Prepare cash flow projections

Introduction:

It’s easy to assume that if your business is healthy today, it’ll be healthy tomorrow. But while optimism is important, so is understanding where your business stands financially–both now and in the future.

Monitoring your cash flow and knowing how to run periodic cash flow projections can help prevent future money troubles.

Cash flow projections are essential financial tools that provide a clear picture of the expected inflows and outflows of cash in a business over a specific period. They enable organizations to make informed financial decisions, assess liquidity, and plan for future growth. However, preparing accurate and reliable cash flow projections requires expertise and a deep understanding of financial management. 

What is a cash flow projection?

Cash flow projections predict the amount of money entering and leaving your small business. As the name suggests, this method uses cash flow to anticipate future business performance. And cash flow is the net amount of cash and “cash equivalents” that transfers in and out of your business.

This transfer occurs through accounts payable and accounts receivable. Accounts payable is money out, while accounts receivable is money in.

Why is cash flow projection important?

Cash is the lifeblood of a business. Businesses require cash flow to operate, and in the long term, negative cash flow can lead to a variety of issues for a business.

Most businesses face cash flow problems at some point.  A survey by QuickBooks found that 60% of small business owners reported that cash flow has been a problem. But if your business experiences negative cash flow, it may be easier to manage if you’ve had time to plan in advance. That’s where cash flow projections can help.

Many business owners mistakenly gauge their business’s health by looking at their business value in assets, intellectual property, and so on. But while these are important for attracting investors or selling your business, they won’t help you predict future business performance. They’re also not factored into cash flow calculations.

Running regular cash flow projections is important because it can help you steer your business toward the future. Rather than making critical plans based on present circumstances, cash flow projections use historical data to help you make a plan for the future, which can be more accurate. The right tools can help you generate accurate cash flow forecasts without requiring manual calculations or spreadsheets to create projections.

Advantages of Cash Flow Projections:

Forecasting Financial Health: Cash flow projections allow you to forecast your business's financial health by estimating the timing and amount of cash inflows and outflows. This empowers you to anticipate potential cash shortages or surpluses and take proactive measures to manage them effectively.

Improved Decision-Making: With accurate cash flow projections, you can make informed decisions regarding investment opportunities, expansion plans, inventory management, and financing options. These projections provide valuable insights into the financial feasibility and risks associated with various business initiatives.

Effective Budgeting and Resource Allocation: Cash flow projections serve as a foundation for budgeting and resource allocation. By identifying cash needs in advance, you can allocate resources efficiently, prioritize expenses, and plan for contingencies, ensuring the financial stability of your business.

Identifying Financing Requirements: Cash flow projections help you assess your funding requirements and identify the need for external financing. This enables you to approach lenders or investors with a well-documented financial plan, increasing your chances of obtaining the necessary capital for growth and expansion.

Disadvantages of PREPARE CASH FLOW PROJECTIONS:

Uncertainty and Inaccuracy: Cash flow projections are based on assumptions and estimates, making them inherently uncertain. Factors such as market conditions, customer behavior, and economic fluctuations can affect the accuracy of projections. Any inaccuracies or unforeseen changes can impact the reliability of the projected cash flows.

Limited Predictive Power: Cash flow projections are based on historical data and future assumptions, which may not capture unexpected events or external factors that can significantly influence cash flow. Changes in the business environment, regulatory changes, or unexpected disruptions can render projections less reliable

Lack of Flexibility: Cash flow projections are typically prepared for a specific period and are not easily adaptable to dynamic business situations. If significant changes occur during the projection period, such as new investments, acquisitions, or shifts in market conditions, the projections may not accurately reflect the updated financial reality.

Dependency on Assumptions: Cash flow projections heavily rely on assumptions, including revenue growth rates, expense levels, payment terms, and market trends. If these assumptions turn out to be unrealistic or inaccurate, the cash flow projections can lead to flawed decision-making and financial planning.

Limited Scope: Cash flow projections primarily focus on cash inflows and outflows, neglecting non-cash elements, such as depreciation, non-cash expenses, or changes in working capital. This limited scope may result in overlooking important financial indicators or potential risks.

Overemphasis on Short-Term Perspective: Cash flow projections often prioritize short-term cash flow management, which can lead to neglecting long-term strategic considerations. It's important to balance short-term cash flow needs with long-term growth and investment objectives.

External Factors Beyond Control: Cash flow projections may not account for external factors beyond a company's control, such as changes in government regulations, shifts in industry dynamics, or unforeseen events like natural disasters or economic crises. These factors can significantly impact actual cash flow and render projections less accurate.

How to Prepare a cash flow projection

Small business owners should take the time to understand their cash flow. Not just to build a solid cash flow projection, but so they can recognize areas of opportunity and potential shortfalls. Follow these steps to perform a month-by-month, year-long cash flow projection. Or use them as a jumping-off point for further talks with your bookkeeper, regarding cash flow projections.

Step-by-Step Guide to Creating a Cash Flow Projection

Step 1: Choose the Type of Projection Model

Determine the appropriate projection model based on your business needs and planning horizon.

Consider the following factors when choosing a projection model:

1. Short-term Projections: Covering a period of 3-12 months, these projections are suitable for immediate planning and monitoring.
2. Long-term Projections: Extending beyond 12 months, these projections provide insights for strategic decision-making and future planning.
3. Combination Approach: Use a combination of short-term and long-term projections to address both immediate and long-range goals.

