Cash flow forecasting: definition, objectives, benefits & techniques

category cash forecasting

by Stijn Boon

reading time 7 min

Cash flow forecasting

Determining what to do next is a decisive moment for business success. Strategic decisions need to be planned thoroughly, and the decision-makers must ensure business continuity and future growth. However, strategic decision-making is often hindered by a lack of financial visibility into the future, slowing down the whole company. 

 

In order for businesses to make informed and quick strategic decisions, they need to know what their financial situation will be in the future. Cash flow forecasting helps with this. In this article, we will discuss everything about cash flow forecasting: its definition, why you need it, its objectives, what goes into it, the techniques, and its challenges and benefits. 

 

What is cash flow forecasting? 

Cash flow forecasting is a cash projection process to estimate the financial position of a business over a specific period of time. It is measured by comparing the cash in- and outflows of the business in the future. 

 

When done accurately cash forecasting helps businesses predict their future financials. It can help with identifying potential cash surpluses or shortages and that information is essential for making informed strategic decisions. 

 

Both finance and treasury teams are primarily responsible for forecasting cash flows. They collect all required data from different business stakeholders and a variety of financial and other systems and combine them to run analyses on future cash positions at certain given times. 

 

Why is cash flow forecasting important? 

Cash flow forecasting is important because it enables businesses to make informed strategic decisions by having an accurate picture of what their cash position looks like in the future. If your cash flow projections show a weak financial status of the business going forward, you should re-consider making bigger investments in the short term. At the same time, a stronger forecasted cash position supports making confident decisions when allocating cash to new investments because there are enough funds available in the future. 

 

Predicting future cash flows also helps to identify scenarios where your business will run out of money, giving you the time to proactively prevent that from happening. For example, you should start to cut costs, apply for extra financing, or boost sales as a result. 

 

Objectives of cash flow forecasting 

The objectives of cash flow forecasting depend on each business individually. Typically, businesses still share a few common objectives that provide them with valuable insights to action:

 

Liquidity planning and liquidity risk management

One of the core objectives of cash forecasting is making sure there is enough cash in the future to be able to pay short-term obligations to creditors and suppliers.

 

Meeting reporting requirements

Periodic reporting requires teams to have finished projections of cash positions at certain times of the year. These deadlines need to be met.

 

Developing strategies

Cash forecasting can reveal a lot about where cash flows are deriving from. For example, forecasts can show higher in- or outflows related to certain projects or entities. This allows your business to reflect on current and future strategies based on project-specific performances.

 

Prepare for different scenarios

Most businesses prepare themselves for different cash flow scenarios, compare them, and prepare actionable plans for all of them in case they occur. Best-case scenarios show forecasts that are highly optimistic. Worst-case scenarios are built on pessimistic cash flow projections. Most-likely scenarios illustrate what is most likely to happen to your cash position.

 

Provide shareholder value

For obvious reasons, shareholders are interested in the cash flow forecasts of a company to see how the company will perform in the future. Future cash flows can also heavily affect a company’s valuation, which shareholders are continuously examining.

 

Attract additional financing

Cash flow forecasts play an important role when you have the objective to attract additional financing. New investors or creditors will always scrutinize your future cash flows and will require you to show elaborated forecasts. 

 

What is included in a cash flow forecast?

When you develop a cash forecast there are certain elements that you should always consider including:  

 

Opening balances: include your opening cash balance that reflects your current cash position. You can then analyze how your forecasts will affect your current cash position.  

 

Cash inflows: all the cash that is flowing in including sales, tax refunds, funding, grants, investments, and other inflows. Add them up to calculate your total inflows. 

 

Cash outflows: all outflowing cash for the projected period including salaries, rent, raw materials, assets, marketing, taxes, credits, loans, fees, investments, and other outflows. Add all of them up to get your total outflows.  

 

Cash forecasting periods 

Before starting to project your cash flows you need to consider the time horizon that you wish to forecast. This can depend on the requirements as to why you are running the forecast. Typically, there are three different time horizons for cash forecasting:

 

Short-term cash flow forecasting

Short-term cash flow forecasting is for a period of thirty days from the moment you start running the forecast. They provide you with a good day-to-day breakdown of cash receipts and payments of different bank accounts.

 

Medium-term cash flow forecasting

Medium-term cash flow forecasting estimates forecasts over a period of one month to six months or even a year. It provides a better picture of average cash positions instead of day-to-day breakdowns as with short-term forecasting. For some businesses, it can be possible that it does not make sense to forecast for up to a year depending on the industry they are in.

 

Long-term cash flow forecasting

Long-term cash flow forecasting typically covers periods exceeding one year. It includes long-term expected in- and outflows. The longer the period of the forecast becomes, the less reliable the outcome is. Yet, some cash flows can be predicted over a longer period of time, such as longer-term repayment schedules, interest payments, and other stable in- or outflows. 

 

Cash flow forecasting methods 

Cash flow forecasting has two primary methods: direct and indirect forecasting. There is no right or wrong cash flow forecasting method, it all depends on the objectives your business has.

