. month)
  • Record the effect of predicted cash outflows for each sub-period of the forecast (e.g. month)
  • Calculate the net effect of all these changes to reveal the predicted closing cash balance

The net cash balance, as described above, for each sub-period in the forecast (e.g. month one) will be the opening cash balance for the next sub-period (e.g. month two) and so forth.

To get you started, we created a basic cash flow forecast template you can download here and provide some extra tips on how to use this below. Don’t forget to include any cash movements due to loans or other forms of finance.

Step One: The sales forecast

Review last year's sales figures to predict what these might look like for each period of the forecast.

NB: Sales should be recorded inc VAT (if you are registered) as the VAT is accounted for separately.

Step Two: The costs forecast

Estimate all direct costs (i.e. expenses which vary because sales alter, such as raw materials).

Estimate all fixed overheads (e.g. rent or salaries). Again, this figure is inclusive of any VAT payable.

Step Three: The capital expenditure

Enter the costs of buying new equipment (e.g. machinery) in the periods when you plan to pay this.

NB: A forecast helps to decide when to make these purchases or review the effect of leasing instead.

Step Four: The tax position

Include the value of any HMRC payments or refunds that the business expects to send or receive.

NB: The forecast should show when actual funds will move rather than the tax due for each period

  • National insurance and PAYE (typically paid each month)
  • VAT payments or refunds (typically resolved each quarter)
  • Corporation tax bill (typically paid on an annual basis)

How useful is a cash flow forecast?

While initially daunting, even a small business will swiftly find that forecasting cash flow is invaluable. Once the business understands what the rhythm of its bank balance is likely to be, it will gain the confidence to think more creatively about how to deliver its products or services.

Aside from identifying a prospective deficit or surplus, the crucial factors are the timescale and scope. For instance, once the business owners quantify both the magnitude of a cash shortfall and whether it will last for weeks or months, they can make the appropriate decisions. Here are some scenarios:

 

Short-term actions

Long-term actions

Cash deficit

  • Arrange overdraft facility
  • Reduce prices to clear inventory 
  • Chase invoices or seek trade credit
  • Raise finance (e.g. loan)
  • Issue new share capital
  • Alter credit terms of business

Cash surplus

  • Invest in additional stock
  • Pay suppliers early to get a discount
  • Offer more credit to reliable clients
  • Expand or diversify business
  • Invest in new equipment 
  • Hire extra staff

 

The business should ideally put together a cashflow forecast estimate annually, or at least per quarter. The shorter the period of time these types of predictions cover, the more accurate the overall document is likely to be. And when the pressure mounts, this precision can make all the difference.

One credible cash flow forecast example is a restaurant in financial distress due to closure during the pandemic, with minimal visibility of future sales income. In these circumstances, it might need to forecast its cash flow daily just to survive. Let’s raise a glass to the prospect of cheerier times and recognise that, until then, a credible cash flow forecast serves-up the greatest chance of success.

Read next: Quick tips on how to improve cash flow

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