This article will cover how to create a cash flow forecast in a business plan or for use within an existing business. If you’re just getting started, you may want to read our guide to creating a business plan. However, if you are looking for more specifics on making a cash flow forecast, this article is for you.
The cash flow forecast (or a cash flow statement) is one section of a business plan that people experience the most difficulty with.
Businesses fail for various reasons; however, ultimately, they close because they run out of cash. This means the better you manage your money, the more chance you have of keeping your business operating.
Preparing a cash flow forecast shouldn’t be that difficult if you follow a few simple steps. If you are applying for a business startup loan through the Startup Loans Company, the cash flow forecast will be the only financial statement you need to produce.
A cash flow forecast can be prepared in two ways: the Direct and Indirect methods.
Cash Flow Forecast – Direct Method
The concept behind the direct method is relatively simple. You will not need to produce a Profit & Loss as a basis of your income and expenditure assumptions. All you need to do is forecast the inflows and outflows of your bank account.
Because you are tracking cash flow, you need to take into consideration when your sales become cash.
- Cash-based businesses get paid immediately.
- Card payments usually are transferred into your bank account in 1-7 days.
- Invoices depend on your payment terms. Make your payment terms soon as possible, offer your customers an incentive for early payment. It is also wise to adjust late payments and bad debts.
Income / Sales
Predicting income can be difficult. You should produce a sales plan based on robust metrics depending on the business.
For example, if you have an online store, you need to forecast:
- Website Visitors
- Lead Conversion Rate (people who register on your website)
- Sales Conversion Rate (people who buy on your website)
- Order Value
- Order Volume by the customer over a period of time (this depends on the business)
Depending on your business type, you need to work out when you get paid.
Cash flow is tight for startups, so it would be prudent not to have payment terms exceeding 30 days.
Your plan should detailedly explain your startup costs, cost of sales (fees to produce your goods/services), administrative costs and asset purchases. Rising costs hit many small businesses as they grow. If possible, include a plan of keeping costs of using by procuring the best value goods and services.
To make a profit, ensure you have priced your goods or services to cover variable and fixed expenses. Variable costs are the costs that are incurred depending on your activity. It would help to structure your business model to make your expenses variable and depend on sales.
Think of all the costs you will incur to make sales: temporary staff, equipment, and food. The second variable costs are costs that you can control depending on circumstances. For instance, marketing can be a variable cost. You may increase your marketing spend on a special promotion like Christmas or reduce your marketing pay when business is slow.
Fixed costs will not change, and you have to pay for insurance, rent and rates. The amount is variable, but you will have to pay for them throughout the year. If you have permanent staff (including your own salary), you need to budget this within this section. Things to consider Seasonality – is your business seasonal? Does it pick up or ramp down at any particular time in the year? Include this in your cash flow.
Depending on the business’s legal structure, you will be obliged to pay income tax, whether personal or business, from the business. It’s usually paid in lump sums and will be a large amount. The same goes with VAT which is paid quarterly. Make sure you seek advice.
You will have to complete your cash flow for at least two years. Don’t be put off by this; make some broad assumptions about your business in the second year. For instance, if you want to grow year on year revenue by 20%, include this in your cash flow. To achieve this growth, you may need to increase staff, your marketing spending or buy additional equipment. Make sure you add these costs into your second-year cash flow.
Cash Flow Forecast – Indirect Method
The indirect method for calculating cash flow uses information from the P&L. A profit-and-loss forecast is a financial snapshot of where your business is headed. It looks at the money you expect to be paid and your likely outgoings.
The P&L always begins with the net income value. The net income is then adjusted for changes in the assets and liabilities account of the balance sheet by adding to or subtracting from net income to derive the operating cash flow. The indirect method can be very confusing for non-accountants, so it’s best to stick to the direct method if you can. The key things you need to take into consideration when preparing your cash flow forecast using the indirect method are:
Days Sales Outstanding (DSO)
DSO estimates the number of days a business takes to collect its outstanding accounts receivable. In the most simple terms, it’s a measure of how long it takes your customers to pay an invoice. The sooner you can get paid, the better.
Days Payable Outstanding (DPO)
Days payable outstanding (DPO) estimate the average time (in days) that a company takes to pay its bills and invoices to its trade creditors, including suppliers, vendors or other companies. A company with a higher value of DPO takes longer to pay its bills, keeping the funds longer. It may allow the company to utilise the cash in a better way to maximise the benefits.
The Matching Concept
The matching concept represents the primary differences between accrual and cash basis accounting. “Matching” means that the business reports revenues and expenses in the reported period. To match or present a true reflection of what occurs in a specific period, the P&L is adjusted by using accruals and prepayments.
Prepayments are amounts paid for by a business before the goods or services are received later. Any payment made in advance can be considered a prepayment. For instance, if you pay in advance for a year of a telephone contract, you would only include one-twelve of the contract value in your monthly P&L.
Accruals are the opposite of prepayments. Using the same example as the prepayments, let’s say you have used your telephone supplier for more than a year, but they haven’t invoiced you yet. Your business has still been using the service; you should include the cost in your P&L to reflect consumption.
To construct your cash flow forecast from your forecasted P&L should take these steps.
- Remember that a cash flow forecast is a forecast of your bank account, so it should include VAT. Your P&L should exclude VAT.
- Adjust sales for when you expect to get paid from your customers
- Adjust expenditure for when you plan to pay your suppliers
- Adjust cash flow to account for actual payment times for accruals and prepayment.
- Keep staff costs the same as the P&L.
- Adjust your cash flow for actual payments for stock or inventory
- Subtract depreciation costs in your P&L.
- Include in your cash flow any capital expenditure plans you may have.
- Take into account and Value Added Tax rebates/payments you may need to make or receive.
Preparing a cash flow forecast should estimate what you expect to spend and receive over a certain period. Look at your bank statements to work out trends. If you have no data to work from, be sure you are conservative with your income estimates and consider late payments and bad debts. On the expenditure side, always add in a contingency for emergency payments.
The main takeaway from this exercise is that your financial success or failure can be predicted by what you know now about the next few weeks of your projected expenses. Cash flow forecasting provides early warning signs so you can anticipate problems before they occur.
You can also get access to our Cash Flow Forecast template as part of our Business Plan Template. Click here to download it.