What Is Cash Flow Forecasting? How To and Meaning

Forecasting the amount of cash expected to flow in and out of a business is much like a captain studying the direction of the tides in order to steer their ship in the right direction. Cash flow forecasts provide business leaders with important insight about likely changes in a company’s cash position and are a critical tool for charting a successful course to the future.

Large multinational companies dedicate entire departments to cash management, which includes cash flow forecasting. Smaller businesses often have fewer in-house resources dedicated to cash management, yet it can be argued that the process is even more critical for their longevity: Industry research indicates that up to 82% of small businesses fail (opens in a new tab) due to poor cash flow management. But in either case, leaning on automation for cash flow forecasting can keep all companies from floating adrift.

This article provides an in-depth look at why cash flow forecasting is important, different methods, advantages and challenges, as well as detailed steps for building an effective forecast.

What Is Cash Flow?

Cash flow measures a company’s sources and uses of cash. When a customer pays for goods and services, that money is a source of cash, also called “cash in”. When a business needs to pay its own bills, such as a utility bill for its warehouse, that’s considered a use of cash, known as “cash out”. When the amount of cash in is greater than the amount of cash out, a business has positive cash flow. That’s good news. But when a company has more cash going out than coming in, it has a negative cash flow — a condition the business may be able to weather for short periods of time but can become problematic in the long run.

It is important to note that cash flow differs from profitability under the accrual method of accounting, which involves recording revenue that is earned but has not yet been received. This includes accounts receivable, noncash items, such as accrued interest income and interest earned on a bank deposit that has not yet been paid in cash to a business, and accounts payable, which represents an obligation to pay but payment has yet to be disbursed. For many businesses, having a positive cash flow may be even more important than profitability, especially since companies must regularly meet practical obligations like paying employees and suppliers.

What Is Cash Flow Forecasting?

A company’s statement of cash flows (opens in a new tab), one of its core financial statements, summarises the inflows and outflows of cash flow for a prior period. In contrast, cash flow forecasting looks ahead to predict future cash flows and balances. This process involves estimating the amount of cash coming in and leaving a business over a specific impending period of time. Forecasting cash flow is important so that a company can avoid being short on cash, though it’s not an easy task because it can be challenging to accurately predict future revenue and expenses.

Key Takeaways

• Cash flow forecasting estimates the amount of cash that will be coming in and going out of the business to predict future cash balances.
• Business managers primarily use cash flow forecasts to determine whether cash obligations can be met so that operations will run smoothly.
• The direct method of cash flow forecasting is often used for day-to-day cash management, whereas the indirect method of forecasting provides a high-level view for strategic planning.
• Downloadable forecasting templates and automation software can ease the cash flow forecasting process.

Cash Flow Forecasting Explained

Cash flow forecasting helps companies estimate their future cash balances. Short-term cash forecasting concentrates on the upcoming 30 to 60 days, medium-term forecasting typically runs through the end of the current fiscal cycle or a rolling 12 months, and long-term forecasting looks beyond a year. Because this process requires making a lot of assumptions and projections, forecasts tend to become more complicated and less accurate the further out a company estimates.

Why Is Cash Flow Forecasting Important?

Cash flow forecasting is important whether a business is doing well or is struggling. Regularly preparing cash flow forecasts is considered good financial hygiene. As a practical matter, some lenders require these forecasts as far out as two years. Knowing what’s likely ahead can help businesses plan accordingly. For example, companies with a cash-positive forecast might look to make some investments, expand their operations or pay their owners or shareholders more. Cash-negative companies will need to keep close tabs on their cash flow to keep operations running smoothly by paying suppliers, employees, taxes and lenders on time.

Why Do Businesses Use Cash Flow Forecasting?

