A cash flow forecast helps to understand the business’s cash position in the coming accounting period. It acts as an intelligent tool to predict if the business is expected to be in one of the following cash positions.
- The business is expected to have excess cash. Hence, it’s in a position to invest.
- The business is expected to be short of money. Hence, it needs to find alternatives for raising the finance.
Timely actions in both given situations are favorable for the business. So, cash flow forecast helps the business in timely cash control and leads to enhanced business profitability. Let’s start with the basics of the cash flow forecast for the business.
What is a cash flow?
Cash flow summarizes the movement of the cash to and from the business. In other words, it’s an inflow and outflow of the cash to and from the business.
Inflow refers to the movement of money into the company’s account in revenues, profits, and loans. At the same time, the outflow is the movement of money out of the company’s account in costs and expenditures. A greater inflow to outflow ratio indicates a positive cash flow, while a greater outflow to inflow ratio indicates a negative cash flow.
Usually, a cash flow statement is given in financial statements to help stakeholders understand business liquidity positions.
Difference between Cash Flows and Profit & Loss:
Cash flows are not the same as profits and losses. Cash flows impact a business’s day-to-day activities like payments to suppliers, tax payments, debt payments, etc. In contrast, profits and losses are maintained at the end of each month and affect the business’s monthly operations. Therefore, profit and loss analysis would ensure the long-term success and profitability of the company, while cash flow analysis would safeguard the everyday survival of the business. Hence, it is important to maintain a cash flow statement in addition to an income statement.
What is a cash flow forecast?
Cash flow forecasting is the practice of predicting the future cash flows of a company by analyzing its income and expenditure patterns. Patter refers to the movement of cash in the past. So, it’s about the expected movement of the cash to and from the business.
Generally, cash flow is divided into three main categories. These include operating activities, financing activities, and investing activities.
Operating activities – Operating activities are about normal business operations like production, purchase, and sale, etc.
Financing activities– It’s about direct receipt and payment of the case related to financing. For instance, raise of the loan and equity, etc.
Investing activities– It’s about purchasing/selling investment and earning a return on it. For instance, the purchase of equity shares is shown as an outflow of the case.
Importance of Cash Flow Forecasting for Startup
Forecasting gives a picture of the business’s current and future cash position. It shows how expenses are affecting the cash in hand. Being familiar with the expected cash movements of the business allows businessmen to take effective and confident decisions. It minimizes the chances of liquidation or bankruptcy and increases business growth and expansion possibilities. This is so because the non-profitable business activities incurring additional expenses can be ceased, and the profitable business activities generating positive cash flows can be enhanced.
Cash flow forecasting is highly crucial for new entrepreneurs and small enterprises as it indicates whether the business is going to survive or not. Following are some factors that make cash flow forecasting important for any business:
- Cash flow forecast is a ‘warning system’ for the inadequate bank balance of the business.
- It gives the business indication about its ability to meet expenses like supplier payments, employee salaries, debt payments, operational expenses, etc.
- Lenders like banks want to have a look at the business’s cash flows every now and then.
- It allows business owners to make confident and informed decisions because of the transparency of cash inflows and outflows.
- It provides an opportunity for business growth. Instead of planning for meeting short-term cash requirements, the business starts planning for long-term projects like improving infrastructure.
- Cash flow forecasts give some degree of control to the management over business processes. For example, management can better tackle uncertain external environment factors like inflation and shortage of supplies by delaying debt payment or payment to vendors, etc.
Advantages of cash flow forecast
Conducting a cash flow forecast is crucial for the success of a business. Forecasting helps businesses to understand their cash flow patterns and identify problem areas.
Identify and plan for cash shortages.
In times of uncertainty for the business, its understanding of cash flows can benefit its financial health. Forecasting cash inflows and outflows allow the business to tackle instability and even a warning signal for unforeseen unfavorable circumstances. Businesses can then look for other financial options like liquidating assets or implementing cutbacks in a certain department.
Manage Surplus Cash
Businesses can effectively utilize their extra cash with a proper cash flow forecast. The forecast can tell when businesses may generate surplus cash which can be further used for reinvestment or paying back loans.
Reduce Foreign Exchange Risk
Knowledge of foreign currency is essential for businesses, especially those operating in international markets. Forecasting can show periods of cash surplus and deficit. Businesses can assess which periods are better for foreign exchange and plan their operations accordingly by using this information.
Track Accuracy of Current Transactions
The cash flow forecast depends upon the current cash generation range of the firm and external factors, such as inflation, that may impact future cash flow. By looking at future cash flow patterns, a business can assess whether its current cash generation is up to mark or not. If a business’s current transactions are poorly planned or improperly executed, it will create a ripple effect on future cash flows. The future cash flows can indicate areas of problem in the current operation.
Disadvantages of Cash flow forecast
No system exists without flaws. Following are some of the drawbacks of cash flow forecasting.
The finance department of an organization gathers all relevant information needed to estimate future cash flows. There may be possible factors overlooked and not incorporated in the calculation of that estimate.
The results might therefore show faulty cash flow forecast values. This can prove detrimental for the business as they might expect a cash surplus and plan for investment, while in reality, they might face a deficit in the future.
False Sense of Security
Positive cash flow forecast results may lead a manager to think that the business is doing well and shall continue to do so in the future. A future cash surplus doesn’t mean that business operations are excellent and there is no need for improvement. Many external and internal factors influence cash flows, and predicting all of them is impossible. So, managers should always incorporate a margin of error in their estimates and not heavily rely on forecast results for performance evaluations.
Proficiency of the Interpreter
Any business manager can perform cash flow forecasts manually or by software. The real task is to interpret and understand the results of the forecast. The finance manager must have the capabilities and skills to understand, analyze and adapt the output to the business’s operations. The interpreter’s proficiency in the interpretation of the cash flow forecast can help improve and/or maintain the business’s financial health.
Conclusion for cash flow forecast
Cash flow forecast acts as a business intelligence tool to control in and outflow of the business cash. If the expected cash position is a cash deficit, the business needs to arrange alternative sources of finance. On the other hand, if there is expected excess of the cash, the business can consider investing and earning a return.
It’s important to note that there is a difference between profit and cash flow. The profit contains multiple accounting assumptions and is subjective. On the other hand, the cash flow is based on the real flow of cash. Hence, it’s objective.
There are multiple advantages of using a forecasted cash flow statement: timely identification of the cash shortages, management of the surplus cash resources, and an overall assessment of the cash-related movement.
However, there are certain problems with the cash flow statement that includes overlooking the factors impacting the cash position, a false sense of security, and problems in the interpretation of the cash flow statement.