How to make a cash flow forecast

How to make a cash flow forecast, a step by step guide.

You can either watch the video or read the blog article on our how to make a cash flow forecast…

Before I begin it is always good to explain what a cash flow forecast is and why should I prepare one.

Cash flow forecasts are one of the best planning tools for both big businesses and small. In some ways they are even more important for smaller businesses, and especially those that don’t have a whole lot of cash in the bank. They are more important for companies that don’t have those emergency funds to draw upon.

A healthy cash flow is essential for all businesses, and as we know cash is king, so it is vital that we plan out our cash flows, to avoid any nasty surprises.

In summary, a cash flow forecast can help you:

1. Plan and forecast the sales you expect to make in the year.
2. Plan out your costs and set your budgets, not just for revenue expenditure, but also for capital expenditure.
3. Assess your cash flows and your monthly bank balance, making sure you remain within your spending limits.
4. Sets your targets and what you plan to achieve over the forecast period.

So now that you understand the purpose of a cash flow forecast, let’s begin our step by step guide of how to make a cash flow forecast.

Step 1. What software should I use?

When it comes to putting together financial plans, you have a choice to make. Do I begin from scratch and use Spreadsheet Software? (if you click on this, link you’ll find a whole host of program’s you can use). Or do I use specifically designed software? There are many free versions of spreadsheet software, along with the list of paid-for versions. Each one with, its own merits, which can be used to make a cash flow forecasts.

Whichever piece of Spreadsheet Software you use, you are going to have to understand spreadsheets in detail and how to put a cash flow forecast together. This is in addition to understanding the various elements of financial forecasts.

The other alternative to using a spreadsheet is to use cash flow software, which is software specifically designed for the job. Again the list is many, but there does not seem to be a similar list on Wikipedia to link to. But alternatively, you can quite easily do a web search for the same.

Either method is fine, except that creating a spreadsheet from scratch will take you longer. However, software designed specifically for the job will likely cost more, especially when compared to the free versions.

Step 2. Decide on a forecast period.

The period you are forecasting over will depend on what it is you need the plans for. For example, if you are simply preparing your cash flows and budgets for next year, then a 12-month forecast is likely to be sufficient.

However, if you are preparing the cash flows for an investor for investment in your business or a bank for a loan, it is likely you’ll need to prepare them for a longer period. In which case, I’d suggest a period of at least 36 months.

The longer the period of your forecast, the more work is involved. So depending on what software you use, this will impact on the length of time it takes. But also this will affect how easy this process will be for you.

Also bear in mind that the further ahead you forecast, the harder it will be to predict sales and what is going to affect your business in the future. Having said that, there is no reason why you can’t update and change your forecasts as you go.

Step 3. The income element of your cash flow forecasts.

In my opinion this is the hardest part of any cash flow forecast, as it is always difficult to predict how many sales you are going to make, and in turn how much income this will generate. However, you have to start from somewhere, and you can then use your forecasts as the targets for your sales team to focus on.

One way to begin is to look at your last years numbers and pay particular attention to any cycles or seasonal variations in your sales of certain products or services. If you understand your trends, you will be able to reflect these in your new forecasts. Are there any trends in the way your sales happen, or did you introduce any new products or services last year to be aware of in this years numbers.

Where there is a cyclical nature to your sales patterns, consider when you are forecasting how you could counter this. Ideas for countering down cycles are the obvious sales or discounted incentives, but you can also look at introducing complimentary products or services. These new products or services may have a counter cyclical nature to them, to balance out your monthly sales.

If your last years sales figures are your starting point, you will then need to decide upon an acceptable, or perhaps achievable increase in your sales forecasts.

However, it is important that you take account of the impact these proposed increases may have on the other elements of your business. So when you begin to look at the costs associated with these increases (see overheads below for more details on this), you take the impact into account. One vital aspect of any cash flow forecast is consistency. You want to make sure that all your numbers and the assumptions behind them hang together.

You might also want to look at your ‘Sales-Mix’ between your product or service lines, and if you feel you’d like to change this, to better reflect a more profitable business. You could do some what-if scenarios with your product lines, to see the impact on both your cash flows and business profitability. It might be you would like to try removing a complete product line, and instead looking at increasing your other lines instead. Cash flow forecasting is a great tool for all these scenarios’ and more.

Looking at this type of detail will help to make you look at things like your advertising costs, your conversions and so on. Also, consider your staffing levels, and make sure that these reflect the level of sales you’ve forecast to happen.

You will need to split out your sales forecasts between the months over the period you have chosen, and split these between the various product lines, if of course you want to go into this much detail.

