cash flow forecasting

How to Hone Your Cash Flow Forecasting for PinPoint Accuracy

8 min read • Apr 15, 2021 • Jesse Sumrak

Cash flow is often referred to as the lifeblood of every business. As an entrepreneur, your business can endure plenty of blunders. Unfortunately, cash flow isn’t usually one of them. Failure to manage cash flow typically ends one way—business closure.

Poor cash flow is marked by owing more than you can pay. Sure, you might hit a rough month (or two) and need financing to cover cash flow gaps, but consistent failure to make more than you spend should be a fluorescent-red-flashing alarm. But don’t panic! The solution could be as simple as fine-tuning your cash flow forecasting.

What Is Cash Flow Forecasting?

Cash flow forecasts are educated projections about the money you will pay and receive. Forecasting your cash flow helps you identify financial gaps and opportunities while there’s still sufficient time to respond. If you foresee a seasonal slump, you can go ahead and secure a business line of credit. Or if you expect a big bump in revenue, you can plan how you’re going to reinvest that cash in the business.

Failure to forecast cash flow or incorrect projections will jeopardize your business. You may run out of inventory before you have enough cash to resupply or you might not have enough money in the bank to pay your employees at the end of the month. Scary, right? It doesn’t have to be. You can avoid situations like these with simple, accurate cash flow forecasting.

The Cash Flow Forecast Formula

There are two ways to calculate your company’s cash flow over a given period. First, there’s the indirect method. It’s ideal for calculating historical cash flows because it involves working backward from your income statement numbers.

In simple terms, you’d start with your net income and adjust it for any non-cash activities, such as depreciation or uncollected sales. Unfortunately, you’d have to create a projected income statement for the desired period before you can use it for cash flow forecasting, 

Second, there’s the direct method. It’s a more natural forward-looking approach than the indirect method, making it better for cash forecasting, especially over relatively short time horizons.

The formula is: 

Beginning Cash Balance + Projected Cash Inflows – Projected Cash Outflows = Ending Cash Balance

How to Forecast Accurate Cash Flow

Every small business owner should know how much cash they have on hand—and how much they’ll have at any given point in the future. To make your projections pinpoint accurate, you’ll need to hone a few financial skills:

1. Regularly Check (and Understand) Your Financial Reports

Bookkeeping software, like Lendio’s software, makes creating and viewing your financial reports a click away. Make it a regular habit to analyze your profit and loss, balance sheet, and cash flow statement. By staying up-to-date on these financials, you’ll always know where your business stands.

Checking and understanding your financial reports are 2 different things. Make sure you comprehend what each statement is telling you and how to make decisions based on that information. For instance, you may look at your profit and loss statement and confuse profit for cash. They’re not the same.

2. Estimate Your Receivables Cycle

With your financial reports in hand, you’ll have reasonable projections for how much revenue you’ll make each month—but do you know how long it’ll take for your sales to turn into cold, hard cash? Sometimes it takes clients weeks or months to pay the bills. 

Accurate assumptions will help you avoid cash flow gaps. Knowing when you’ll expect payments will help you decide if you need to secure account receivable financing or if you can wait it out. 

3. Dial-in Your Budgets

Don’t look at your budgeting as a one-and-done ordeal. Regularly evaluate your cash flow to make sure you’re on track to hit your metrics. If unexpected expenses pop up, you may need to postpone resupplying your inventory or reschedule a planned renovation.

Yes, it’s important to make monthly and quarterly budgets, but don’t hold yourself strictly to those estimates. Frequently check in with your budget and make changes to keep your cash flow positive.

4. Expect the Unexpected

Most cash flow forecasts fail when it comes to unexpected expenses. Business owners nail revenue forecasts and cost of goods sold, so the gross profit estimate is usually spot on, but the projections fall short after that. 

