Building a Cash Flow Forecast Model (with examples)

Cash Flow Forecasting

There are few things more critical to a business than its cash flow. Without adequate cash, sustaining operations or stimulating growth is nearly impossible. Cash flow forecasting anticipates a company’s cash inflow and outflow over time. The cash flow forecasting process provides foresight for businesses, allowing them to manage their cash strategically.

What is Cash Flow Forecasting?

A cash flow forecast projects the future cash “flowing” in and out of a business. It estimates the timing and amounts of cash inflows and outflows. However, this isn’t the same thing as a cash flow statement. A cash flow statement outlines the business’s flow of cash over some historical date range. A cash flow forecast is only forward-looking and doesn’t look backward at historicals.

 

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Cash flow forecast vs budget

If you grasp the cash flow forecast explanation, there is a clear difference between cash flow forecasting and budgeting. Both are crucial tools, though they serve distinct purposes. A budget outlines upcoming revenue and expenses, while a cash flow forecast projects the timing of cash transactions, offering insights into the business’s liquidity. A cash flow forecast model will predict when the company receives the cash from the revenue outlined in the budget.

A cash inflow represents any source of cash. When a customer pays their invoice, for example, this is a cash inflow as money comes into the business. A cash outflow occurs whenever cash is used, like when the business pays rent or purchases new equipment without credit.

Operating cash flow vs financing cash flow

Within the cash flow forecasting process, it is essential to differentiate between operating cash flows and financing cash flows. Operating cash flows comprise cash transactions related to a company’s core operations. This includes revenue from sales or payments to suppliers. Typically, operating cash flow represents the most significant part of a business’s cash flows and is a metric used to measure their overall financial well-being. Non-operating cash flows, such as those from financing, reflect the cash movement between a company and its owners, investors, and creditors.

Why Cash Flow Forecasts Matter

Before you can learn how to build cash flow forecast models, it is key to understand their role. A few benefits of cash flow forecasts are as follows:

  • Help businesses manage cash and liquidity by identifying cash ebbs and flows in advance
  • Identify future cash shortfalls or surpluses. Planning ensures businesses do not run out of cash to cover their essential operations.
  • Aid in strategic business decisions. For example, a cash flow forecast can clarify the impact of investment in new technologies.
  • Secure financing from lenders. A strong cash flow forecast reflects financial health and can help a company secure additional financing.

Cash flow forecasting example

Consider the example of a local café owner who wants to expand their menu to include takeaway dinners. Cash flow forecasting can help the owner determine the cash implications of the new offering. It can also help them manage their cash, ensuring they remain liquid throughout the expansion.

Forecasting begins by calculating the cash inflows. For the café, sources of cash will include monthly beverage and food sales. Cash inflows should also consider the expected revenue from the new takeout line. It is also important to note seasonal trends in the analysis, such as pastry and coffee sales that spike in the winter and plateau in summer.

For outflows, consider the cost of food and beverages, rent, utility bills, and employee wages. Additional uses of cash are monthly loan payments for the kitchen and coffee equipment. The outflows must also include estimated inventory costs for the proposed menu items. The expansion may also affect utility expenses and increase labor expenses.

To calculate the net cash flow, subtract the cash outflows (uses of cash) from cash inflows (sources of cash). A negative net cash flow value shows a cash shortage over the period.

The café owner can use the cash flow forecast to assess their idea’s feasibility and gauge potential return while ensuring the business maintains adequate cash to cover all expenses. A cash flow forecast is also crucial for communicating with the café’s potential investors or lenders. It shows the owner understands their business’s trajectory and is ready for future growth opportunities and challenges.

How to Build a Cash Flow Forecast

Even if you understand the cash flow forecasting meaning and its importance, knowing how to build cash flow forecasts is a different matter entirely. Below is an outline of the cash flow forecasting process.

Step 1: Project operating cash inflows

Begin by identifying all sources of operating cash. A significant source of cash that falls into the operating cash inflow category is the proceeds from sales or services from the business’s core operations. The sale proceeds are only part of the operating cash flow once the customer has paid for them with cash. If, for example, the business invoices the customer, the sale is not tracked as cash flow until the customer pays the invoice.

Step 2: Project operating cash outflows

To project operating cash outflows, include cash items such as payments to suppliers, payroll costs, rent, and other operational expenses. Remember that a cash outflow does not occur if the company receives an invoice but does not yet pay.

