3 Essentials of Cash Flow Forecasting

One step that is often overlooked in managing the small business is forecasting Cash Flow. Even if budgets are created the critical step of translating the budget to a cash flow forecast is avoided. Why? Lack of time, lack of resources, and lack of knowledge regarding how are the most cited reasons. It often seems like an overwhelming process, even for accountants who are not focused on Management Accounting. However, this critical step that we provide for many of our clients is what has allowed them to reassess their business practices in time to make the necessary changes to keep them out of financial trouble.

Cash Flow forecasts are by definition rolling forecasts. I like to prepare a higher level 12 month cash flow forecast to see the larger picture and then a more detailed short term weekly forecast that runs for just as long as you reasonably can predict what will occur. That might be 4-12 weeks depending upon how quickly you collect your receivables and how predictable your sales are. I revisit the short-term forecast as often as necessary (daily, weekly, or monthly) depending upon the needs of the business and only reassess the higher level 12 month forecast if something has changed drastically.

1. In order to begin you need to know a few key facts about your business. The first is when you expect the revenue to come in. If you do not offer any terms and are paid up front, then your revenue forecast will be the same as your weekly sales forecast. If you do offer terms, then you need to continually keep a pulse on 2 items, the percent of your sales that are credit sales and your average days to collect your outstanding Accounts Receivable (A/R turns in financial terms). You will need to determine if these factors change significantly at various times of the year or if you can analyze them only occasionally. Initially I would look at them monthly to get a feel for what they are doing and how they are reacting to the economy. Besides being necessary for your Cash Flow forecast, watching these two numbers can also be an indicator of how your customers are reacting to larger economic events and what is happening in their businesses. Further, it can be an indication of whether you are being too lax in your own collection policy.

2. Secondly you need to do some analysis of your expenditures. You need to analyze when your own payments are due (how far ahead do you have to purchase to fill your sales demand, what percent of your inventory terms are prepaid, net 30, net 60?). Add to this the various weekly and monthly payments that are due such as payroll, insurance, rent, interest and loan payments, tax payments, distributions to owners, to give you a comprehensive layout of when your cash needs to be spent.

3. The third piece is your sources of funds outside of collections. If you have a line of credit that you can tap into or a loan you can draw upon, then you need to factor the limits of that into your equation.

Build a spreadsheet using all of these parts and I guarantee that you will more effectively stay on top of your cash flow needs. You will see the shortfalls before they occur. You will know how much cash you need to have each week and can then work on the various strategies to bring in cash more quickly, extend the time needed to pay your vendors, and plan your capital expenditures more wisely. Cash Flow Forecasting is one ore tool to allow you to run your business, not have it run you.

Rolling Forecast v. Budget

With many of our clients we have moved to a rolling forecast instead of the traditional budget model. Why? To be frank, we started with this method a few years ago because so many of our micro businesses just used the budget more as a forecast anyway. Many solo entrepreneurs and micro business owners make quick decisions and run their businesses a bit on the fly. The mention of a budget is a painful thought to some of them and one that they resist as unnecessary with all their heart. They did not use the budget in the traditional sense of controlling their spending each month but rather as a forecasting tool for looking at where they will be now that they already made a decision and spent the money.

While this method served our small clients, it has actually become critical with our larger small businesses. With the rapid changes in technology and the continual political and economic uncertainty, small businesses need to be able to adapt to changes in the business environment in a very short time. It is no longer a certainty that you will be able to turn to a bank or outside investment to shore up a temporary short-fall in cash, so having a better way to plan the future and having the agility to adapt is crucial to success.

The purpose of a Rolling Forecast is to be able to foresee risks and opportunities, adapt your strategy given those risks and opportunities, and assign resources in a continual planning mode. The model depends upon identifying the key drivers in your business. In other words, identify what might cause your plan to vary, how you will know it is deviating from your original plan, and what you need to measure to see the deviation. And the model also needs to incorporate a cash flow aspect in the rolling forecast, since cash flow will make or break your business.  For some businesses, for example, the key drivers in your plan might be the dollar value of open sales orders as of a certain day of the month, the price of raw materials, the number of credit sales and the average accounts receivable days outstanding.

Once the drivers are identified, various forecast models can be built to predict expected, worse case, and best case scenarios. By using a rolling process, you are constantly looking at what your results were versus what you expected, and by using multiple predictive models you will have already planned ahead and assigned the resources to act quickly given your results.