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 a variety of 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 as long as you follow a few simple steps.
If you are applying for a business startup loan, the cash flow forecast will be the only financial statement you need to produce. You will not have a Profit & Loss as a basis of your income and expenditure assumptions.
A cash flow forecast can be prepared in two ways, the direct method and the 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 is an estimate of the number of days it takes a business 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) is an estimate of the average time (in days) that a company takes to pay its bills and invoices to its trade creditors, which include suppliers, vendors or other companies.
A company with a higher value of DPO takes longer to pay its bills, so it keeps the funds for a longer duration. It may allow the company an opportunity to utilise the cash in a better way to maximise the benefits.
The matching concept represents the primary differences between accrual accounting and cash basis accounting. “Matching” means that business reports revenues and the 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 being received later on. 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; then 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 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 take into account 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.
The direct method is much simpler. You won’t need to deconstruct your P&L and make adjustments. You just forecast inflows and outflows of your bank account.
How To Prepare A Direct Cash Flow Forecast Step By Step
A Cash Flow Forecast comprises the following sections:
Predicting income can be difficult, but if you understand your marketing and sales plans, know when you will make sales. 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 how you will keep costs of using by procuring the best value goods and services.
Variable costs are the costs that are incurred depending on your activity. You should try to structure your business model to have as much of your expenses to be variable and depend on sales. To make a profit, ensure you have priced your goods or services to cover variable and fixed expenses. Think of all the costs you will incur to make sales; this could be temporary staff, equipment, food.
The second variable costs are costs that you can control depending on circumstances. For instance, marketing can be a variable cost as you may increase your marketing spend on a special promotion like Christmas or reduce your marketing pay when business is slow.
Fixed costs are costs that 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 certain time in the year. Include this in your cash flow.
Taxation – depending on your legal structure of the business, 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. Make sure you seek advice. Same goes with VAT which is paid quarterly.
Future Years – 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 what your business will be 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 spend or buy additional equipment, make sure you add these costs into your second-year cash flow.
Preparing a cash flow forecast should be an estimate of 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 take into consideration some late payments and bad debts. On the expenditure side, always add in a contingency for emergency payments.