Success of a business is dependent on adequate management of the cash flow. According to research by a U.S Bank, 82% of business failures are caused in part by cash flow challenges. Let’s take a moment to understand what cash flow management is and how a business can use this essential tool for effective management.
What is cash flow management and how can we improve it?
Cash flow management is all about adequate management of the cash resources to fulfill business needs.
It can be enhanced by appropriately anticipating plans for future cash needs. Adopting the proactive approach of cash forecasting can be the best tool indeed. Cash flow management enables a business to focus on small operational details connected to the whole financial spectrum. It also helps assess if a business has sufficient cash flow to meet its operational needs in the future.
When a business can forecast which payments and/or collections are expected, it can manage business needs and expectations properly. Moreover, such refined information can also help manage liquidity and reduce the risk of business failure. This process can be assisted by the adoption of working techniques introduced by cash flow forecasting.
What is cash flow forecasting?
Cash flow forecasting is the process used by businesses to estimate cash movement in and out of business. It helps businesses to predict future needs of cash to avoid shortages at the eleventh hour. Let’s discuss the steps that how cash forecasting works and how you can make the best use of it.
1. Set your forecasting objective
Clearly set the objective of your cash flow forecasting. Why are you doing it? What do you hope to achieve? Set a vision for the forecasting activity. In other words, what does the business want to achieve with the forecasting process? The motive may include:
- Managing operational/ongoing cash flow to ensure smooth daily operations.
- Repayment of debt/reduction of some financial obligation.
- Expansion/growth planning for the business
2. Set the period of forecasting
Setting a reasonable period for forecasting is important. This may vary from one business to another but generally, the longer the forecast the more the assumptions and therefore the higher the chances of failure. Longer periods of forecasting may compromise accuracy and predictability. It’s important to find a balance between the forecasting objective and the period covered.
3. Decide method of forecasting
There are two methods of forecasting that include direct and indirect methods. The direct method uses actual flow data, and the indirect method depends on the projected balance sheet and income statement. Following are some of the key differences between these methods.
Direct method
Direct cash flow forecasting predicts when cash will be coming in and out of the business at specific points in time. It tries to identify when payments will be made on the exact day or week in a month. For example, when the payment has actually been made rather than when the invoice was sent out. As the forecast is based on predicted actuals, it creates more accuracy especially in the shorter-term.
The direct method includes all types of transactions including credit and cash transactions as well as bills, invoices and tax.
Indirect method
The indirect method of cash flow forecasting is more widely used amongst businesses. It is a simpler process that uses the balance sheet and profit and loss statements in order to predict cash flow.
This process comes in handy when there is a higher volume of transactions. By using data that has already been recorded, you have the information needed to put together your cash flow. The data is converted to the cash flow by adjusting the net income to a cash basis.
Data from the balance sheet is used to determine any cash from operating activities by adding in depreciation and earnings before interest and tax. It also predicts cash flows from investments and potential loans. Taking information from the profit and loss statement and balance sheet can help to predict long-term growth for the business.
4. Gather item-wise details to complete the forecast
Direct method
A business needs to have access to the following key details to process its cash flow forecast.
Opening cash position
These figures can be obtained from the closing of the last accounting period.
In period cash inflows
All receipts of the business are forecasted. The receipts may include revenue from customers, dividend income, collection of accounts receivables, other income, proceeds from divestment, and any other expected receipt during the period.
In period cash outflows
All payments of the business are forecasted. The payments may include expenses, payment to suppliers, payment for the accounts payable, payment for the interest, dividend payment, loan repayment, capital repayment, or any other activity involving the cash outflow.
Benefits of cash forecasting
While it is probably clear by now how cash flow forecasting can help a business, here’s some key highlights:
- It helps to encourage critical thinking within an organization. Further, it helps to enhance coordination among different departments of the business.
- It helps the business to arrange for payments falling due.
- It provides business management a certain direction to make a decision for financing and other matters related to money.
- The business can better estimate the timings of investment/divestment and the purchase of equipment etc.
- If the business does not have cash forecasting practices, it may have to face liquidity problems. Sometimes, these problems may be so severe that they lead to liquidation.
Limitations of Cash Forecasting
However, cash flow forecasting isn’t a silver bullet solution. Depending on how the process if followed, it has limitations:
Forecasting is just an estimate of the future, and it can never be 100% accurate.
There may be little use of cash forecasting if the business operates in a highly dynamic environment.
All the unforeseen factors may not be incorporated in the process of forecasting. Hence, leading to inaccurate forecasted figures.
There is inherent uncertainty in predicting the future, which can be reduced to a little extent despite applying certain safeguards.
Conclusion
Cash management is one of the essential aspects of adequate business management. A business’s need to ensure the adoption of effective cash management practices.
Cash flow forecasting can be an excellent tool to manage the business’s cash needs in line with the purpose of its existence. In addition, cash forecasting helps encourage an overall environment of critical thinking and enhanced coordination between different departments of the business.
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