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Cash Forecasting: Predict the Future of Your Business's Money

min read
August 21, 2023

As every business owner knows, the future is never certain. It isn’t easy to predict how many sales you’ll make next week or whether your account receivables will be delayed. 

But just because the future is uncertain doesn’t mean there aren’t techniques you can use to try and make it clearer.

Cash flow forecasting is one such technique. If used correctly, it can help you predict how much money you will have at the end of a future period of time.

Predicting this information is essential, as it helps you answer questions like: Do you have enough cash on hand to pay employees and suppliers on time?

Curious to learn more? Let’s take a closer look at what cash flow forecasting is, how to use it, and ways it can benefit your business.

What Is Cash Flow Forecasting? 

Cash flow forecasting is the process of predicting how much cash your business will make, spend and lose in the future. This helps you figure out your cash position–or how much cash you’ll ultimately have in hand.

Cash forecasting also helps you identify periods of positive and negative cash flow. Positive cash flow means you have more cash coming in than going out of your business.

There are a lot of advantages to estimating the amount of cash you will have down the road. If your future cash flow looks positive, you can use that information to plan for future growth. If it’s negative, you can begin cutting costs where necessary.

What Are the 2 Types of Cash Flow Forecasting? 

Businesses often use two types of cash flow forecasting—direct and indirect. 

So, which of these should you use? It depends on your cash flow forecasting objective. But first, let’s understand these data forecasting methods. 

Direct Cash Flow Forecasting

In the direct method, you’ll use a bottom-up approach to cash flow forecasting. It’s suitable for accurate cash flow predictions for the short-term or medium-term. 

With this method, you’ll use actual financial data like accounts payable, accounts receivable, and sales to forecast how much money you will have at the end of the period.

Indirect Cash Flow Forecasting

The indirect cash forecasting method uses a top-down approach to make long-term cash flow predictions. 

With this method, you start from the expected net balance at the end of the given period and estimate how much cash inflow and outflow you need to achieve that balance. 

You use high-level financial reports like a profit & loss statement (P&L) and a balance sheet to predict future cash inflows and outflows.

Benefits of Cash Flow Forecasting

Cash flow forecasting allows you to predict how much cash you will have in the future. Having an accurate cash forecast is a good financial practice that will attract creditors and lenders. Let’s dig deeper into the benefits of cash flow forecasting.

Avoid Cash Shortage

Experiencing a severe cash shortage in the long term could lead to your business closing its doors for good.

Cash flow forecasting helps you understand if your business will be short on cash anytime in the future. Identifying negative and positive cash flow periods will help you with better cash flow management.

For example, if you have a big mortgage payment in two months, the cash flow projections will tell you if you’re likely to run out of money. If you see a negative cash flow forecast, you can try to cut overheads, generate sales, and raise pricing.

Stay in Control of Debt

Paying back debt can drain your money. Cash forecasting can help you account for future debt payments. So, you’ll be able to make informed decisions on your other expenses to minimize negative cash flow. 

For example, you don’t want to buy costly equipment in a month when you have a big loan repayment coming up.

Make Smart Growth Plans

Cash forecasting will help you predict when you may have surplus cash to make a realistic budget and investment plans, like:

  • Opening a deposit account
  • Investing in fixed assets like furniture or equipment
  • Expanding to new markets, investing in products, and hiring extra staff

For example, let’s say you wanted to expand to a new facility.

Without cash forecasting, you’d have to make all your decisions regarding the new space in real time. In other words, you’d always be constrained by the amount of cash you currently had on hand. 

And while you focused on saving up, someone else—who may have taken advantage of cash forecasting—could swoop in and rent the space out first. Ouch!

With cash forecasting, on the other hand, it’s a different story. By meticulously tracking your cash inflows and outflows, you’d be in a reasonably confident position to predict when you’ll have extra cash to afford the new office space.

Acting on that prediction, you could pay an advance on the space, locking it in so that no one can steal it out from under you.

Maintain a Good Cash Level for Lenders  

Certain lenders may require your business to maintain a particular cash level throughout the duration of a loan. This is what’s known as a debt covenant. 

For example, a lender might ask you to have $10,000 in your business at all times. If your business’s cash level falls below this threshold, the lender might consider that a breach of the loan’s terms and ask you to repay the debt.

Cash forecasting can help you stay on top of your business’s cash level, making it easier to adjust the cash outflow if necessary to ensure you don’t breach the debt covenant.

How Do You Forecast a Cash Account?