You need to factor other necessary costs into your forecasts—salaries, repairs, marketing, rent, etc. These are obvious examples, but the not-so expected expenses are the ones that really trip up cash flow forecasts. Make sure you keep in mind the following variable expenses:

  • Months with 3 payrolls
  • Increased taxes as a result of increased sales
  • Months when premiums are due

Even when you go to great lengths to cover all your bases, unexpected expenses will still creep up on you. That’s why it’s important to budget a cushion of cash each month for “other expenses.” At worst, you’ll have money on hand to deal with any unforeseen costs. At best, you’ll put a little extra money away for next month.

Cash Flow Forecasting Example

To help you understand the cash flow forecasting process and how it might look for your business, let’s run through a quick example. To keep things simple, we’ll use the direct forecasting method.

Say you run a landscaping business. It’s March 15th, and you have $3,000 in your business account. You’re worried that you might not be able to meet your tax obligation on April 15th, so you want to forecast your net cash flow over the next month and subsequent cash balance.

First, you have to calculate your projected cash inflow, and you estimate the following future earnings:

  • $2,000 from your retainer clients
  • $3,000 to close out a net-30 project completed in February
  • $3,000 as a down payment for a project you’ll start in April
  • Total = $8,000 in cash inflows

Second, you have to calculate your estimated cash outflow. You project that your spending will look something like the following:

  • $500 monthly advertising costs
  • $750 for tax preparation services
  • $500 payment for your total liabilities
  • $1,000 rent for landscaping equipment
  • $1,500 for labor on the project completed in February
  • $500 for materials on the project completed in February
  • Total = $4,750 in cash outflows

Now you can plug those numbers into the cash flow forecasting formula: 

$3,000 Beginning Cash + $8,000 Projected Cash Inflows – $4,750 Projected Cash Outflows = $6,250

You estimate that you’ll have about $6,250 when taxes come due, but you expect your tax liability to be about $5,000. 

You have enough to cover the large expenditure, but it’ll leave you with little excess cash, so you take out a business credit card just in case you need help covering a surprise expense.

Cash Flow Projection Tips

As we saw above, cash flow forecasting involves making educated guesses about your future cash inflows and outflows. Your ability to predict them as accurately as possible is the most important aspect of your cash flow forecast.

Here are some things to keep in mind as you make your projections:

  • Study your past: Your historical cash flows are your best source of clues for projecting your future cash flows. Look at the patterns your business has shown previously. Find out if your revenue stream is seasonal and what percentage of your receivables you usually collect. Do variance analysis and incorporate the results into your projections.
  • Factor in your plans: Your past can teach you a lot, but the future won’t mirror it exactly. Document what you plan to do differently going forward, then consider how it might affect your cash flows. For example, if you’re getting better at weeding out clients that won’t pay, your collections will increase and boost your cash inflows.
  • Leave room for error: Always make an allowance for unexpected events in your financial planning. You can never make 100% accurate predictions, and it’s better to error on the side of caution than to risk falling short of your revenue goals and running out of cash.

Ultimately, cash flow forecasting is a skill that you’ll improve the more you do it, so you should make it one of your regular business processes. Not only will you get better as you practice, but your consistency will give you more data points to better inform your predictions.

You Have Accurate Forecasts—Now What?

Don’t wait until the end of the year to create your next 12-month forecast. Continue to check back in with your projections and reevaluate. At the end of each month, add another month to your forecast so that you always have an up-to-date rolling 12-month plan.

By following these 4 best practices, you’ll be better able to forecast your cash flow with spot-on precision. Will it always be perfect? No—especially when you’re just getting started. As time goes on, you’ll recognize trends in your business and the industry and fine-tune your forecasts. Once you’ve mastered cash flow forecasting, you’ll have greater control of your finances. With greater control of your finances, anything is possible for your business.

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Jesse Sumrak

Jesse Sumrak is a Social Media Manager for SendGrid, a leading digital communication platform. He's created and managed content for startups, growth-stage companies, and publicly-traded businesses. Jesse has spent almost a decade writing about small business and entrepreneurship topics, having built and sold his own post-apocalyptic fitness bootstrapped startup. When he's not dabbling in digital marketing, you'll find him ultrarunning in the Rocky Mountains of Colorado. Jesse studied Public Relations at Brigham Young University.