Cash Flow Forecasting: What You Need to Know

cash flow forecasting stock photo laptop with cash on the keyboard

Every morning at my children’s bus stop, there’s a foolproof way to tell that the bus is about to arrive: When you see a hoard of children running from the park to the bus stop, you know the faithful yellow hardtop is on its way.

Is this child’s play or strategy? I’d say tactical because experience has shown these kids that they have just enough time to get from the park to the bus stop once they’ve seen the bus heading their way. What does this have to do with cash flow forecasting, like a free assessment from PayPie? Everything.

If you pay attention to how and when cash is flowing in and out of your business, you’ll never miss the bus. Or, at the very least, you’ll have a pretty solid idea when the bus is coming, if it’s running late or if you’ll need alternate transportation.

Another reason to watch for the bus known as your cash flow: Nearly 60% of all failed businesses say cash flow was the main reason for their demise.

What’s a cash flow forecast?

A cash flow forecast (cash flow projection) is a report created over time, using information from a business’ cash flow statement (cash flow analysis). Think of it this way: When you have a checking account, you get a monthly statement. If you develop a system for comparing these statements over time, you get a history of your checking account activity. Using this history, you can then make forward-looking predictions.

If you only look at one statement, you’re only getting the details for one specific period of time. It’s like taking a survey of five people instead of 500. When your sample is smaller, your results are less reliable, and cause and effect is much harder to prove or discern.

This is where cash flow forecasting comes into play. Building upon regular cash flow analysis, cash flow forecasting helps you develop a better, more comprehensive picture of your cash flow over time.

“When it comes to liquidity analysis, cash flow information is more reliable than balance sheet or income statement information. Balance sheet data are static — measuring a single point in time — while the income statement contains many arbitrary noncash allocations — for example, pension contributions and depreciation and amortization. In contrast, the cash flow statement records the changes in the other statements.”

— Journal of Accountancy

In the words the pre-Socratic Greek philosopher Ephesus, “The only thing that is constant is change.”

What can a cash flow forecast tell you about your business?

A cash flow statement looks at all the main areas where cash comes in or out of your business. When you pull all this information together and repeat the process over time through cash flow forecasting, you can see:

  • Where your cash comes from:
    • Sales of products and services
    • Sales of assets, like equipment
    • Funding from investors or loans
    • Your own savings
    • Cost-cutting activities
  • Where your cash is going:
    • Production, inventory or labor costs
    • Loan or investor payments
    • Research and development
    • Marketing and advertising
    • Facility or office expenses
  • The timing of when:
    • Bills are due
    • Customers pay you
    • You need to pay your employees
    • You have the highest and lowest levels of cash flow
    • A potential cash flow shortfall could happen

The more you often you complete a cash flow analysis, the more information you have to build your cash flow forecasts and the better perspective you’ll get of how your business is really performing.

Nearly 60% of all failed businesses say cash flow was the main reason.

How can cash flow forecasting help you make smarter business decisions?

Imagine if you didn’t pay attention to your bank account balance and your cash management system was saying a tiny prayer every time you used your debit card. Not the most effective or confidence building method, right?

The same rules apply to the financial health of your business. Having an awareness of how and when money flows in and out of your company through cash flow forecasting, lets you plan and prepare more effectively for:

  • Cash flow surpluses and shortages
  • Current and future tax obligations
  • Labor needs
  • Strategic purchases or initiatives
  • Short- or long-term funding

For seasonal businesses, cash flow forecasting gives you a better idea of how to plan for busy and slow periods. For any business, comparing the numbers in your cash flow statements against your projections will determine just how accurate your predictions are. This can also further pinpoint strengths and weaknesses in a range of areas.

If sales are higher than projected, you can plan to order more product or enhance current features. You might even consider a price increase. On the other hand, if sales are down, you’ll need to figure out what’s happened and why. Before the issue eats away at your cash flow.

Is it time for a sale or special offer? If you’re watching your financials closely, you’ll have a much better idea of what the answer should be.

Read more on how to read a cash flow statement.

What are two areas that get the most scrutiny in a cash flow forecast?

Two areas that get a lot of attention as part of a cash flow forecast and analysis are accounts receivable and accounts payable. This makes sense from a top-down level because accounts receivable is what a business is owed from third parties and accounts payable represents the amount of money a business has to pay to other third parties.

When you monitor your cash flow as a business, you need to be specific about when payments are due versus when you get paid. For instance, you may have several bills due at the start of each month. However, due to you your payment terms, the cash from your customers won’t hit your account until the end of the month.

Two metrics that you’ll want to determine and keep track of over time are:

  • Average collection period — How many days it takes for your customers to pay you.
  • Average days payable — How long it takes you to pay your bills.

Keep in mind that both of these numbers are averages. Some vendors will always take longer to pay and there will always be that one debt that you’ll have to keep whittling down. The norms for your industry will also affect these figures.

It’s all about knowing the patterns. It’s like keeping your personal calendar up to date so that you don’t forget you have a meeting next Tuesday at 3 pm.

Discover the 10 best businesses for cash flow. 

Are there other indicators to look at as part of a cash flow forecast?

Ok, this was a leading question. Of course, there are. Fair warning… there’s math ahead.

Once you’ve started systematically recording your cash flow metrics, you can begin to leverage this data. One way this is done is through ratios — using the relationship between variables to create a new indicator.

It’s “playing” with your numbers, but in a good way — not a burn-the-books-they’re-at-the-door-with-a-warrant sort of way. When you request a free cash flow assessment from PayPie, the following ratios are featured at the top of your report:

  • Cash inflow to cash outflow ratio — Your total cash inflows ÷ total cash outflows indicates the proportion of assets to debts over a set period of time. As you want your inflows to be greater than your outflows, you should aim for a number that’s 1.0 or higher.
  • Current ratio — A current ratio (current assets ÷ current liabilities) shows if you have enough cash to meet your current levels of debt. Ideally, you want this number to be 1.0 to 2.0 or higher, signifying that you have more money than debts. Again, that’s a little simplistic because it all depends on the business, its lifecycle and other factors. For instance, in the early stages, any business might have more debt than income as it’s getting off the ground.
  • Debt-to-equity ratio — Your debt-to-equity ratio (total liabilities ÷ equity) demonstrates how much debt your business carries in relation to every dollar in assets — telling you how much debt is currently affecting your business. In a perfect world, this figure should be 1.0 or lower.
  • Quick ratio — A quick ratio (cash and cash equivalents + short-term investments + accounts receivable ÷ current liabilities) is an “acid test” for liquidity. This is because it includes things, like inventory and accounts receivable, which are considered assets that are easily converted into cash.

Over time as you figure out which metrics to watch, you’ll put together more and more pieces of the cash flow puzzle.

Among SMEs only 12.5 - 57% routinely measure or project their cash flows

When inventory management is integral to your cash flow…

If your business is heavily reliant in inventory as a source of revenue, you will also want to determine an average of how long it takes you to sell or turn over your inventory. The official term for this is days inventory outstanding. In conjunction with this metric, you’ll want to calculate the number of times you deplete or sell all of your inventory per year as well as your cash conversion cycle (average collection period + inventory outstanding – average days payable).

Is there an easy way to automate my cash flow forecasting?

Cash flow forecasting doesn’t have to be time-consuming. With PayPie, you simply connect your accounting software, select the business you’d like to analyze and go.* Our unique algorithms do the rest. Best of all, your highly visual and easy-to-read report is free and you can run your forecast as often as you need — so that your cash flow statements can give you enough history to create long-term projections.

“A cash flow forecast is considered one of the most critical early warning systems for companies that operate with debt, and should be done on a regular basis.” — QuickBooks Resource Center

Is there any margin for error for cash flow forecasting?

As you get into a regular routine of measuring your cash flow statements against your cash flow forecast you’ll start to see the allowable percentage of variance for your business. Should a result skew high or low of this percentage, it’s a sign to take a deeper look and take action.

In most cases, you’re really only able to use your cash flow projections to look ahead about a year. This is because there are some many things that you can’t control, like interest rates, minimum wage increases, fuel costs and other variables.

If my business is profitable, do I need a cash flow forecast?

The short answer is yes. Profitability is just the money coming in from the sale of goods and services. But, it’s only one part of the equation. You can be making money, but if you’re not paying attention to where you’re spending your money, a surplus can evaporate quickly. (More quickly than an unsupervised bowl of candy at a children’s party.)

The customer may always be right. But, cash is always king. Surveys conducted by the Business Development Bank of Canada (BDC) show that among small to medium-sized businesses only 12.5 – 57% routinely measured or projected their cash flows.

If you’ve got enough drive and determination to own your own business, you’ve got the fortitude to take a good hard look at your numbers with cash flow forecasting (shown below).

Ready to get started? Sign up here.

PayPie Cash Flow Forecast Example

*PayPie currently integrates with QuickBooks Online. Additional integrations are coming soon.

This article is intended to be informational only and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.

Image via Pexels.