Cash Management Part IV – Cash Flow Forecasting

by Garrett Fisher

December 19, 2011

Cash flow forecasting is a subjective exercise that operates outside the confines of prepared financial statements and accounting regulations. It is something that organizations need only get involved with to the extent necessary for the situation. Here are common categories that small companies forecast:

To meet payroll. The most popular choice – making sure that there will be enough cash on hand to meet payroll. Drivers to this way of forecasting are the fact that payroll is inflexible and catastrophic if trifled with. Almost everything else can usually wait. Unless an organization is flush with cash and lines of credit, this is a very reactive cash management method.

1 to 3 months. Twenty percent of small businesses will forecast this far with any detail. Very proactive measure and a good goal to strive after.

Budgeting for the year. The budgeting process is often used/confused as the forecast for the year. We will review an alternative perspective further down in the article.

The point of forecasting is to shrewdly and effectively foresee issues and challenges before they create a crisis. It is the difference between a reactive, crisis-managing organization and a proactive one. An organization in a financial reporting and accounting crisis will have tremendous difficulty introducing a proactive cash forecasting process overlaid on a crumbling foundation. Essential to cash forecasting ingredients is the practice of maintaining current cash registers in an accounting system (requiring aggregation of transactions for most company operations on a reasonably quick basis), relying on register balance to make present decisions, having quick processes to reconcile month-end differences and a solid understanding of cash reporting on prior periods.

It is with this basis of information and understanding of cash reporting that an organization finds it easiest and most useful to overlay forward-looking forecasts.

My official recommendation to most organizations (custom situations notwithstanding) is to have two sets of forecasts:

Daily Cash Forecast (forecasting as much time as the organization needs): For relatively stable companies with consistent balance sheets, a few months are all that is necessary. For organizations in high-growth or troubled phases, longer periods are needed to adequately plan for large trip wires. This is the forecast where being buried in details is expected and helpful – daily cash detail is essential – as is interfacing with A/R and A/P departments regarding their view of expected cash receipts and disbursements. I have seen forecasts be as basic as small spreadsheets. In other occasions, we have been able to build cash flow by day out for the next 400 days.

Annual Accrual Forecast (by month): Instead of making one annual budget and leaving it to stagnate without updated information, creating a month-by-month P&L, balance sheet and cash flow statement forecast is a key tool for long-range planning. It allows for a highly efficient projection to be available nearly at all times for banks and other capital sources. It also allows for a mindset that steps back from day-to-day minutia, stresses and emotional catalysts (things prevalent in the forecast to meet the next payroll run) and foments a mindset to focus on reasonable leverage levels, customer payment habits, inventory levels, loan levels and so on. With such a long-term model available, capital expenditures, investor infusions and credit facilities can be seen clearly and arranged before a crisis hits.

Having both forecast methods (cash and accrual) serves to prevent excessive focus on survival mechanisms (“will we have enough cash?”) and balance it with performance-based realities. Organizations can neither be run entirely on an unhealthy obsession with day-to-day survival or a strictly income-statement view.

What is especially challenging in any forecasting environment is the staff qualifications required to be able to generate and maintain such forecasts. Frankly, reporting on historical transactions is much easier (and far less useful) than looking forward.  Another challenge is that mainstream and affordable accounting software does a terrible job of accurately forecasting an entire business’ operations. Custom solutions many times will do the trick – looking at key business drivers, importable data and ability to corral inputs and variables to a few user-operated adjustments.

A key to being able to develop an accurate (and therefore useful) forecast is to fully understand the ramifications of working capital flows and what changes in those flows do to cash balances. Such changes often lead to initially opposite cash flow than expected and create tripwires for the unwary. In our next article, we will analyze growing companies and the effect of growth on cash flow cycles.