Accurate cash flow forecasting is easier said than done.
After all, you are at the mercy of your customers regarding how much money is received each month. And, sometimes, unplanned expenses can put an unexpected strain on financial resources.
Indeed, if you are expecting to see your actual month-end bank balance match your forecast to the penny, you will likely be disappointed. However, a cash flow forecast should be reliable enough to allow you to plan and make informed decisions.
If your cash flow forecast is always widely off the mark, you could be leaving yourself open to a cash flow catastrophe. So, check out these tips to help you improve your cash flow forecasting accuracy.
Document Business Plans
A cash flow forecast must be built from the ground up. And the foundations for your budgets and forecasts are your business plans for the next twelve months and beyond. So, it is best to have a rolling business plan that you update regularly. That plan should include the financial implications of each of the changes you plan on making.
Suppose you are hoping for a 30 percent increase in sales in the next year, for example. In that case, it won’t only be the income line on your forecasts that will need to be revised. Your direct costs will increase, too. You might also need to employ more staff and those staff will need resources such as a computer, phones, and software. If they are not remote workers, a larger office space might be in order. All of these things will affect your cash flow planning.
Turn Plans into Budgets
Annual budgets, broken down by month, are another essential business management tool. A budget will enable you to monitor business performance, and it will help you make better decisions.
Budgets can be prepared based on historical data and the rolling business plan mentioned above. However, financial budgets are usually based on the accrual accounting convention. So, they don’t allow for the timing differences caused by customer and vendor payment terms.
Budgeted profit and loss accounts also usually account for depreciation rather than fixed asset purchases. So, there is some work to be done to turn a budget into a cash flow forecast.
Turn Budgets into Cash Flow Forecasts
As mentioned above, a budget accounts for costs and revenues as they are incurred. But a cash flow forecast must be based on when items are paid. So, you will need to adjust your budgeted figures to arrive at an accurate cash flow forecast.
For example, cash from sales must be deferred by the average number of days customers take to pay their invoices. Supplier credit terms will need to be accounted for on vendor payments. And some costs, such as software subscriptions, might be paid quarterly, but shown in the budget as a monthly figure.
You will also need to forecast the payments for any fixed asset acquisitions or replacements. And remember to allow for purchasing raw materials to be held in inventory before being used in production.
Maintain a Short- and Long-Term Cash Flow Forecast
It is best to maintain both long-term and short-term cash flow forecasts. The long-term forecast might be projecting cash flow for the next twelve months, for example. And the short-term forecast would be analyzing daily cash flow for the next thirty days.
The long-term forecast will be less accurate than the short-term projection because the long-term figures will be based on certain assumptions. But the short-term forecast should be based on known facts rather than assumptions wherever possible.
You will know from your aged payables, for example, what you will need to pay to vendors. And you can estimate what you will receive from your receivables based on past payment performance.
Your long-term forecast can be a slightly optimistic version of the most likely position. But the short-term forecast should take a more conservative and realistic view.
Maintain a Rolling Sales Forecast
Expenses can generally be forecast relatively accurately. It is the income from new sales that is usually less reliable. So, it is advisable to maintain a rolling sales forecast to keep your cash flow forecast updated with sales fluctuations.
A sales forecast will usually consist of several elements. There might be recurring income from existing customers that can be accurately predicted. In an established business, you will also be able to forecast new business based on historical performance. And then, there will also be the less than certain new-business sales or even the wishful thinking.
You might include the less than certain sales in the long-term cash flow forecast. But the closer you get to the current date, the more accurate you will want your projection to be. So, it is advisable to only include reasonably certain income in your 30-day cash flow forecast.
Keep Forecasts Updated
The cash position of a business will change from one day to the next. So, a cash flow forecast needs regular updating to keep it as accurate as possible.
A large company with a steady and reliable income might only need weekly updates to its cash flow forecast. But a smaller business running closer to the edge will probably require daily updates to its short-term cash flow forecast. And the payment of vendors will likely need to be moved around depending on the availability of funds.
Review Forecast Vs. Actual and Adjust Accordingly
It is advisable to complete regular reviews of original cash flow forecasts against the actual figures. How far were you off on cash receipts from sales, for example? Were there any new payments not in the forecast that will be repeated? Reviewing the accuracy of past projections will enable you to adjust future forecasts to make them more accurate.
Budget variances and KPIs (key performance indicators) may also reveal trends or variances that must be reflected in your cash flow forecast. An increase in the accounts receivable average days to pay, for example, will lengthen the working capital cycle and impact cash flow. And a relatively small drop in the gross margin percentage may not affect the cash flow immediately. Even so, when projected over twelve months, the cumulative effect on cash could be significant.
Regularize Income and Expenditure Wherever Possible
Your cash flow forecasts will become more accurate if you can make your income and outgoings more predictable. So, you might want to look at ways to regularize income and expenditure to improve cash flow predictability.
For example, leasing vehicles and equipment rather than purchasing them outright would eliminate the one-off significant capital purchases. Offering customers subscription services would create a regular income stream, and invoice factoring sales invoices would reduce the unpredictability of AR receipts.
The Bottom Line
A cash flow forecast is not something that you prepare and leave to one side. Instead, a cash flow forecast is a management tool that needs regular updating and refinement.
So, use your rolling business plan and budget as your baseline. Adjust the budget to account for the timing differences caused by payment terms.
Then revise your short-term forecast daily and the long-term forecast monthly to keep your predictions as accurate as possible. Regularize income and payments wherever possible to make cash movements more predictable.
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