Cash flow forecasting extends a business leader’s line of sight for managing liquidity, leading to more informed decision-making. Companies without a sustainable positive cash flow typically go out of business. Cash flow forecasts provide early warning signs of potential cash shortfalls so that a company can change course before it’s too late. Even startups, which are initially expected to be cash negative, need to carefully monitor their burn rate — the rate at which they spend money — since research shows running out of cash is their No. 1 reason for failure. Cash flow forecasting also allows a company to prepare for particular situations that require extra cash. For example:

• Companies that pay employees biweekly may need to plan ahead for months that have three paydays.
• Seasonal businesses may need extra cash to build inventory to avoid running out of stock on certain popular items before prime selling time.
• Companies may need cash on hand to make periodic employer, real estate and income tax payments.
• Businesses may need to set aside cash for completing scheduled maintenance, making unexpected repairs and replacing equipment.

How to Measure Your Business’s Cash Flow

Cash flow is measured and reported on a statement of cash flows. This report, prepared in accordance with Generally Accepted Accounting Principles (GAAP) (opens in a new tab), groups sources and uses of cash into three sections: cash flow from operations, cash flow from investing activities and cash flow from financing activities. The statement of cash flow reflects historical results and is often the format used for presenting forecasted cash flow.

Operating cash flow accounts for the majority of cash flows. It is generally considered the best measurement of a company’s financial health because it shows whether a company is generating cash from its core business. Operating cash flow includes money received from selling products or services to customers, as well as cash paid out to cover operating expenses, such as raw materials and labour. A business can have a positive operating cash flow yet be unprofitable if it has a lot of debt, perhaps because it’s investing in future growth. Conversely, operating cash flow can be negative, but the company’s income statement may show overall profitability due to nonoperating activity that is unrelated to daily operations, such as selling off a business unit for a profit. Discrepancies between cash flow and profitability give business leaders and investors insight into a company’s quality of earnings, which is an especially key factor when predicting a company’s future.

Investing activities relate to gains and losses on the sale of assets, which might occur when equipment is sold off for more or less than its carrying, or book, value. Additionally, they reflect any sources and uses of cash from buying or selling securities, like stocks and bonds, or buying and selling other businesses. Measuring investing cash flow helps show how a company might be spending to invest in its future or supplementing any cash-negative operations.

Financing activities are related to changes in a company’s debt and equity. Financing cash flow is an important measurement of nonoperating cash flow, since it highlights how a company is funded. Loan proceeds and capital contributions from owners are examples of cash flows into a company from financing activities. Dividend payments, loan repayments and interest payments are examples of cash outflows.

Free cash flow is another measurement of cash flows, reflecting a company’s ability to generate its own cash to fund future growth. Higher free cash flows generally indicate that a company is healthy. It’s important for business leaders to monitor and forecast free cash flow when making decisions about expansions, acquisitions or new product launches. Free cash flow is not presented on a statement of cash flows but instead can be calculated using information from the statement. The formula for free cash flow is:

Free cash flow = cash flow from operations - capital expenditures

How to Build a Cash Flow Forecast: Direct Forecasting vs. Indirect Forecasting

Two methods are typically used for building a cash flow forecast: the direct method and the indirect method. Factors to consider when determining which one to use are the time frame being forecasted, the volume of business transactions, the availability of other financial forecasts and the amount of deployable finance resources.

Direct forecasting:

The direct method of building a cash forecast can be described as a bottom-up accumulation of expected transactions. Depending on the volume of transactions in a business, completing a forecast with this method can be extremely time-consuming and tedious, since it requires integrating data from bank accounts, accounts payable, payroll and accounts receivable/collections. However, this method also tends to be the most accurate for short-term cash flow forecasts. Here are a few tips to consider before forecasting cash flow:

• Focus only on the amount of cash collected. Ignore accrual-based accounting, which involves recording revenue and expenses when earned rather than when a payment is made or received.
• Make well-informed assumptions about how long it takes customers to make payments, and take into consideration the percentage of customers who don’t pay at all.
• Base estimates on realistic sales projections.

