What is cash flow forecasting?

What is cash flow forecasting?

Cash flow forecasting is a financial management approach that predicts future inflows (cash coming into your bank account) and outflows (amount of cash going out) for your business.

How are cash flow forecasts different from cash flow statements?

As opposed to a cash flow statement, which outlines cash inflows and outflows for a prior period, cash flow forecasts are forward-looking.

What data is included in cash flow forecasts?

Cash flow forecasts can be based on historical data from company financial statements like the income statement and balance sheet, including YTD revenue, inventory, and costs of goods sold.

What period of time should my cash flow forecast cover?

Cash flow forecasts are a dynamic tool that can be applied to several different time periods depending on the context.

Short-term forecasts – New businesses might find quarterly (i.e., 13-week cash flow forecasts) or monthly cash flow forecasts to be more insightful than a 5-year projection.

Medium-term forecasts – Growth-stage companies could find it helpful to project cash flow for the next 1-2 years.

Longer-term forecasts – Global enterprise companies eyeing international expansion might forecast the next 3-5 years.

Why is cash flow forecasting important?

Cash flow forecasting helps businesses maximize their liquidity, anticipate future cash positions, and avoid future cash shortages that could prevent your company from meeting its financial obligations (e.g., tax payments and payroll) and covering operational expenses.

In short, it helps you ensure you have enough cash in the bank to cover your costs and future investments.

When done right, cash flow forecasting provides several advantages.

Advantages of cash flow forecasting

Cash flow forecasting helps you:

• ‍Improve financial planning. Helps businesses plan their finances more efficiently by allowing them to anticipate future cash needs and ensure they have enough liquidity to cover expenses, invest, and meet financial goals. ‍
• Enhance your budgeting. Budgeting for the future is difficult if you don’t take time to forecast. With a clear picture of expected cash inflows and outflows, you can allocate funds to various expenditures and projects more confidently.‍
• Mitigate risks and identify opportunities. Identifying potential cash shortfalls or surpluses before they happen is a critical benefit of the cash flow forecasting process. Knowing well in advance is better when cash crunches could happen due to negative cash flow. The same goes for when you see an unexpected surge in revenue. You want to be prepared to act if and when these occur. For example, if you anticipate cash flow gaps occurring, you can take steps early to secure additional financing, adjust pricing, or manage company spending. ‍
• Make better strategic decisions. For example, businesses can assess whether they have the cash to make strategic investments, expand operations, or conduct M&A – moves to support long-term growth and competitiveness.‍
• Manage debt. It ensures that loan payments can be made on time without causing cash flow disruptions. This can help maintain a good credit rating and access to financing.

Cash flow forecasting example

To illustrate the concept, let’s use an example cash flow forecast model for an imaginary small retail business over the next three months.

Month 1: October

Starting Cash Balance: $10,000

Cash Inflows:

• Sales Revenue: $20,000 (based on historical data and sales projections)
• Other Income: $500 (e.g., interest income)

Cash Outflows:

• Cost of Goods Sold (COGS): $10,000 (the cost of items sold e.g. raw materials)
• Rent: $1,500
• Employee Salaries: $4,000
• Utilities: $500
• Inventory Purchases: $5,000 (restocking inventory)
• Marketing Expenses: $1,000
• Loan Repayment: $1,000

Net Cash Flow for October: -$2,500 (Cash Inflows - Cash Outflows)

• Ending Cash Balance: $7,500 (Starting Cash Balance + Net Cash Flow)

Month 2: November

Starting Cash Balance: $7,500

Cash Inflows:

• Sales Revenue: $30,000
• Other Income: $500

Cash Outflows:

• COGS: $11,000
• Rent: $1,500
• Employee Salaries: $4,000
• Utilities: $550
• Inventory Purchases: $6,000
• Marketing Expenses: $1,000
• Loan Repayment: $1,000

Net Cash Flow for November: $5,450

Ending Cash Balance: $12,950

Month 3: December

Starting Cash Balance: $12,950

Cash Inflows:

• Sales Revenue: $34,000
• Other Income: $500

Cash Outflows:

• COGS: $12,000
• Rent: $1,500
• Employee Salaries: $4,000
• Utilities: $600
• Inventory Purchases: $6,000
• Marketing Expenses: $1,000
• Loan Repayment: $1,000

Net Cash Flow for December: $8,400

Ending Cash Balance: $21,350

As seen in the cash flow forecast example above, although the company is expected to show a net cash outflow (burn) in October, forecasted strong sales in November and December are expected to drive a net cash flow increase during these two months.

Knowing this information would inform the business that meeting their financial obligations during Q4 shouldn’t be an issue.

Additionally, the business owner can confidently ramp up spending on inventory purchases and perhaps marketing expenses as well, given the expected increase in sales due to high product demand during the fourth quarter.