The reason you might need to split out your income between different lines on your forecast, is if some of your sales are chargeable to VAT (sales tax or GST), whereas some might not be. This is important, as the income shown on the profit and loss report is net of VAT, whereas the income on your cash flows is gross of VAT. This may be true of different product types, or alternatively international sales are treated differently to sales made within your own country.

The other consideration in deciding on whether to split out your income to separate lines, is how the different lines are paid for by your customers. It might be that some of your sales are received in cash or paid by credit card, whereas others might be paid in a variety of 30 days, 60 days etc. This payment difference may be very different between certain of your customers.

It is known that many larger organisations take a longer time to pay than smaller businesses, so if you have this type of split in customers, you will need to reflect this in your cash flow forecasts.

Where your customers pay you otherwise than in cash, you will also need to consider the amount that will be outstanding at the end of each period end, to be included on your balance sheet.

Step 4. Your cost of sales.

Now that you have set your sales forecast, you are now in a position to work out your cost of sales, if your business has a cost of sale.

It might be that you decide to keep this simple and include one total for cost of sales, as a simple percentage of sales. However, you may also wish to make your cash flow forecasts a bit more detailed than that, for similar reasons to your sales forecast.

It may be that different elements of your cost of sales are subject to VAT (sales tax or GST), whereas other costs are not. In which case you will need to split these out into the respective cost types, as the net of VAT amounts will be included on your profit and loss account, whereas your VAT inclusive amounts will be included on your cash flows.

In addition to the VAT consideration, you may also have different payment terms with your suppliers too. If this is the case, you will need to reflect these differences in your cash flow forecasts too.

Depending upon your type of business, you may well have wages as a cost of sale. If this is the case, you will need to separate out the amount paid directly to the employee from the amount paid to the government. The government amount for Pay As You Earn (PAYE, in the UK Income Tax and National Insurance), is normally paid in the month following when the net amount is paid to the employee.

Also make sure to include any taxes you pay in addition to your staff wages cost, like Employers National Insurance Contributions, and make sure you include this in the cash flow forecast with the right payment timing of these taxes too.

Where this is a significant part of your cash flows, for example if you are an employment agency, this type of detail is crucial to getting your cash flow forecasts right. The timing of the different cash flows may be critical to your month end bank balance.

Make sure to remember that where you are given payment terms with your suppliers, you will need to include the amount outstanding at each period end on your balance sheet too.

With regards to cost of sales, make sure you also take account of changing stock levels, as this can have an impact on your cash flows too. And the opening and closing stock levels at the beginning and end of the month, will affect your net cost of sales and gross profit.

For new businesses, building up your stock or buying your opening stock, can be a significant part of your setup costs. So being aware of this and planning for it is crucial in the planning stages, and should never be under estimated.

Step 5. Working out your overheads.

Your overheads are usually more straight forward to work out, and a good starting point is to look at your prior year profit and loss. However, having said that, you will need to look to see if any of your overheads had any unusual or exceptional items included, which should in theory be excluded in the current year. But when you consider this, you might want to think about any one-off type expenditures that might happen over the forecast period, that didn’t happen last year.

You will also need to look at whether or not any of your costs will be affected by an increase in your sales, if you have increased your sales forecasts. Ordinarily many of your overheads are fairly consistent, but you need to reflect any major changes in these, for example additional marketing costs required to achieve the higher sales levels.

If you have increased your sales significantly, you need to reflect this in your marketing budget, if this is how you are going to increase your sales. You may also need more administrative staff to cope with the increases in turnover or perhaps you will be recruiting a new sales person to effect the sales increase.

I suggest you go through each overhead line and consider the following for each one:

1. The level of the cost last year and how much you expect this to increase this year. Or perhaps you could re-negotiate with your suppliers or change suppliers to reduce the current years forecasts.
2. Consider how the cost is paid and what payment terms you have with your supplier, to reflect the difference between the monthly cost in the profit and loss and the timing of the payment in your cash flow forecasts.
3. Consider whether the cost is subject to VAT (sales tax or GST), as this will also impact on the cash flows. You need to reflect different numbers in your profit and loss over the numbers in cash forecasts.
4. Consider any new costs you might incur in the forecast period, which may not have been relevant in the previous period.
5. Look at your premises costs and make sure you have considered whether your present building is sufficient for any expansion plans, particularly if you are looking at a longer forecast period. Make sure the premises are adequate to house the staffing levels and stock levels, if you carry stock, for your proposed business growth.

The type of costs to budget for would include all your premises expenses like rent and rates. But also electric and gas for heating, together with any repairs and maintenance costs.

You need to consider all of your marketing costs, including advertising, printing of brochures or other marketing costs. Also, have a think about any other marketing costs your business is considering, to achieve your growth plans. Make sure you also includes costs for other printing costs, like letterheads and business cards alike.