With those tips in mind, here are the steps for completing a cash flow forecast using the direct method:

1. Determine the length of time in the forecast, such as 30, 60, 90 or 180 days.
2. Break the forecast into shorter periods, such as monthly, weekly or daily, choosing the most practical time frame based on how a business runs. Shorter time periods may lead to more accurate cash flow predictions, yet the process may be more cumbersome and tedious if completed manually.
3. Identify expected cash inflows, such as from sales to customers and nonsales items, such as tax refunds, owner contributions, sales of assets, loan proceeds and interest income.
4. Plot out the cash receipts from each of the identified cash inflows in each of the periods identified in step two based on when they are anticipated to be received.
5. Identify expected cash outflows, including payments for all operating expenses, such as payroll and inventory, and nonoperating items, such as rent, loan payments and tax payments.
6. Plot out the cash payments from each of the identified cash outflows in each of the periods identified in step two based on when they are anticipated to be released.
7. Subtract the outflows from the inflows in each period to calculate the net cash flow for each daily, weekly or monthly period. Doing so can uncover days, weeks or months when a business is expected to generate extra cash or come up short.
8. The sum of net cash flows from each period shows the total positive or negative cash flow for the overall forecast period. This amount is added to the opening cash balance at the beginning of the period to arrive at the estimated closing cash balance at the end of the forecast period.

Indirect forecasting:

The indirect method is commonly used for formal, external cash flow forecasting. Indirect forecasting provides a high-level view of expected cash flow and is helpful for guiding long-term strategy, rather than day-to-day cash needs. It relies on forecasted income statements and balance sheets that are prepared using typical projection methods. The indirect method reconciles the projected net income on a forecasted income statement with a projected cash balance by taking into consideration the projected noncash items. This reconciliation uses data from the forecasted balance sheets, such as changes in assets and liabilities.

The indirect forecasting process is similar to preparing a historical statement of cash flows, which uses financial statements from previous periods. However, the indirect method uses forecasted financial statements instead. Here are the 10 steps a business can take to complete a cash flow forecast using the indirect method:

1. Create a forecasted income statement for the same period as the cash flow forecast. In addition, develop a projected balance sheet as of the end date of the forecast period.
2. Identify the net income or loss for the period on the forecast income statement.
3. Calculate the change in accounts receivable (AR) on the balance sheet at the beginning of the forecast period compared with the projected balance at the end of the period. Subtract an increase in AR from the net income, since this represents revenue that was included in the projected income statement but has not been collected in cash. Conversely, add a decrease in AR to net income since that represents cash collected in the period for revenue that was recognised in a prior period.
4. Determine the change in accounts payable (AP) on the balance sheet at the beginning of the forecast period compared with the projected balance sheet at the end of the period. Add back an increase in AP because this represents expenses that were included in the projected income statement but have not been paid in cash. Conversely, subtract a decrease in AP, since this represents the amount of cash paid during the period for expenses that were recognised in the net income during a prior period.
5. Add back depreciation expense since this is an expense recognised on the income statement that has no impact on cash.
6. Repeat step three for other assets, such as fixed assets and notes receivable.
7. Repeat step four for other liabilities, such as taxes payable and prepaid revenue.
8. Adjust net income, adding amounts for proceeds and subtracting amounts for the repayment of future loans — sum the steps 2 through 7.
9. Add amounts for purchases and subtract for sales of future investments not already included in forecasted income statement and balance sheet.
10. Adjust the net income or loss by the sum of these reconciling items to calculate the net cash inflow or outflow for the period. This amount is added to the opening cash balances at the beginning of the period to arrive at the estimated closing cash balance at the end of the forecast period.

Advantages of Cash Flow Forecasting

A useful cash flow forecast is critical for guiding management decisions. Otherwise, business leaders are sailing blindly into the future, increasing the likelihood of introducing errors. Cash flow forecasts have several advantages. They can:

• Help businesses recognise periods of negative cash flow and potential insolvency (opens in a new tab).

