Cash is the life and blood of a business. Without enough cash, companies cannot pay for their daily operations, possibly ending in business failure. One tool that helps businesses maintain sufficient operating capital is the cash flow forecast. What are cash flow forecasts? How can they help a company sustain itself and grow? What information is needed to create a cash flow forecast? In this explanation, you will find out.

Cash flow forecast definition

One of the most important tools for allowing businesses to prepare and plan for the future is the cash flow forecast.

Specifically, cash flow forecasts estimate the amount of cash going into or out of a company:

• The amount of money going into a business is called cash inflow, e.g. sales revenue.

• The amount of money going out of a business is called cash outflow, e.g. raw materials purchases, interest payments, rent.

Net cash flow is cash outflow minus cash inflow:

• Negative cash flow happens when the company has more money flowing out than flowing in. This indicates a high chance of future cash shortage.

• Positive cash flow occurs when the company has more money flowing in than flowing out. This shows the business is more able to meet its operations needs and buffer against financial challenges.

To better understand cash flow forecasts, let’s look at a company's projected cash flow during the October - December 2022 period:

Table 1 - Cash flow forecast example

The beginning cash and ending cash in Table 1 is the amount of cash a company has at the beginning and the end of each month. Note here that the beginning cash of each month is the same figure as the ending cash of the previous month. For example, the beginning cash of November 2022 is the same as the ending cash of October 2022, which is £20,000.

Net cash flow is calculated as cash outflows minus cash inflows:

In the example above, the net cash inflow for October 2022 is £25,000 - £15,000 = £10,000.

To calculate the ending cash of each month, we simply add the net cash flow to the beginning cash:

$\mathrm{Cash}\mathrm{at}\mathrm{the}\mathrm{end}\mathrm{of}\mathrm{the}\mathrm{month}=\mathrm{Net}\mathrm{cash}\mathrm{flow}+\mathrm{Cash}\mathrm{at}\mathrm{the}\mathrm{beginning}\mathrm{of}\mathrm{the}\mathrm{month}$

The cash at the end of October 2022 is 10,000 + 10,000 = 20,000 (£).

Cash flow statements

Here's a simple example of what a company's cash flow statement might look like:

Table 2 - Cash flow statement example

A cash flow statement gives an overall picture of a company’s financial position. From the statement, you can see how much a company earns per year and whether it has enough cash for future operations.

The cash flow statement is different from the income statement and balance sheet in that it does not include non-cash transactions such as depreciation or receivables not yet collected.

Keeping track of the cash flow statements over the years allows the company to assess its liquidity (the ease of transforming non-cash assets into cash) and solvency (the ability to pay off debts) levels, thus making more accurate cash flow forecasts.

Why are cash flow forecasts important?

Companies need cash to pay for their day-to-day operations, distribute profits to investors, and overcome unpredictable events. The more cash a company has on hand, the more it is likely to survive harsh market conditions and achieve sustainable growth.

The main objective of cash flow forecasts is to ensure businesses have enough operating capital and are prepared for future cash shortages.

Figure 1 outlines the most common uses of cash flow forecasts:

Fig. 1 - Reasons for Cash Flow Forecasts

• Plan for the future: Future financial predictions help your company to make key decisions such as whether to hire more staff, open a new branch, or expand to a new market.

• Identify cash shortages: Projected cash flow alerts your business to possible future cash shortages and come up with solutions. These may include finding new finance sources or extending bank overdrafts, the credit agreement with a bank that lets the account holder withdraw more money than they have - up to a limit.

• Assess future performance: You can analyse future business performance based on the forecasted cash flow data. A positive future cash flow means that the business will be able to meet daily operations needs and distribute profits to the shareholders, whereas a negative future cash flow indicates imminent financial struggles.

• Predict financial goal accomplishment: Cash flow forecasts show how likely it is for your company to reach its financial objectives. If the predictions deviate too far from the business plan, you may need to change the current strategy or adjust the financial goals.

Advantages and disadvantages of cash flow forecast

Fig. 2 - Cash Flow Advantages and Disadvantages

Advantages of cash flow forecast

There are three main benefits of predicting future cash flows:

• Plan for future cash shortages. Practicing prevention is always preferable to looking for a cure. By knowing about possible cash shortages, you can create plans to handle crises before they hit, or avoid them altogether.

• Manage cash surplus effectively. Avoiding cash shortages is one thing, but what do you do in case of cash excess? Being aware of future cash surplus allows you to plan and invest the extra money more effectively.

• Plan for growth - With positive cash flow comes an opportunity to expand your investment portfolio and earn a higher profit. Having cash flow forecasts on hand allows you to recognise opportunities for growth and come up with plans to achieve them.

Here are some risks associated with cash flow forecasting: