According to US Bank, 82% of small businesses fail due to cash flow problems. The reasons for that include economic volatility, unsustainable business models, and reduced consumer demand. These challenges aren’t going to go away, so the solution is for small businesses to improve how they handle and forecast cash flow. Here’s some of what we’re going to cover today.
- Cash flow forecasting is predicting how much cash will flow into your business and what is required to cover cash outflows.
- Retail stores, manufacturing companies, and seasonal businesses are examples of industries that rely heavily on cash flow forecasting.
- Accounting platforms like QuickBooks Online (QBO) and FreshBooks can generate basic cash flow reports to get you started.
What is cash flow forecasting, and why does it matter?
Cash flow forecasting focuses exclusively on the actual money moving in and out of your business. It differs from revenue projections based on accrual accounting records. The distinction matters because a company can show a profit and still run out of money. For instance, a manufacturing company getting a $100,000 order can list it as revenue, but it’s not cash until the invoice is paid.
Forecasting can be short-term or long-term. Short-term cash flow forecasting looks at the next 30-90 days. Long-term cash flow forecasting is done for a six to eighteen-month period, usually to evaluate strategic equipment purchases, business expansion, or adding new employees to facilitate growth and scale. Both are essential for healthy business operations.
Start with solid cash flow forecasting processes.
Effective cash flow forecasting relies on accurate data, specifically your previous cash flow statements. The first step in the process involves a “look back” at statements from the last 12 to 24 months. If you’re a new business, go back as far as you can. Look for repeating patterns like seasonal sales spikes or higher outflows at certain times of year.
This gets easier over time because you’ll have more data to work with. Once you have the information you need, categorize your cash flows into three areas:
- Operating activities: Sales receipts, supplier payments, and payroll.
- Investing activities: Equipment purchases, asset sales, and major capital expenditures.
- Financing activities: Loan proceeds, debt payments, and owner distributions.
An honest assessment of your sales pipeline is required if you want an accurate cash flow forecast.
For instance, if a customer generally pays you in 45 days, don’t assume they will pay sooner without some type of action on your part. You’ll also want to include other revenue sources, not just sales, like rental income, interest earned, and asset sales.
The next step is estimating cash outflows. Start with fixed costs.
Expenses like rent, insurance premiums, and base salaries fall into this category. Variable costs that fluctuate are materials, shipping costs, and sales commissions. You should also add periodic expenses like quarterly tax payments, annual insurance renewals, and equipment maintenance contracts.
Once all the data is in place, use it to create multiple scenarios.
Everyone hopes for the best, but you should always prepare for the worst. What happens if revenue and sales projections aren’t met, or if several customers pay late? These are the questions that cash flow forecasting can answer for you. Look at it from all sides so you’re prepared for anything.
Accurate cash flow forecasting requires specialized software.
Accounting platforms like QuickBooks and FreshBooks can generate basic cash flow reports to get you started. Smaller businesses and startups can utilize an Excel spreadsheet tailored to their specific industry or situation. As your company grows, you may want to consider specialized forecasting software. Alternatively, you can simply contact my office, and we’ll handle it for you.
There are two types of cash flow forecasting.
The direct method tracks actual cash receipts and payments. The indirect method, which is used by companies with more complex accounting systems, is based on net income and includes non-cash items like depreciation.
We can implement either once we’re familiar with your business and financials. We’ll be able to tell you whether your operating cash flow ratio is sufficient to cover liabilities within a week or two.
Retail stores, manufacturing companies, and seasonal businesses are examples of industries that rely heavily on cash flow forecasting.
Retail stores have peak and off-peak months. For instance, a toy store might do more business around the Christmas holidays. Seasonal businesses, like pool installers, could have no cash inflows for several months.
Knowing that a slowdown or peak sales period is coming is critical to the success of your business. Certain liabilities are fixed and must be paid regardless of your sales situation. Cash flow forecasting can tell you when you need to set aside money for those and when you can afford to spend more to buy inventory or expand operations.
Another example of this is a service company hiring new consultants to help grow its business. It takes time to onboard and train these individuals, and then more time for them to build a pipeline. Do you have sufficient cash flow to cover their salaries during this period? Cash flow forecasting will answer that question.
The most common mistake in cash flow forecasting is overestimating future revenue.
It’s important to work with accurate numbers, so list cash flows you know will be coming in, not what you hope will happen. Every entrepreneur believes their idea is the best and that their business will experience rapid growth. Unfortunately, that’s not always the case.
Consider the potential for collection delays.
If you invoice with net-45 terms, don’t expect everyone to pay you within thirty days. Assume that all customers will send their payments by the due date, but build in some margin for those who don’t. This is part of that “worst case” scenario planning I alluded to above. Even the best customers fall behind.
Neglecting to record one-time expenses? It could be a dangerous mistake.
Examples of oft-neglected one-time expenses include annual insurance premiums and quarterly tax payments. Create a calendar of known periodic expenses to avoid surprises that can strain cash reserves.
Make informed strategic decisions in hiring, inventory, and growth initiatives.
Our team of accounting and financial professionals is ready to implement cash flow forecasting, accounting, and financial reporting for any business owner looking to tame complex accounting and achieve periodic and stable growth.
To learn more, schedule a discovery call today.
Talk soon,
Jeremy A. Johnson, CPA