• Identify periods when supplemental sources of cash, such as a line of credit, may need to be drawn against.

• Allow companies to obtain loans, since many lenders require forecasts during the application process.

• Reduce the likelihood of missing payments to suppliers and employees, which in turn helps keep the business running smoothly.

• Enable business leaders to be cognizant of when they can afford to make cash payments for business investments, expansion, hiring and wage increases.

• Proactively recognise when surplus cash may be available to boost returns.

• Help optimise working capital borrowing to avoid excess interest charges.

• Assist with managing foreign exchange risks for companies that do business globally.

• Allow companies to raise additional capital from potential investors who use cash flow forecasts when assessing a company’s financial health.

Drawbacks to (or Challenges of) Cash Flow Forecasting

When weighing the pros and cons of cash flow forecasting, it is commonly believed that the positives outweigh the negatives. However, there are challenges to cash flow forecasting that businesses should be aware of. Overall, cash flow forecasting can be a time-consuming process, especially when completed manually. In addition, forecasts are often inaccurate.

Cash flow forecasting challenges that may contribute to inaccurate figures include:

• Capturing and organising all of the data needed in painstaking detail when using the direct method.
• Inaccuracies in underlying forecasted income statements and balance sheets when using the indirect method.
• Uncommunicated changes in accounts payable procedures that extend or reduce the time frame for days payable outstanding (DPO), the average number of days it takes a company to pay its bills.
• Uncommunicated changes in selling tactics that extend customer payment terms.
• Changes in accounts receivable procedures that extend or reduce the time period for days sales outstanding (DSO) (opens in a new tab), the average number of days it takes for a company to collect payment from its customers.
• Unanticipated market shifts that impact sales assumptions.

Corporate Finance vs. Entrepreneurial Cash Flow Forecasting

Cash flow forecasts serve different purposes for different business leaders. Entrepreneurs most often use a cash flow forecast to carefully manage cash on hand in order to keep their businesses running smoothly. For them, forecasting is about understanding their businesses’ cash conversion cycle so they can better manage the day-to-day cash inflows from customers and cash outflows to suppliers, employees and creditors. In this case, the direct method of cash flow forecasting may be most helpful.

At a more strategic level, corporate finance managers use cash flow forecasting to plan for the capital needed to accommodate structural changes, such as during a merger or acquisition. Forecasts are also a key part of planning for new ventures, since they can provide an estimate of the startup cash that may be required. In this case, the indirect method of cash flow forecasting is more commonly used.

Cash Flow Forecasting Examples

To demonstrate how a company would prepare its cash flow forecast for an upcoming month, consider this hypothetical scenario for company ABC Inc., a small hardware store.

1. Determine the length of time to be forecasted — in this case, one month: April 20XX.
2. Break the forecast time frame into smaller periods by, for example, creating weekly forecasts, since payroll in this example is completed on a weekly basis.

3. Identify expected cash inflows, including:

   • Sales made to customers in cash.
   • Collections on previous credit sales to contractors.
   • Bank interest.
   • Loan proceeds from drawing down on ABC’s revolving credit facility.
   • Proceeds from the expected sale of a cash register that was replaced in the prior month.
   • Tax refunds.
   • Miscellaneous cash from a vending machine in the store.

4. Plot out the cash receipts from each of the identified cash inflows based on when the money is anticipated to arrive. This includes:

   • Sales made to customers in cash. Base this estimate on current trends and make projections for each week.
   • Collections on previous credit sales to contractors based on the estimated AR collection rate, using 30-day payment terms. In this case, ABC would look at credit sales from March.
   • Bank interest paid, which is estimated using the average amounts paid each month.
   • Loan proceeds, which includes the estimated draw down to pay the second week of payroll and inventory purchases.
   • Proceeds from cash and carry sale of cash register in week two.
   • Tax refund to be received on April 15.
   • Miscellaneous cash from a vending machine in the store, a figure that is based on the average amount from the last three months.

