Best practices for cash flow forecasting

Whether you are managing inventory or planning an acquisition, to maintain day-to-day operations you need a clear cash flow forecasting process. Staying on top of cashflow means you can gauge your solvency and profitability from a long and short-term perspective.

However, without knowing how much your business makes and spends while making budgeting decisions, you could easily let your outflows eclipse your inflows — resulting in shortfalls that throw your operation into the red.

The good news is you can gain insight into your cash flow and then use that data to make sound financial planning decisions that ensure the health and stability of your business. The gold standard is 3-way forecasting or three statement modeling, which provides deeper, more comprehensive insights into your future cash flows. Here are some best practices for setting up a cash flow forecasting system and how to incorporate 3-way forecasting to help you steer your business toward a more profitable future.

What is cash flow forecasting?

Cash flow forecasting is a financial planning process that involves estimating the future cash inflows and outflows of a business over a specific period. It provides a detailed projection of expected cash movements, helping to predict how much cash will be available at any given time. Business planning and analytics programs often have 3-way forecasting which syncs changes across all three financial statements providing a complete plan for cash forecasting. 

How to forecast cashflow

To perform cash flow forecasting, you choose a specific period and then estimate your receipts and payments, factoring in their timing.

However, the “what” isn’t as important as the “why.”

Suppose your company identifies another, smaller organization that has branches you’d love to add to your portfolio. You quickly realize that an acquisition would make more sense than investing millions of dollars and thousands of hours in setting up these offices.

But how do you know whether you’ll have the cash needed to fund the deal or establish financing to make it go through? Furthermore, how can you time the acquisition, so it doesn’t drain your cash and threaten cash-dependent operations?

Using cash flow forecasting, you can approximate how much cash you must put towards an acquisition and how much you should finance. You can also use your forecasts to pinpoint the best time to do the deal so it doesn’t impact your solvency.

In short, cash flow forecasting gives you greater peace of mind, regardless of your financial goals. Whether you use long—or short-term forecasts, your system can prevent shortages and ensure you have the right amount of cash for your business needs.

Best practices for cash flow forecasting

Using these best practices, you can improve the accuracy of your cash flow forecasting and ensure your data is actionable.

Ensure accurate data collection and storage

The foundation of your cash flow forecasting system is accurate data collection and storage because this results in dependable, accessible financial data. The data you gather and consolidate can include financial information from your ERP system, sell thru data from retail partners, headcount information from your HRIS system and other relevant data sources.

In addition, it’s important to include operational data. This operational data in conjunction with financial data gives you a more comprehensive view of your cash flows.

For example, you can  incorporate inventory data in real-time from your ERP. Using this data, you may notice that your inventory reorder points have shifted due to higher turnover rates. This may indicate that you will have to spend more on inventory over the next quarter than you did the previous year.

In this way, your ERP and other data sources integrate with your business planning and analytics (BP&A) software, resulting in a more accurate cashflow forecasting base. By ensuring the data streaming into your system is accurate, you set the stage for more useful cash flow forecasts.

Build a cashflow model

Building a cashflow forecasting model involves mapping historical data along with target metrics into dashboards so you and other stakeholders can review patterns and trends. It’s important to examine your data in context, however, considering the following conditions as you build your model:

• Seasonality. Depending on your business, some products or services may have higher—or underwhelming—demand during or leading up to holidays or any of the four seasons.
• Market conditions. You should consider fluctuations in financial markets, interest rates, and even the regulatory environment as you build out your model.
• Industry trends. As demand, pricing, and preferences change in your industry, the amount of money you receive or spend shifts as well.
• Upcoming major expenses or investments. In addition to factoring in the cost of future investments or expenses, it’s also important to factor in the costs associated with maintaining, repairing, or insuring items or properties you acquire.

By using financial modeling techniques and BP&A software, you can arrive at more accurate and detailed projections.

Use scenario planning

Scenario planning involves a combination of considering potential circumstantial cash flow outlays and scenarios resulting from informed decisions you’re considering.

