Cash flow forecasting is a common term in the business world. However, few people understand what it actually is. Utilising forecasting can provide security for the future of your business, and allow you to ensure you’re hitting your goals.
What actually is cash flow forecasting?
Cash flow forecasting is the process of obtaining an estimate of the company’s future financial position. In other words, it’s about projecting where the company will financially be at a point in time. Based on the company’s revenue and anticipated payments, it serves as a core planning tool in a company’s financial management.
How is cash flow forecasting done?
There are two dominant types of cash flow forecasting – the direct and indirect method.
Direct method
The direct method is a short-term forecast, generally between 30 – 90 days. Its primary aim is to outline the cash required to fund working capital. It schedules the company’s receipts (what the company gets paid), and the company’s disbursements (what it has to pay).
Indirect method
Indirect forecasting is generally long-term, and relies on various income statements and balance sheet derivations. To create this, the company uses;
- The adjusted net income.
- The pro-forma balance sheet.
- An accrual reversal method.
The indirect method shows the cash required to fund longer-term company strategies. This can include capital projects or company growth.
What are the goals of forecasting?
Forecasting assists with managing the liquidity of the business. It ensures that your business has the necessary cash to fulfil their short and long-term goals. Failing to utilise forecasting can mean your business has funding issues, or fails to meet obligations as they don’t have the necessary cash at the right time. Having most of your company’s worth in assets may seem ‘safe’. However, it means you might be unable to pay your required obligations.
Why is forecasting important?
There are numerous reasons why cash flow forecasting is important. These include;
- Ensuring you can pay your employees and suppliers are paid on time. Without forecasting accounts payable and received, you may not have the cash necessary to pay the people who make your business run. Failing to do so can lead to awkward situations such as falling out with suppliers, or legal issues with employees.
- Forecasts can act as early warning signs for issues with your business. Identifying how much cash a business will have in the near future allows you to identify if an overdraft or bank loan is necessary.
- Investors will generally request to see a company’s cash flow forecast before considering investment. It is unlikely an investor will be willing to supply their personal capital, without proof that the company is likely to be able to reward them.
Final thoughts
Cash flow forecasting is an essential tool to ensuring that your company can have both short and long term success. In short, your business can’t afford to not have a cash flow forecast. If you’re unsure whether your business needs to manage their liquidity better, a financial services lawyer can assist.