All businesses have communication and stationery costs, like telephone charges and internet charges. Make sure you include your mobile phone costs within your communication overhead. Your stationery costs would include the likes of paper, pens, paper clips and other stationery costs associated with running a business.

In addition to these type of costs, most businesses have legal and professional fees, like accountancy, book-keeper and payroll costs to take account of. But also you might need to include costs associated with solicitors too.

In addition to this, if your business has to deliver its products to customers, make sure all these type of costs are fully accounted for. Make sure you reflect any increases in these relating to your increased sales forecast.

The other important expense for any business is insurance, which includes premises insurance and insurance for general business and your vehicles.

One of the great things about cash flow and profit planning, is that you now have a budget forecast to work to. This now forms your template, broken down month by month. So long as you stay on track with your sales forecast, and you keep to within your overhead budgets, your cash flows should all work out. Assuming you also keep a tight rein on your customer credit function.

As with Step 4 above, make sure you take account of payroll taxes like Income Tax and National Insurance, with regards to your wages and salary costs. Not forgetting those taxes that are paid in addition to the wages cost, like employers National Insurance.

The importance of splitting out wages and salary costs, is in relation to the payment timings on the cash flow forecasts. Net wages and salaries are usually paid in the month they are earned, whereas the tax element is paid for in the following month.

Always remember the important difference between your profit and loss and your cash flow, whereby expenses are included on your profit and loss when they are incurred, whereas they are included on your cash flow when they are paid.

Step 6. Other income.

It might be that your business has other sources of income that you need to include. This can include rental income, if you have a rental property in the business, or if you sub-let a part of your building.

This type of income needs to be incorporated into your cash flows and forecast profit and loss account. And don’t forget all the necessary VAT entries where necessary for this income source.

Step 7. Capital expenditure.

As a part of any forecast, you are likely to encounter capital expenditure in addition to revenue expenditure. This could be as lavish as buying new premises for your business, through to new equipment or the purchase of new vehicles.

When taking this type of expenditure into account in your cash and profit forecasts, you have the following considerations to be aware of:

1. The timing of the payment for the asset, as this is when it will be included in your cash flow forecasts.
2. Whether the asset cost is subject to VAT (sales tax or GST). Sometimes where you have a large capital purchase, the timing of the VAT can have a significant affect on your cash flows. So getting this right and planning the right timing, could become a crucial element to your financial forecasts.
3. With capital additions, usually the only affect on the profit and loss is in relation to depreciation. You will need to look at what your depreciation accounting policy is and simply reflect this in the charge to your forecast profit and loss accordingly.
4. The sale of assets during your cash flow forecast period will need to be considered. The profit or loss on the sale of the asset needs to be reflected in the profit and loss account, and the proceeds on sale included in the correct month of sale in your cash flow forecasts.

Getting the timing of these capital expenditures right is important, as they have a significant impact on cash flows. However, you may be using asset finance by way of a loan or hire purchase, which will alleviate the impact on your cash flow. However, if this is the case, you will need to include the relevant cash inflows and outflows associated with the loans, into your cash flow forecasts too.

Step 7. Taxation.

Where your company makes a profit, and depending on the structure or business medium you use to trade with, the business will be subject to tax on its profits.

It is a good idea to take taxation into account when you are preparing your cash flow forecasts, to make sure you account for the cash outflow of the tax liability payment.

I wouldn’t say that your tax figure has to be accurate down to the last few pounds. I wouldn’t expect a business owner to necessarily understand all the complexities of company taxation. However, an estimate would be advisable, at the relevant corporate tax rate applicable to your type of business and the level of profits it makes.

The tax charge will then need to be incorporated into your profit and loss account forecast, as well as your cash flow forecast. This includes the correct timing for the payment.

Something to bear in mind though, when you are calculating the tax charge, is that the tax charge is not always charged on the actual profit made. There are always various tax adjustments made, in order to arrive at the taxable profit of the business.

Step 8. Choosing your reports.

Ultimately, the reason for preparing cash and profit forecasts is for planning purposes for the business. If this happens to be planning in order to satisfy bank lending or investor finance, to prove to them that the business is capable of supporting either the loan or the investment, then the reports you prepare become that little bit more important.

The two key reports for any business plan, would be the cash flow forecast report and the profit and loss report. The first one demonstrates your cash inflows and outflows, and should also report your closing cash balance or net lending requirement, on a monthly basis.

Whereas the profit and loss report will obviously show how profitable (or how much of a loss you will make*) your business will be over the forecast period.