 

Direct cash flow forecasting

Direct cash flow forecasting simply compares cash in- and outflows. Essentially adding all the cash inflows and deducting the cash outflows, result in your cash position over a period of time. Direct forecasting is typically a highly accurate outcome because the time horizon is short-term, and the calculations are based on actual cash flows. However, in the long term, it becomes increasingly difficult to predict this data. The result of direct forecasting provides you with a good picture of your company’s working capital.

 

Indirect cash flow forecasting

Indirect cash flow forecasting covers the long-term and is based on forecasted income statements and balance sheets. Indirect forecasting provides you with insight into the cash available to use for growth strategies and external funding because it is focused on the long-term.

 

Sensitivity analysis

Many larger organizations also subject their long-term cash flow forecasts to a sensitivity analysis, which takes into consideration fluctuating changes such as currency risks, interest rates, market trends, competitors, and economic conditions. This results in several ‘what if’ cash forecasting scenarios that businesses can then prepare for. 

 

How do you build a cash flow forecast? 

Once you have decided on your preferred method of cash flow forecasting it is time to start building the cash flow forecast based on what is included in that method and your set time horizon. It is recommended that you start collecting all the necessary data in a consolidated place where you can then start running cash forecast scenarios without having to consult other source systems all the time.

 

The different sources that you should pull your data from include ERP systems, banks, treasury management systems, subsidiaries, spreadsheets, payment hubs, accounting software, AR and AP solutions, etc. Basically, every source that includes relevant data is required to cash in and outflows. Also consider whether you want to do your cash forecasting on a group, subsidiary, geographical, or any other level.

 

The next step is to organize the consolidated data in a logical manner. There are many different cash flow forecasting templates out there that you can use. Here are some examples of cash flow forecasting templates that we like to use.

 

For granular short-term forecasts on a daily basis, as in the example below, we consider all outflows and inflows, the net cash flow, and the closing balance for each day. This gives you great insight into your day-to-day cash flows. 

Short-term cash flow forecast

 

For longer-term forecasts, we like to use reports that show forecasts on a weekly, monthly, or yearly basis, with cash flows categorized into groups, that you can expand to analyze detailed information about each in- and outflow.

Long-term cash flow forecast

 

Tables provide good overviews of how your cash flow forecasts are doing, and with the right visualizations such as graphs or charts, they can even show trends and patterns that would otherwise be hard to identify. We recommend using a combination of the three to enable optimal analyses. 

Cash flow forecast visualization

 

The way you present your cash flow forecasts often depends on those to whom you report and their requirements. In addition, you should consider the objectives that you were trying to reach and see whether your reports match them. 

 

What are the challenges of cash flow forecasting?

There are several challenges that finance and treasury teams face related to cash flow forecasting. These are important to understand and should be tackled by businesses in order to efficiently produce accurate cash flow forecasts.

 

Most challenges relate to a significant amount of manual work that goes into cash forecasting and a lack of automation that businesses should be leveraging. Though spreadsheets are considered the norm in finance and treasury, they are by no means scalable when your business grows. They inevitably lead to mistakes and errors when you need to combine data from many systems, subsidiaries, banks, and contributors. This can be tackled by having a centralized and automated system in place that automatically collects the right data from all source systems.

 

Businesses typically also struggle with setting accurate long-term cash flow projections based on historical data as well as scenarios with external influences. Finding historical trends and patterns and including them in your forecasts can be challenging. Running multiple scenarios with external influences also requires extra work, not to mention the work that goes into developing follow-up plans. To tackle these challenges, you can also start looking into a cash flow forecasting solution that can help you.

 

The benefits of cash forecasting 

Forecasting cash flows help business understand their cash positions at different points in time in the future. As a result, it allows you to make informed decisions that can mitigate risk when financial health is weaker or capitalize on growth opportunities when cash flows are positive. The main benefits of cash forecasting are:

 

Strategic planning 

Cash flow forecasting enables businesses to do strategic planning. While negative cash forecasts may require strategic decisions to boost inflows and cut outflows, positive cash flows can provide extra investment opportunities to expand the business further. Based on different forecasted scenarios you can adapt the strategic plans of the business and stay agile.  

 

Mitigate risk 

Whenever your cash flow forecasts indicate financially challenging times you can immediately take action to start mitigating any financial risk. This allows organizations to become proactive rather than reactive.  

 

Analyze working capital 

Cash flow forecasting provides great insight into your current assets and liabilities and enables you to manage them better. For example, accounts receivable and accounts payable are tough to forecast because they depend on multiple external variables such as customer behavior, payment methods, goods deliveries, and much more. By identifying inefficient and unpredictable patterns you can start enforcing improved practices to create better continuity with receivables and payables, allowing you to better forecast your future cash positions as a result. 

 

Tracking outflows 

During cash forecasting, it is the ideal time to examine cash outflows to see what they consist of and whether there are costs that you want to change in the future. By re-evaluating your costs, you can also re-allocate certain investments to match new strategies. 

 

Cash flow forecasting tools and automation 

Depending on the complexity of your technology stack as well as the size of your organization it is worth looking into the different cash flow forecasting tools that are available on the market. They can help you automate cumbersome routine tasks while making cash flow forecasts increasingly accurate. The ideal solution can automatically centralize all the required data for forecasting from different source systems, regardless of different data formats. 

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