“Forecast - to calculate or predict (some future event or condition) usually as a result of study and analysis of available pertinent data.”  (Merriam-Webster Online Dictionary)

Introduction

Producing accurate and timely financial statements - the Balance Sheet, Income Statement, and Statement of Cash Flows – are absolute necessities for all businesses regardless of size.  Their purpose is historical in nature – and is vital for reporting past company operating results to owners, investors, creditors, as well as various taxing and government authorities.

However, to assist entrepreneurs of small and mid-size companies make better business decisions, a forward looking management information tool needs to be employed – the Cash Flow Forecast.  All business owners know that positive cash flow is what keeps their business alive.  Running out of cash is among the most devastating events that any business can experience.  The cash flow forecast helps predict future cash flows, under normal operating conditions, as well as under alternative scenarios using various assumptions, to help plan for their company’s future working capital needs.

Preparing a Cash Flow Forecast

Depending on the type of business and the use of the forecast, a cash flow forecast can be laid out in various formats - such as a 13-week (one fiscal quarter), 12-month (one fiscal year), or multi-year formats.  Historical data needs to be available so it can be referred to in developing any forecast of future activity.  Developing a cash flow forecast requires a systematic approach to projecting the sources and uses of cash in future periods.

Sources of Cash

The beginning of the cash flow cycle always begins with sources of cash, which is a forecast of sales.  This can be done at the company level but it would be a more useful tool if sales were forecasted at the product line level, using product-specific quantity and pricing assumptions.

Next, we will have to understand how those sales convert into cash receipts.  The sale to cash conversion cycle depends on your company’s particular business model – cash is received either immediately as transactions are completed, or over time under credit and billing terms.  If customers were typically billed, then we would apply the historical average Days Sales Outstanding (DSO) ratio (which measures average collection time to convert sales into cash receipts) to each period’s sales.  This will allow us to determine the amount of cash we expect to receive each period that we are forecasting.

Uses of Cash

With the cash receipts forecasted, we can start forecasting cash disbursements.  Typically, we would start by forecasting cost of sales, including direct labor, direct materials, and indirect overhead costs; preferably, we will do this at the product level.  After we have forecasted the costs of sales, we need to translate these costs into cash disbursements, which are determined by the various timings of disbursements.  For example, internal labor would be forecasted based on normal payroll cycles.  For all other items in cost of sales, it would be based on average vendor terms, whether that is 30 days, 45 days, etc.  Next, we would forecast operating expenses such as administrative and sales costs, research and development, other expenses, and taxes.  After projecting these costs by period, we would again apply the same timing techniques described above to determine the timing of cash disbursements for these items for each period being forecasted.  After incorporating the cash balance at the beginning of the period we are forecasting, we can see in advance, the level of fluctuations in our operating cash flow.

Now What?

It is at this point that we can start to plan what to do about any extreme fluctuations in the forecasted cash flow.  By looking at the drivers of our cash flows, we can determine what, if anything, we need to change in our business model to achieve a positive cash flow.  We may need to plan for ways to increase sales, or change the timing of expenditures, or we may need to discuss with our local banker the use of short-term credit lines.

The cash flow forecast takes the surprises and the guessing out of operating a business, and it allows you time to plan what your response will be to potential cash deficits, or even surpluses that are forecasted in your company’s operations.

Contact William Wright at (757) 685-2455 or by email at wwright@b2bcfo.com