These two reports work in conjunction with one another and will demonstrate two key pieces of information about your business. These are; is your business ‘Cash positive’; and is your business ‘Profitable’? You need both of these for a healthy business. A profitable business with bad cash flow can go bust just as quickly as one which is a loss-making business.

There are other reports in addition to these two reports that you should include with your cash flows and business plan, which would include the following:

1. Balance sheet – I always put this report at the top of the list, as this is like the ‘King Pin’ of your forecasts, as it makes sure that everything hangs together and that your numbers balance and are all in the right place.

2. Trading report – This report should be designed to backup your sales and cost of sales numbers in a bit more detail. For example, this report would show the split of your sales between your different product or service lines. It would also show the split of your cost of sales between your various raw materials.

3. Overhead report – Depending upon how you have prepared your profit and loss report, and how much detail this shows, you may want to have a detailed report showing your overheads split out. I always like to show a summary on the face of the profit and loss account with a total for wages costs and general overheads, for example, and then put the detailed split of these main headings on a separate report.

4. Summary report or snap-shot – With this report you can show a summary of your profit and loss, cash flows, loan requirements and perhaps your break even point for the business.

5. Loan report – On this report you would provide a bit more detail behind any of your loans you might already have or intend to takeout during the forecast period. On each loan you might want to split out the detail of the amount of the loan, the interest rate, payment period, any lump sum payments, repayment holidays, and so on. You would then only need to show the loan repayments on the cash flow report, together with the loan receipt. Then show the interest charge on the profit and loss report.

6. VAT report – Where your business is registered for VAT (sales tax or GST), it is a good idea to have a report to explain your VAT numbers, and how these are made up. This backs up the figures that appear on your cash flow report and balance sheet.

7. Fixed asset report – A report detailing the movements in your capital expenditure is a good idea. This report will show both capital expenditure on new assets, together with showing assets sold also. In addition to this, the fixed asset report would show a more detailed breakdown of your depreciation.

8. Assumptions report – It is always a good idea to include an assumptions report. This report would include some of the more detailed assumptions behind your cash flows and profit forecasts. For example, an explanation of your debtor days, or how long your customers take to pay you. Details on your company’s depreciation policy might be useful for each of your asset classes. Other items might include the assumptions made on taxation, interest rates used for money held on deposit or charged on a bank overdraft.

* You may be wondering why a business would consider preparing cash flow forecasts when it is making losses. Many businesses, particularly at the outset, make a loss in the first couple of years, and it is important to plan your cash flows through this period. For example, you need to work out your funding sources to fund the loss, be it your own investment or loans or outside lending or investment. Of course you need to be happy that your business will succeed for yourself, but where outside funding is being sought, you will need to demonstrate to them that the business will become profitable, and cash flow positive. This is perhaps where a longer term cash flow forecast period might be more useful than a short one.

Step 9. Other considerations on how to make a cash flow forecast.

Other considerations to think about when you are preparing cash flow forecasts include some of the following:

1. Going over the threshold for VAT registration during the forecast period. If your business is not registered for VAT at the outset of your forecast period, you may want to include the transition from non-VAT registered to VAT-registered. You can then see how this impacts on your cash flows.
2. Factoring or invoice discounting your sales. You may be considering introducing factoring or invoice discounting to your business, which might be your reason for preparing the forecasts in the first place. By including this type of business finance into your cash flows, you will be able to demonstrate the effects this has on your business cash flows.
3. Loans and hire purchase contracts to fund capital purchases. As already mentioned, your business may be considering the use of loans, to help fund your proposed capital expenditure. If this is the case, you will need to incorporate these details within your forecasts and the various reports.

Armed with the knowledge and information that your cash and profit forecasts give you, you will be well placed to make important decisions about your business. You will also be able to use the reports, preferably as a backup to a business plan, for presenting to a bank where you are seeking a loan or to an investor where you are looking for outside investment.

The other uses for preparing cash flow forecasts could include any of the following:

1. You intend to introduce a new product or service, and you’d like to see the impact on your business.
2. You intend to change something about your business, for example, your customer payment terms, putting up your prices, changes in your supplier payments terms, changes to product mixes or changes to your transaction values etc.
3. You may wish to see the impact of starting to trade in a different country.
4. I have already touched upon staffing changes. This may be the reason you are  prepaying the cash flow forecasts, to see the impact of taking on new staff.

So whatever your reason is for preparing a cash flow forecast, always bear in mind that it should be an easy process to complete, and the reports don’t need to be accurate down to the last penny.

However, all the reports must hold up to scrutiny and be representative of a realistic forecast of what you think is achievable for your business.

If you need any further help on how to make a cash flow forecast, you can always visit our support forum and post a question there.

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