First published: September 9, 2022 @ 6:00 pm
Cash flow forecasting is one of the most misunderstood concepts in business.
It is the practice of estimating cash inflows and outflows in accounts payable, and it is an essential skill for any entrepreneur.
In this article, we’ll talk about what cash flow forecasting is, how to do it, and why it’s important.
What Is Cash Flow Forecasting?
Cash flow forecasting is the practice of estimating cash inflows and outflows. Cash inflows are when money comes in, and cash outflows are when money goes out.
It involves using your best estimate of the future to calculate how much money will come in or go out.
People often confuse cash flow forecasting with forecasting revenues and expenses.
The key difference between these two concepts is that revenue forecasts are only predictions of how much money we will receive, while cash flow forecasts estimate both inflows and outflows.
This makes them more valuable to business owners because they provide more insight into their financial situation, especially regarding their cash flow statement.
How To Do It
You can use a variety of methods to do cash flow forecasting: you can do it by hand with a spreadsheet, or you can use software like QuickBooks to help you manage your finances.
Either way, the process is fairly simple:
1. Project your sales forecast and set aside a percentage of that amount to use for cash outflows.
2. Project your expenses and set aside a percentage of that amount to use for cash inflows.
3. Combine the two, and calculate the total amount of money you will have coming in over the next few months.
If this future cash position number is lower than your projected sales, you have too much cash balance tied up in unproductive assets (like inventory).
If it’s higher than your projected sales, you have too much money tied up in unproductive expenses (like salaries).
Use this information to decide about what to do with your business over a period of time.
Photo by Jp Valery on Unsplash.
Negative Cash Flow Vs. Positive Cash Flow
Both negative cash flow and positive cash flow can be cash flow metrics. The only difference is that negative cash flow is money going out, while positive cash flow is money coming in.
For example, a business has $100,000 in sales during the month, but the sales revenue doesn’t cover all the expenses that are associated with running the business.
Here, we would say that the business has a negative cash flow for the month. We also refer to negative cash flow as a “negative net income” or “negative bottom line”.
It’s important to note that a negative cash flow can result from any type of expense or revenue and doesn’t have to involve losses (like when a business pays off debt).
A positive cash flow can result from any type of expense or revenue and doesn’t have to involve gains (like when a business pays off debt).
Accounts Payables and Account Receivables
In business finance, accounts payable (AP) and accounts receivable (AR) are two accounts that are not debited or credited.
Instead, they show the amount of money owed to a business by a customer or supplier. AP and AR represent amounts due from the customer to the business.
These two concepts are important in accounting. It must match the money that a business owes to its customers or suppliers, up with the money that the business receives.
This matching process is called matching up accounts.
These two concepts are also important in business finance. A company’s accounts payable and accounts receivable often change throughout the year.
For example, a company might sell more goods to one customer than it buys from that customer, and this can cause AP and AR to increase (or decrease).
Conversely, if a company doesn’t sell as much merchandise as it buys from its suppliers, AP and AR will decrease (or increase).
Is It Necessary?
For most small businesses, cash flow forecasting is absolutely necessary.
It allows you to make moral decisions about what to do with your money: invest it wisely or pay down debt, for example.
A business owner who can’t accurately predict how much money will come in or go out over the next few months is at risk of running out of money.
It could cause serious financial problems for the business.
If a business owner knows exactly how much cash will come in and go out over the next few months, they can make more informed decisions about the business.
For example, if the business owner knows that a big sales month is coming up soon, they might want to make an investment in new equipment.
Photo by Alexander Schimmeck on Unsplash.
Why It’s Important
Cash flow forecasting is important because it helps you make better decisions about your business.
If you know exactly how much money will come in and go out over the next few months, however, then it makes sense to wait until the end of the month before paying down debt or making other investments.
If you do this, then by the time your cash flow estimate comes out at the end of the month (or sooner), your projected cash flow should be high enough that these investments are unnecessary.
How To Get Started With Cash Flow Forecasting
If cash flow forecasting is so important to a small business owner’s success, why isn’t everyone doing it?
The reason is that cash flow forecasting is not intuitive. It requires a bit of math, and most people are afraid of math.
It’s true that some small business owners are better at it than others, but it’s not the sort of thing you can learn overnight.
In fact, it can take a long time to get good at any method of cash flow forecasting. If you’re interested in learning more about how to do it, here are some helpful resources:
Different business models have different cash flow needs.
For example, if you’re in the manufacturing business, your cash flow requirements are likely different from a consultant or consultant-led business.
But even within an industry, there can be vast differences in cash flow requirements between companies of similar size.
Therefore, you need to be careful about generalizing about cash flow for a small business.
Get Your Forecasting Process Solution Now
Hopefully, this article has given you a better understanding of what cash flow forecasting is, how to do it, and why it’s important. If you have questions, leave them below.
Our blog, WorkDeputy, also talks about cash flow forecasting and other financial topics. Check it out for more helpful tips and tricks!
