A good cash flow forecast might be the most important single piece of a business plan. All the strategy, tactics, and ongoing business activities mean nothing if there isn’t enough money to pay the bills.
That’s what a cash flow forecast is about—predicting your money needs in advance.
By cash, we mean money you can spend. Cash includes your checking account, savings, and liquid securities like money market funds. It is not just coins and bills.
Profitable companies can run out of cash if they don’t know their numbers and manage their cash as well as their profits.
For example, your business can spend money that does not show up as an expense on your profit and loss statement. Normal expenses reduce your profitability. But, certain spending, such as spending on inventory, debt repayment, and purchasing assets (new equipment, for example) reduces your cash but does not reduce your profitability. Because of this, your business can spend money and still be profitable.
On the sales side of things, your business can make a sale to a customer and send out an invoice, but not get paid right away. That sale adds to the revenue in your profit and loss statement but doesn’t show up in your bank account until the customer pays you.
That’s why a cash flow forecast is so important. It helps you predict how much money you’ll have in the bank at the end of every month, regardless of how profitable your business is.
There are several legitimate ways to do a cash flow forecast. The first method is called the “Direct Method” and the second is called the “Indirect Method.” Both methods are accurate and valid – you can choose the method that works best for you and is easiest for you to understand.
Unfortunately, experts can be annoying. Sometimes it seems like as soon as you use one method, somebody who is supposed to know business financials tells you you’ve done it wrong. Often that means that the expert doesn’t know enough to realize there is more than one way to do it.
The direct method for forecasting cash flow is less popular than the indirect method but it can be much easier to use.
The reason it’s less popular is that it can’t be easily created using standard reports from your business’s accounting software. But, if you’re creating a forecast – looking forward into the future – you aren’t relying on reports from your accounting system so it may be a better choice for you.
That downside of choosing the direct method is that some bankers, accountants, and investors may prefer to see the indirect method of a cash flow forecast. Don’t worry, though, the direct method is just as accurate. After we explain the direct method, we’ll explain the indirect method as well.
The direct method of forecasting cash flow relies on this simple overall formula:
Cash Flow = Cash Received – Cash Spent
And here’s what that cash flow forecast actually looks like:
Let’s start by estimating your cash received and then we’ll move on to the other sections of the cash flow forecast.