Cash forecasting is a complex process that requires data and support from multiple departments. To keep things simple, let’s break it down into a step-by-step process.

1. Determine Your Cash Forecasting Objective

Before you create a cash flow forecast, you need to decide what your objectives are. Here are a few possibilities:

  • Estimate future cash position: You may want to estimate how much working capital you’ll have in the upcoming weeks or months. Doing so will help you identify potential cash shortages in the immediate future.
  • Growth planning: Perhaps you want to expand your small business but want to ensure you can afford it. Cash forecasting can help determine if your future financial position is favorable for expansion, hiring, or capital expenditures.
  • For lenders: If you want a loan, banks and other lenders might want to evaluate your business’s liquidity. In other words, they want to know whether you’ll have sufficient cash or liquid assets to pay off the loan. They might also ask for your projected cash flow statement.

2. Choose a Data Forecasting Method

Once you have your objective in mind, it’s time to decide which data forecasting method makes the most sense.

If your objective is short-term, then the direct cash flow forecasting method works best. It’s the most accurate of the two, but it is also a time-consuming process.

In contrast, indirect forecasting is better for longer-term objectives. It isn’t as accurate as the direct method, but it provides you with high-level forecasting for your financial planning.

3. Gather Data for Forecasting

To build an accurate cash flow forecast, you need to look at your business’s current and historical data. 

If you are planning to do short-term forecasting using the direct method, start by gathering the following data: 

  • Cash outflow data: accounts payable, salary, mortgage, and tax payments
  • Cash inflow data: accounts receivable, interests, and credits 

If you are using the indirect method, you should gather historical high-level financial statements like:

Once you know what kind of data you need for forecasting, think about how you’ll collect it. Here are some questions you should answer to get accurate data:

  • How will different departments coordinate to give you this data? 
  • Are you going to collect it manually and store it in spreadsheets?
  • Can you pull the data from your enterprise resource planning (ERP) and payroll systems?

If you’d like some help with your payroll, take a look at Hourly. Our payroll software is a one-click solution for paying your employees and managing their taxes. It’s simple, effective, and lets you see labor costs in real-time.

4. Perform Cash Flow Forecast Using the Chosen Method

After you have chosen your cash forecasting method and have gathered sufficient data, you can start the forecasting process. 

Direct Forecasting Method

In the direct method, you must first identify the expected sources of cash (inflows) and expected expenses (outflows) for a specific period.

  • Expected cash inflow: cash from sales, tax refund, sales of assets
  • Expected cash outflows: Operating expenses, loan repayments, supplier payments, taxes, and other liabilities 

Now, you’ll break up the prediction period into small chunks of time and project the expected cash inflow and outflow for each of these chunks. You get the net cash flow by subtracting the cash outflow amount from the cash inflow amount. 

Finally, you’ll add the net cash to your opening cash balance to get the final forecast. 

Here’s an example of the direct method cash forecast calculation for three months. You can use this as a template too. Just click “Make a copy” to edit your own.

Direct forecasting method

Indirect Forecasting Method

Unlike the direct method, here you start with the expected net income, and you’ll make adjustments to it. You’ll adjust the net income by using the following financial data. 

  • The expected depreciation in business assets (depreciation expenses)   
  • The expected increase in the accounts receivable
  • The expected increase in the accounts payable
  • The expected increase in the inventory

Now, you can calculate the final cash balance for each time period using this formula: 

Future Cash Balance = Net Income + (Depreciation Expenses + Sales + Value of Assets Liquefied - Expenses - Liabilities Paid Off)

Here’s an example of the indirect method for cash forecasting for six months. You can use this as a template. Just click “Make a copy” to edit your own.

Indirect forecasting method

5. Measure the Accuracy of Your Data Forecasting

Check the accuracy of your forecast so you have a firm sense of whether your predictions were right. That way, you can have the assurance you’re not making business decisions based on false data.  

To figure out if your forecast is accurate, compare your actual cash flow statement with the forecast and see where they differ. 

Examine which cash inflow or outflow category was inaccurate and adjust your cash forecasting model. 

Creating a cash forecasting model is a long-term project, and you’ll need to keep adjusting it to improve the accuracy of your predictions. 

Final Thoughts on Cash Flow Forecasting

It’s no use sugarcoating it—cash flow forecasting is a multi-step process that requires a lot of time, coordination, and diligence on your part.

But you shouldn’t let that discourage you. With a little trial and error, cash flow forecasting can become a powerful tool in your business’s arsenal, allowing you to take control of your business’s future.

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