A circumstantial scenario would include situations that impact cash flow that are relatively out of your control. For example, a seasonal promotion may go better than expected, giving you 10% more revenue for the second and third quarters. Warm summer months, especially, may result in higher cooling expenses, bringing your utility costs 15% higher than normal.

Scenarios stemming from potential business decisions involve hypothetical strategic choices that could significantly impact your cash flows and decision-making. For instance, a wholesale distribution company may be considering acquiring another company and have to assume some of the other company’s short-term debt. At the same time, they’ll also be bringing in additional revenue from the other company’s customers.

By factoring in these kinds of situational considerations, you can come up with a range of scenarios you can use to:

• Design operational strategy
• Make staffing decisions
• Restructure debt
• Invest in new materials, space, or equipment
• Apply for loans

Round off with a 3-way forecast

By incorporating all the work from the above three steps into your BP&A platform, you can build a 3-way forecast for cash flow.

Three-way forecasting refers to integrating three financial statements:

• Income statement
• Balance sheet
• Cash flow statement

Cash flow forecasting primarily focuses on predicting cash inflows and outflows over a specific period. However, 3-way forecasting takes your forecast a step further because it considers how changes in income and balance sheets impact your cash flow.

Your income statement, which is also known as your P&L, gives you a summary of your revenues, expenses, and net income over a certain period. When you use 3-way forecasting, your income statement is the basis for projecting your revenues and expenses, which have a direct impact on your cash flow. Therefore, when you forecast revenue and expenses accurately, you’re able to do a better job of estimating your future cash inflows and outflows.

Your balance sheet gives you a snapshot of your financial position at a particular point in time. It details your liabilities, assets, and shareholders’ equity.

Three-way forecasting factors in changes in items in your balance sheet, and you can use this data to better predict cash flowing into or out of your organization.

For instance, if you have an increase in accounts receivable, this may indicate future cash inflows resulting from collecting the receivables.

On the other hand, if your accounts payable increase, your repayments may affect your cash on hand. Therefore, an increase in payables may indicate future cash outflows as you settle these accounts.

The same could be said of increases in inventory levels. When you must maintain more inventory to support production levels, your cash outflows will likely rise as you pay for more components and materials.

With the right forecasting software, 3-way forecasting is relatively straightforward. For instance, in Phocas Budgets and Forecasts, you can make adjustments to elements of your income statement, balance sheet, or cash flow statement and see how they instantly impact your forecast.

How to use Phocas’ 3-way forecasting for more effective cash flow forecasting

Because Phocas’ 3-way forecasting tool can automatically adjust your forecast using your integrated data, it takes the time-consuming grunt work out of generating accurate, reliable forecasts. This prevents negative cash flow situations while positioning you to use positive cash flow to fund growth initiatives. Suppose you’re a CFO or finance controller and you realize your average accounts receivable timeframe of 30 days, is not accurate. You can identify this timeframe as a mini-driver in your Phocas software. A mini-driver is a factor that impacts your forecast and three out-of-the-box templates cover common scenarios for debtors (accounts receivable), creditors (accounts payable), and stock. Quickly using the drivers you can then adjust your timeframe from 30 to 45 days.

Phocas then automatically revises your receivables, cash, and cash flow. Instead of combing through spreadsheets and adjusting formulas, you can make quick adjustments and see their impact with a few clicks.

After making a change, you can render your adjusted financial statements to review them in the context of your budgetary goals. You also have the option of generating a dashboard that displays your original budget against your revised forecast. In this way, you automatically contextualize your new data, seeing it from the perspective of your original and adjusted cash flow projections.

Returning to the accounts receivable example, suppose after adjusting your timeframe from 30 to 45 days, you see that it results in about 3% less cash on hand six months in the future. However, you’ve already committed to purchasing a new piece of equipment in about seven months, and with a 3% drop in cash, your liquidity may drop below your comfort level.

With Phocas’ 3-way forecasting, you get real-time business analysis that supports a range of important decisions.

By automating elements of your cash flow forecasting, you increase its accuracy while reducing the amount of work you have to do. The Phocas platform provides deep business analytics in a user-friendly format so you can guide your business in the right direction.