Step 3: Calculate operating cash flow

To determine the business’s operating cash flow, subtract the operating cash outflows from the operating cash inflows. The result will tell you whether the company has a surplus or shortage of cash from its core operations over the period. A cash surplus resulting from operating activities suggests the business is functioning sustainably.

Step 4: Add non-operating cash flows

Next, integrate other cash sources and expenses not part of a company’s day-to-day operations. These non-operating cash flows include capital expenditures, asset sales, investment income, loan repayments, and equity or credit funding proceeds. A company’s non-operating cash flow provides information about cash generated from the business’s non-typical activities.

Step 5: Link cash flow forecast to balance sheet

Once you have the business’s operating and non-operating cash flows, you can determine the change in cash over the period. This net change in cash will be the difference between the cash balance at the beginning and the balance at the end of the period. The final cash value will link to your balance sheet by becoming the current period’s cash balance. If the numbers are not coherent, it is a sign that your financial model is not working correctly.  

Step 6: Test assumptions and scenarios

Now that you have projected cash flow, you will also need to test your assumptions using different scenarios. Run multiple scenarios through your forecast, from the most pessimistic to the most optimistic, to determine how the business’s cash flow looks in each scenario. In the case of a projected shortfall, the business can protect against volatility by adapting its cash management strategy in anticipation of a tighter cash position. 

Cash Flow Forecasting Methods and Models

Cash flow forecasting methods

When you build a cash flow forecast model, you can use two primary methods: direct and indirect.

The direct forecasting method utilizes actual cash transactions to offer a clear picture of the movement of cash, tracking its position at certain points in time. The method records all upcoming cash expenditures as well as cash payments coming into the company. The direct method shows greater accuracy for short-term forecasting of 90 days or less.

The indirect method uses historical data to project future cash flows. This forecasting method starts by taking the projected net income and adjusting for non-cash items and operating assets and liabilities changes. The indirect method is often more reliable for longer-term projections.

Best practices for cash flow models

Any cash flow forecast explanation is incomplete without discussing best practices, including the use of automation. Not only can automation help gather real-time data faster, but it can also minimize the risk of errors present in manually updated spreadsheets. Automation allows you to shift your focus from tedious data extraction to analysis.

Another best practice for cash flow modeling is constructing multiple scenarios, including a best-case and worst-case scenario. Incorporating scenario analysis enhances the accuracy of your projections while preparing the business for various outcomes.

Tips for improving cash flow forecasts

The value derived from cash flow models highly depends on how well they predict the actual movement of cash. To improve your forecast, consider the following:

  • Update the forecast frequently with real-time data to align the model with market realities.
  • Collaborate across departments, gathering information from the source. Encouraging input from all departments gives you a 360-degree view of operations, creating a more precise model.
  • Your forecast will improve when you automate and link it to actual data sources or resulting key performance indicators (KPIs).
  • Conduct routine reviews of the forecast’s accuracy and determine how it deviates from the business’s actual cash flow. Once you understand the variance, refine the model to improve its predictive abilities.

Common Cash Flow Forecasting Mistakes to Avoid

Effective cash flow forecasting can enhance a business’s financial health, but several common errors can undermine its benefits. A few common mistakes to avoid during your cash flow forecasting process are:

  • Not updating projections frequently enough: Obsolete data can lead to outdated cash management strategies.
  • Failing to collaborate with operations teams: This can result in a lack of operational insights, hindering the model’s ability to make accurate projections.
  • Building overly complex models: Though you need to be thorough in your cash flow forecasting process, adding unnecessary complexity to your model can obscure key insights.
  • Not scenario planning for uncertainty: While a base case may likely materialize, it is essential to prepare for all contingencies. Failing to address other scenarios can leave the business unprepared for financial challenges that may arise.

Avoiding these common mistakes can ensure your cash flow forecast model is a reliable tool for business planning.

Conclusion

Understanding the cash flow forecasting meaning is crucial for businesses as it allows for strategic financial planning and cash management practices. The efficiency of a cash flow model depends on a clear understanding of forecasting methods and a keen eye for analyzing inconsistencies. By avoiding common pitfalls and embracing best practices, financial professionals can build formidable expertise in cash flow modeling, equipping businesses with the tools to make informed decisions for sustainable growth. 

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