Common challenges with cash flow forecasting

Overly optimistic revenue projections

Assuming that your sales and revenue will always meet or exceed expectations can lead to overestimating cash inflows. Be realistic and base your future cash flow projections on historical data and market conditions.

Ignoring seasonality

Failing to account for seasonal fluctuations in cash flows can result in cash shortages during slow periods or excess cash during peak seasons. Seasonal adjustments are essential for accuracy.

Neglecting expenses

It's not just about revenue. Ignoring or underestimating expenses can lead to cash flow problems. Include all fixed and variable costs, including unexpected expenses.

Inaccurate timing

Timing is crucial. Recording income or expenses on the wrong dates can distort your cash flow forecast. Be precise in when you expect cash to be received or paid.

Overlooking accounts receivable and payable

Not factoring in the time it takes to collect receivables or pay bills can lead to inaccuracies. Calculate the timing of these transactions correctly.

Relying solely on historical data

While historical data is valuable, it's essential to consider changes in your business environment and market trends. Don't assume that the past will always predict the future accurately.

Ignoring debt service

If your business has loans or credit lines, failing to account for the timing, payment terms, and payment amounts can lead to cash flow problems. Ensure you include these in your forecast.

What is FP&A, and how is it related to cash flow forecasting?

FP&A, or financial planning and analysis, is a key function within the wider Finance organization responsible for financial planning, budgeting, forecasting, and analysis.

The FP&A department is crucial in helping companies make informed decisions backed by data, allocate resources efficiently, and achieve their strategic objectives.

Here’s how FP&A relates to cash flow forecasting:

Budgeting and forecasting

FP&A professionals create the company's annual budget and long-term financial forecasts. This includes projecting expected revenues, expenses, and cash flows.

Cash flow forecasting is a critical component of this process as it helps the organization understand how much cash it will have available in the future to meet its financial obligations and fund its initiatives.

Strategic business planning

FP&A teams collaborate with the CFO, extended finance team, and cross-functional leaders to align financial plans with the company's strategic goals. The goal: Provide insights that help you determine if you have the necessary funds to support initiatives like a new marketing campaign or product build-out.

Performance analysis

FP&A professionals regularly analyze the company's financial performance by comparing actual results to budgeted and forecasted figures.

Cash flow forecasts serve as a benchmark against which actual cash flows are measured. Deviations between forecasted and actual cash flows can indicate areas where the company needs to adjust its operations or financial strategies.

Risk management

Cash flow forecasting helps identify potential cash shortages or surpluses in advance. FP&A teams use this information to assess financial risks and develop mitigation strategies.

For example, if the forecast indicates a cash shortfall, the team may recommend drawing on a line of credit or reducing discretionary spending.

Working capital allocation

FP&A professionals help determine how the company allocates its financial resources. Cash flow forecasts are crucial in prioritizing projects and investments based on available cash. Projects that are expected to generate positive cash flows are typically given higher priority.

Useful tools for cash flow forecasting

If you aren’t careful, cash flow forecasting can be quite time-consuming. Like cash flow management, there are several forecasting software providers that FP&A managers might use to support this function:

Excel

Microsoft Excel is a prevalent tool in our finance toolkit, especially regarding cash flow forecasting. It offers flexibility and a deep pool of functions that, when mastered, can provide insightful forecasts. However, remember that effective use demands comprehensive knowledge of Excel's formulas.

Anaplan

For a more sophisticated approach, there's Anaplan, a cloud-based platform tailored for financial forecasting and planning. It's reliable and user-centric, with functionalities such as real-time updates and scenario modeling. Anaplan is impressive regarding scalability and coping with dynamic business needs.

Essbase

Oracle Essbase is designed for organizations that need to process complex financial data sets. It effectively tackles multifaceted forecasting that involves various variables and scenarios. Essbase is distinctively powerful when it comes to dealing with complex reporting and analytical needs.

Pigment

Pigment is an effective solution for volatile cash flows, offering an innovative blend of spreadsheets, business intelligence, and financial planning. With features designed for real-time updates and automation, Pigment can offer a significant advantage in controlling cash flow accuracy.

The FP&A Guy Paul Barnhurst has a helpful guide to FP&A tooling I recommend readers check out as well.

Easy-to-use cash flow forecasting template

To help you get started, we have developed a sample cash flow forecasting template you are free to adapt to your business.

Wrap-up: How Rho supports cash flow forecasting

Cash flow forecasting is one of the best ways to measure your business’s financial health.

A critical foundation for accurate cash flow forecasting is the ability to have a holistic understanding of how money moves in and out of your organization.

Rho enables finance teams to manage all their expense management, AP, banking, and treasury needs in one unified platform that syncs seamlessly with your ERP or accounting software.

Learn more about how companies like Anti Agency Group use the Rho platform’s banking and budgeting features to make finance frictionless.

Want to learn more about expense and budget management with Rho? Get in touch

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Reviewed by Sergio Borjas, VP of Finance, at Rho.