Step 2: Gather Historical Data and Sales Information

Want to determine where you’re going? Take a look at where you’ve already been. Collect relevant historical financial data, including cash inflows and outflows from previous periods.

Analyze sales information, considering seasonality, customer payment patterns, and market trends.

Step 3: Project Cash Inflows

Estimate cash inflows based on sales forecasts, considering factors such as payment terms and collection periods.

Utilize historical data and market insights to refine your projections.

Step 4: Estimate Cash Outflows

Identify and categorize various cash outflows components, such as operating expenses, loan repayments, supplier payments, and taxes.

Use historical data and expense forecasts to estimate the timing and amount of cash outflows.

Step 5: Calculate Opening and Closing Balances

Calculate the opening balance for each period, which represents the cash available at the beginning of the period.

Opening Balance = Previous Closing Balance

Calculate the closing balance by considering the opening balance, cash inflows, and cash outflows for the period.

Closing Balance = Opening Balance + Cash Inflows – Cash Outflows

Step 6: Account for Timing and Payment Terms

Consider the timing of cash inflows and outflows to create a realistic cash flow timeline.

Account for payment terms with customers and suppliers to align projections with cash movements.

Step 7: Calculate Net Cash Flow

Calculate the net cash flow for each period, which represents the difference between cash inflows and cash outflows.

Net Cash Flow = Cash Inflows – Cash Outflows

Step 8: Build Contingency Plans

Incorporate contingency plans to mitigate unexpected events impacting cash flow, such as economic downturns or late payments.

Create buffers in your projections to handle unforeseen circumstances.

Step 9: Implement Rolling Forecasts

Embrace a rolling forecast approach, where you regularly update and refine your cash flow projections based on actual performance and changing circumstances.

Rolling forecasts provide a dynamic view of your cash flow, allowing for adjustments and increased accuracy.

Benefits to cash flow projections

Once you know how to create a cash flow projection, you’ll find plenty of benefits to measure future performance this way.

1. Understand your money and where it goes

For many small business owners, cash on hand doesn’t last long. Bills and unexpected emergencies can drain your business’s cash balance and derail your business growth. That’s why it’s critical to know when to pivot and when to stay the course.

A cash flow analysis can help you determine any consistent causes of negative cash flow. And, hopefully, show you when, historically, you have enough cash in your bank account to invest or spend. From there, a cash flow projection can help you understand and predict future cash inflow and cash outflow.

2. Make more confident business decisions

QuickBooks found that nearly three in five small business owners (59%) report that they have made a poor business decision due to concerns about insufficient cash flow. Cash flow projections don’t just increase your understanding. They also help you act with confidence. 

Knowing how your business will perform in the coming months, based on actual cash flow data, can enable you to make informed decisions. You can say with confidence if now is a good time to invest in a new opportunity or put money aside. For instance, you may find that, right now, you’re in a period of negative cash flow. But if the coming month looks positive, there’s less need to postpone investments.

3. Convince others to trust your plans

Budgets help you stay on course, but cash flow projections show you and others where your business is going. Outsiders—even insiders sometimes—need to know your business’s financial health is sound. Cash flow statements and cash flow forecasts can work together to help them understand your business’s current and future performance.

Accurate financial statements and cash flow forecasts may help you secure a business loan when you’re ready to grow your business. A solid cash flow projection may help you gain future investors or win a new business contract. It could also make your company more attractive to buyers.

4. Prevent problems before they arise

While cash flow projections can’t always predict events, they can help you prepare for the worst. For instance, let’s say you know when your business is most cash flow positive. That’s a great time to put aside some extra savings in an emergency fund. Then, if there’s a hiccup, you have a cushion to prevent negative cash flow.

Another example is unpaid invoices. A cash flow projection might tell you there’s a time when those outstanding payments tend to stack up. If you know that problem is likely to occur, you may prevent it with additional communications or early payment incentives.

Elements Require to Create Cash Flow Projection

Here are all the elements you’ll require to create a cash flow projection:

1. Opening balance 
2. Money received. This could include cash sales, investments, and more.
3. Money expended. This could include payments, materials, marketing effort cost, payroll and taxes, bills, loans, and more.
4. Cumulative money received and money expended.
5. Total cash flow for the period
6. Closing balance

Cash Flow Projection FAQs

How do you prepare a projected cash flow statement?

Steps to prepare a projected cash flow statement:

1. Analyze historical cash flows.
2. Estimate future sales and collections from customers.
3. Forecast expected payments to suppliers and vendors.
4. Consider changes in operating, investing, and financing activities.
5. Compile all these estimates into a projected cash flow statement for the desired period.

What is a 3-year projected cash flow statement?

A 3-year projected cash flow statement forecasts cash inflows and outflows for the next three years. It helps businesses assess their expected cash position and plan for future financial needs and opportunities.

What are the 4 key uses for a cash flow forecast?

1. Evaluate cash availability for operational expenses and investments.
2. Identify potential cash flow gaps or surpluses.
3. Support financial planning, budgeting, and decision-making.
4. Assist in securing financing or negotiating favorable terms with stakeholders.