5. Identify expected cash outflows, including:

   • Weekly payroll for store employees.
   • Weekly rent.
   • Inventory purchases for stock.
   • Utility expenses, such as phone, heat and electricity for the store.
   • Employer payroll and sales tax payments.
   • Repayment of the revolving loan.
   • Miscellaneous cash paid out from the petty cash box.

6. Plot out the cash payments from each of the identified cash outflows based on when they are anticipated to be released:

   • Weekly payroll for store employees, which is projected based on paying a full staff for all shifts.
   • Weekly rent, which is projected based on the lease agreement.
   • Inventory purchases for stock, which is based on previous purchases from suppliers in March. These payments are projected to be paid on the due dates indicated on supplier invoices.
   • Utilities, such as phone, heat and electricity for the store, which is estimated using the average amount paid during the prior six months. These bills are projected to be paid on their due dates to avoid penalties.
   • Employer payroll taxes and sales taxes, which are estimated payments to be submitted during weeks one and two.
   • Repayment of the revolving loan.
   • Miscellaneous cash paid out from the petty cash box. This estimate would include, for example, the mid-month and month-end catering bill from serving food to staff during the store’s inventory cycle counting.
7. Subtract the outflows from the inflows for each period to calculate the net cash flow for each weekly period, highlighting that weeks one and three are net negative cash flow and weeks two and four are net positive.
8. The sum of net cash flow from each period shows the overall positive or negative cash flow for the forecast period, which is $2,960 for April 20XX. When added to the opening cash balance of $3,500 on April 1, 20XX, the forecasted closing cash balance on April 30, 20XX is projected to be $6,460.

Easily Manage and Forecast Cash Flow With Increased Accuracy

Manual preparation of a cash flow forecast is tedious and time-consuming, and spreadsheets are often incomplete or have errors. In addition, the ABC Inc. example above highlights the need for companies to use underlying data analysis in their projections. To make this process easier and more accurate, a solution like NetSuite Cash Management, which tracks payments, charges and balances in a single location, can help ensure that cash flow forecasts capture all required transactions. In addition, real-time data and analytics can inform the necessary estimates embedded within the forecast. Equally important, forecasts can be compared to actual results, alerting management to variances and helping to refine future forecasts to make them even more accurate, particularly when combined with NetSuite Financial Management solutions.

Conclusion

Cash flow forecasting is a core part of financial planning and assists with the day-to-day management of a business. Regardless of whether the direct or indirect method is used, confidence in cash flow forecasts can help business leaders make more informed decisions regarding how to spend and conserve a company’s cash. The benefits of cash flow forecasting outweigh the challenges, especially when the process is supported by automation.

Cash Flow Forecasting FAQs

How can automation streamline cash flow forecasting?

Automation helps reduce the time it takes to accumulate the data for cash flow forecasting, and it reduces the risk of overlooking important transactions when businesses use the direct method of cash flow forecasting. In addition, businesses can use automated analysis tools and dashboards to refine the underlying estimates needed for cash flow forecasting and eliminate manual errors that are common in spreadsheets. Also, the automated financial reporting tools can generate forecast income statements and balance sheets when businesses prepare cash flow forecasts using the indirect method.

How do you calculate a cash flow forecast?

A cash flow forecast can be prepared using the direct method or the indirect method. The direct method is better suited for day-to-day cash management and is typically used over short periods of time. The indirect method is commonly used for long-term, high-level strategy decisions, such as capitalisation and business combinations.

Why do we forecast cash flows?

Regularly preparing cash flow forecasts is simply good financial hygiene. Excess cash reserves can represent lost opportunities, especially when cash-positive companies might be looking to make some investments, expand their businesses or pay their owners or shareholders more. Cash-negative companies need to keep close tabs on cash flow to keep operations running smoothly by paying suppliers, employees, taxes and lenders. Too many periods of negative cash flow can cause significant trouble for a company, so it’s important for businesses to make financial adjustments based on cash flow forecasts.