Just as the same cashflow cycles show up year after year, we keep seeing companies falling into the same cashflow hole.  The good news is that there is a better way! A well-prepared cashflow forecast is an early warning system that lets you spot signs of cash trouble months, or even years in advance system.  More importantly, it provides the time and space for businesses to take action to avoid a cash crunch.

The bad news is that cashflow forecasting, like most of life, follows the GIGO principle (garbage-in-garbage-out).  You can’t just grab a notepad and pencil or fire up Excel and expect to throw together a robust cashflow forecast in a few minutes.  It does take some effort, but the effort is worthwhile if it means you can enjoy Christmas lunch without worrying about where your next meal is coming from.

Thankfully, there are software tools like Castaway Forecasting available that make it easy to prepare your cashflow forecast the right way.  They will look after the calculations, freeing you up to focus on getting the assumptions right.

The goal when building a cashflow forecast is for the model to reflect reality as closely as possible.  The more realistic the model, the more reliable the outcomes, so the more confidence you can have in making the right decisions. To help you get there, I’ve boiled down the 5 principles of building a great cashflow forecast:

If you want to be sure your cashflow numbers are properly calculated, the only way to go is a 3-way forecast.  This is a special type of model that combines forecasts for all 3 basic financial reports for a business – the Profit & Loss, the Balance Sheet and the Cashflow Statement.  Banks love 3-way forecasts, because they know the cashflow numbers have ‘accounting integrity’.  They also provide a great sanity check to make sure you haven’t missed anything in your forecast workings.

Although it may sound complicated at first, the idea is that you forecast the Profit & Loss Statement (revenues, expenses, taxes and dividends) and the Balance Sheet (assets, liabilities and equity), and then the cashflow numbers will ‘fall out’ of movements in the 2 reports.  The great thing is that if the Profit & Loss numbers are realistic and the movements in the Balance Sheet seem sensible, then the cashflow forecast by definition will also make sense. 

In the real world, the cashflow pattern for, say, your Electricity Expenses line will be different to the cashflow pattern for Staff Wages, or Rent, or Stock Purchases.  Electricity Expenses might be paid quarterly, Staff Wages might have, say 70% of the cost being paid in the current month with 30% being held back to be sent to the Tax Office next month.  Rent might be paid one month in advance and Stock Purchases might involve a 30% deposit up front, with the other 70% paid 30 days after the goods are received.  

A good forecast will reflect these differences by using a separate set of Cashflow Attributes for every line.  This means a little more time in setting up the forecast, but the increase in accuracy is well worth it.

When putting a forecast together, you will often face a choice between entering static numbers or building the numbers up from the underlying operations drivers.

Consider these two alternative approaches.  If you decided to enter static numbers, (the first approach), you might enter $1,000 for revenue, $600 for Cost of Goods Sold and $1,200 for Closing Inventory. If you instead worked from drivers (the second approach), you might enter sales as 50 units being sold at $20 each. Cost of Goods Sold would be set as 60% of sales and you would hold 60 days of Closing Inventory.

Both methods will show the same results on the Profit & Loss and the Balance Sheet, so you might think the simplicity of the first method is more attractive. However, when it comes time to update the forecast, you will find the second approach far more useful.  Let’s say business has been good and you want to increase your sales forecast by 10%.  In the first approach, you would need to work out the new sales, COGS and inventory figures and then enter them into the forecast manually.  In the second, more dynamic approach, you only need to change the sales units (up to 55), the forecast will then automatically update the sales revenue, COGS and Closing Inventory numbers for you.

In business, the only constant is that things change. Customers come and go. Prices and margins change. The business environment changes.  As the world changes around your business, it is important that your cashflow forecast changes to match it.  We encourage our clients to review the forecast often (at least monthly) and update it where necessary so that it always reflects the ‘best view of the future’.   An out of date forecast is at best misleading and at worst dangerous as a basis for making business decisions. 

As economic times become more uncertain, our approach to forecasting needs to become more sophisticated.  Once you have a robust cashflow forecast in place, don’t stop there.  Create several copies of the model and test the cashflow impact of different scenarios – it could be general sales growth or decline, gaining or losing specific customers, taking on new product lines, buying new assets, or whatever is on your mind.

Remember, the point of forecasting is not to try to predict the future perfectly.  Rather, it is about working out what the future would look like if a given set of assumptions were to take place and then figuring out a game plan to deal with the situation.