What to Do If Your Cash Flow Forecast Doesn’t Match Reality
A cash flow forecast is an essential tool for managing a business. However, an inaccurate forecast can lead to bad decision-making, causing working capital shortages. Furthermore, it can be highly frustrating to spend hours and hours working on cash flow projections that are always widely off the mark. So, what can you do if your cash flow forecast never seems to match reality? Here are ten reasons why a cash flow forecast is not as accurate as you would like.
1. You Have Unrealistic Expectations of Accuracy
In most businesses, there are so many variables outside your control that it is unrealistic to expect a cash flow forecast to be 100% accurate. For example, there be unexpected expenses, some of which may be significant. And, of course, some customers may not pay sales invoices on time.
In a survey by treasury and finance solutions provider Kyriba, 53% of treasury professionals said their cash flow forecasts were “somewhat accurate,” sometimes containing significant variances. None reported highly accurate projections with zero variances.
So, a certain degree of inaccuracy is inevitable. Nevertheless, the forecast should be as close to reality as possible if it is to be a useful management tool. The following should help you improve the accuracy of your projections.
2. The Forecast Doesn’t Include Everything
The more comprehensive your forecast is, the more accurate it will be. So, all items of income and expenditure must be included, not just the significant ones. Of course, you may wish to bundle the smaller items into a line labeled “sundry” or “other” on the forecast. However, it is best not to lump too many things into such categories, or you might lose sight of some critical payments. Any payment or receipts significantly impacting the cash flow should be a separate line on the forecast.
3. You Have Fixed Variable Costs
Variable costs are those that vary with sales or output. For example, the monthly cost of raw materials will vary with production in a manufacturing business. The fuel costs of a haulage business will vary with the miles traveled. Your cash flow will be inaccurate if you have a consistent monthly figure for these variable expenses.
Variable costs are not limited to direct costs, however. Some expenses, such as power, might have seasonal fluctuations. If you sell a seasonal product, your marketing expenses may be higher during the peak season for your product. Factor in these seasonal changes, and your forecast will be more accurate.
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4. You Haven’t Accounted for Payment Terms
If you offer credit terms to customers, you won’t receive the cash from sales invoices in the same month the invoices were issued. Similarly, you won’t pay vendors that offer you credit in the same month you receive the goods or services. Consequently, you must consider payment terms when preparing a cash flow forecast.
The above is one reason your cash flow forecast will not match your budgeted income and expenditure. Others include fixed asset and inventory purchases, prepayments, and accruals. Fixed asset purchases do not appear in the budgeted profit and loss (P&L) in the month they are purchased. Instead, they are capitalized and amortized over their useful life. Inventory is held in stock until used. Prepayment and accruals spread the cost in the P&L of purchases invoiced in advance or arrears. Nevertheless, fixed asset and inventory purchases need to be in the cash flow forecast in the month they are paid, not when they appear in the profit and loss account. As do prepayments and accruals.
5. You Haven’t Considered Payment History
You may have already factored payment terms into your cash flow forecast. However, it is unlikely that all your customers will pay their invoices on time. And you may offer different terms to different customers. Consequently, you will improve the accuracy of your projections by using the average number of days customers take to settle invoices rather than your terms. Your accounting software may calculate and display average debtor days. If not, the formula is (accounts receivable/annual credit sales) x 365 days.
6. Your Forecast is Unrealistic
Accepting that your forecasts will contain variances, it is clearly best that those variances are favorable. Consequently, it is advisable to overestimate costs and underestimate sales. And assume that you will pay vendors on time but that customers will not.
A cash flow forecast should be a realistic or slightly pessimistic view of what you think will happen, not what you hope will happen.
7. You Don’t Forecast Multiple Scenarios
The most likely scenario mentioned above will likely be the forecast you use for day-to-day cash management. It can be helpful also to have a best-possible and worst-possible scenario projection for planning purposes. Maintaining multiple cash flow forecasts can be time-consuming. However, it does enable planning for unexpected high or low sales.
8. You Don’t Maintain a Short-Term Forecast
Like a weather forecast, a cash flow projection becomes less reliable the further into the future you project. Consequently, it is advisable to have long-term figures for planning and short-term forecast for day-to-day management. The long-term forecast might project cash flow forward twelve months. But the most accurate projection will be the short-term forecast, which might be for the coming four weeks.
9. The Forecast Needs Updating
A cash flow forecast must be regularly updated to maintain accuracy. And projections must be modified to reflect significant changes when they occur. A monthly update might suffice in an established business where sales and costs are predictable and there is some flexibility in cash resources. For a new business, though, or if cash is tight, weekly or even daily updates would be advisable.
10. You Don’t Compare the Forecast to Reality
If cash flow forecasts are always inaccurate, comparing projected figures to the actual ones will reveal where the inaccuracies lie. Then, you can adjust future projections to improve accuracy. Comparing the forecast to actuals may also provide the first indications of problems elsewhere. For example, consistent shortfalls in accounts receivable receipts could indicate that collection procedures need tightening up.
The Bottom Line
To sum up, a cash flow forecast is unlikely to be spot on every month. But, if your projections are always wide of the mark, the above points should help you improve the accuracy of the figures. The crucial point to note is that preparing a cash flow is not a one-off exercise but a continuous process of updating and refining to improve the reliability of the projection.