Why Cash Flow Forecasting Is Crucial for Small Businesses
Having enough cash to run your business is often the key difference between staying afloat and filing for bankruptcy. Yet, even with accounting solutions becoming more accessible than ever, many small businesses still find it difficult to consistently and accurately forecast their cash flow.
What is cash flow forecasting?
Cash flow forecasting is about predicting when money will move in and out of your bank account in the future. With online banking and app development, it’s now relatively quick and easy to see how much cash you have in the bank today, but if you want to know what your bank balance will be next week, next month, or next quarter, you need either a list of all planned income and expenditure or a model that will help you make a prediction.
There are two different kinds of cash flow forecasting.
The first is the indirect method, which derives a forecast based on financial documents, including your balance sheet, profit and loss, and cash flow statement. The second type is the direct method, which shows you a picture of your cash based on the due dates of your open invoices and bills combined with your own forecasts. The direct method shows you how much you will actually have in the bank at a given point in the future.
Indirect (or three-way forecasting) is generally the method used for long-term strategic forecasting. It doesn’t include the same level of detail, so the accuracy won’t be as high. The direct method, which brings much more granular details, is generally preferable for operational cash flows in the short- to midterm.
Why is cash flow forecasting important?
Knowing your cash flow can help you:
1. Know whether you can meet your financial obligations
The amount of cash your business has in the bank will dictate what you can and can’t do. For example: It’s the end of the month and you need to pay your employees. It doesn’t matter how much money you are owed; either you have the ability to pay your staff or you don’t. This is just one example of why it is incredibly important for business owners to know how much money will be available to them at any point in the future.
2. Use scenarios to plan for the future
Are you thinking of hiring new staff or buying new equipment? Doing a cash flow forecast with different “what if” scenarios helps you see whether you can afford it. In any eventuality, or different “future,” you need to properly plan where your cash is going to understand whether it’s doable.
3. Track spending and stay on budget
Having an overall idea of how much comes in and out of your business is great, but are you always right? With a cash flow forecast that has been updated with actual figures, you can compare your best guess to what really happened, helping you see if you need to revise your forecasts up or down based on reality.
4. Pay your suppliers on time and in full
Maintaining a positive organizational culture will require you to be a responsible and timely payer. Forecasting how much cash you will have in the bank will show you whether this is possible or it’s time to manage expectations with suppliers. In addition, by making timely payments, you will also cultivate a positive relationship with your suppliers, making them more likely to do you favors down the line.
5. Spot gaps and address them in good time
For many businesses, cash is unpredictable, coming infrequently and in big chunks. It is important to place your company in a position to respond rapidly and effectively should a big gap appear to prevent a cash crisis, and enable you to meet your short-term obligations such as payroll.
It could be that you have paid for materials before your client pays you, or maybe there’s a gap coming up between jobs. Forecasting your cash flow will help you understand whether you can weather the storm, have to put short-term funding in place, or need to make cut backs. Properly forecasting your cash flow will better prepare you for the future and more serious discussions with your stakeholders. You need to know when you’re over or under budget, so you can adapt your forecast moving forward.
6. Prepare yourself for external changes
What if a supplier increases their rates? Or an investment you thought you had secured gets delayed? Any external change may directly affect your cash flow. Looking to the future, not to the past, will help you understand the repercussions of such a change. It is this information that will guide you through crucial operational decisions.