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Cash flow forecasting is a time-tested, essential process for startup founders to gain a detailed understanding of their company’s overall financial health. It helps fledgling companies to more accurately predict profit and losses while improving investor reporting and communication. Adequately funding their business continues to be the main problem for entrepreneurs. With this in mind, it is therefore especially important for startups to manage their cash flow as well as possible.
Strong cash flow forecasting positions startups to optimally prepare their company for the future and make informed strategic finance decisions that minimize downside financial risk and drive overall performance and growth. Below, we dive into some of the most common cash flow issues startups face and discuss how to avoid them.
Understanding the cash flow forecasting process
A cash flow forecast is a way to predict the future financial position of your company based on two primary elements: accounts receivable and accounts payable, or cash inflows and outflows. At its core, it is a vital method of making sure that your company keeps on top of its debt obligations, pays its bills, and has enough cash to support operations and growth. If your company has a positive cash flow, it means you have more money coming in than you have to pay out, whereas a negative cash flow means you have more money to pay out than is coming in.
By and large, there is a direct link between how far-dated you want your forecast to be and accuracy. For instance, it is generally much easier to understand your near-future cash flow, such as in one month’s time, as you likely have current client orders to fill, near-term payments to take, and perhaps you also know the accounts payable you have to process. In comparison, predicting your financial position in one year’s time is more difficult, with so many variable factors to take into account, such as market movements, business performance, access to funding, and so forth.
The benefits of cash flow forecasting: Why is it important?
Periodically committing to predicting your startup’s financial health for a given period of time helps handle cash management in many crucial ways.
- It gives you insight into your company’s future health
- It highlights unexpected developments, such as becoming cash-negative
- The company can identify and plan for cash flow shortfalls
- A cash flow forecast helps you to not overlook important cash outflows
- Founders get a better idea of current and future capital needs
- Predicting the future enables a company to hedge against downside risk
- It provides insights for investment and financing decisions
- A good forecast helps provide investors with a detailed picture of their investment
Foregoing cash flow forecasting or treating it as an afterthought is detrimental to a company. Without understanding its future predicted financial health, a company adopts a passive position. Lack of insight into future cash flow makes strategic business planning difficult, whereas it impairs the financial department’s ability to allocate capital across the business.
It can lead to a company overestimating its financial health and suddenly finding itself in debt. Failure to produce optimal cash flow forecasts can also damage investor confidence.
How to forecast your cash flow in 5 steps
First of all, identify your sources of accounts receivable. This usually comes from sales, but it can also come in the form of tax rebates, sales of equipment, property, digital property such as a website, interest, and government grants.
Second, identify all your sources of accounts payable. These usually include employee salaries, supplier payments, utility bills like electricity, hardware and software purchases, property and equipment rental, and software subscriptions.
1. Decide the period of forecast
Each cash flow forecast needs a period of time for which to predict. This might be monthly, quarterly, or longer-term, such as six or 12 months. However, it can be for any period of your choosing.
2. Calculate expected accounts receivable
This includes all types of cash inflows, as outlined above. For instance, this would involve any incoming standing order receivables such as client payments or incoming payments due on or by specific dates.
3. Calculate expected accounts payable
In this step, get a full and thorough understanding of what payments must be made for the period of time under consideration.
4. Draw up a forecast chart
Cash flow forecasting doesn’t have to be complicated. It should include an opening balance - i.e., the amount of money in your startup’s bank account. Then, it should have two separate sections, one for cash inflows and another for outflows. It should finish with a predicted surplus/deficit cash balance after all calculations are accounted for.
5. Always review and compare
At the end of each forecast period, be sure to compare your original cash flow forecast to reality.
By comparing each forecast to what has actually happened in terms of accounts receivable and payable at the end of the forecast period shows exactly how close - or far away - a cash flow forecast was, and highlights discrepancies to address in future forecasts.
5 common cash flow forecasting challenges
Accurate forecasting depends on getting a number of factors right. Also, if your startup consistently reviews and contrasts each forecast to how reality transpires, it will position you to improve forecasting with time. Below are the most common cash flow problems startups face when forecasting.
1. Optimism bias
The prevalent human trait of ‘optimism bias’ means that startups can overshoot sales predictions and underestimate the potential for negative financial developments. It is of critical importance to be realistic about both cash inflows and outflows. Failing to be so can damage your business.
2. Inaccuracies from manual data entry
Relying on manual processes and traditional tools such as spreadsheets raises the possibility of human error. Moreover, non-uniform methods among different employees can create a lack of consistency, which slows cash management efficiency. A cash flow forecast can only be as good as the quality of its data.
3. Failing to update forecasts regularly
Market and business conditions can and do change unexpectedly. However, startups may not make the appropriate amendments to their cash flow forecasts to reflect such change, which opens them up to higher financial risk and means that they continue to operate based, at least in part, on out-of-date cash flow forecasts. The longer the period of time in a forecast, the greater the likelihood of changes that can affect the business, and thus, the higher the need for updates.
4. Lack of communication among team members
Data and the free flow of relevant information is critical for the creation of the most precise forecast possible. Should there be a misalignment between finance department team members or on an interdepartmental level, the precision of the forecasting process will be more difficult to achieve.
5. Eschewing scenario planning
Drafting up various scenarios provides even greater insight into possible future financial positions. For instance, scenario planning might include three forecasts: predicted, worst realistic case scenario, and best realistic case scenario.
Tips for improving cash flow forecasting
Startups can implement a number of measures to create an efficient, optimal cash flow forecasting process.
Understand why it is important
It is key for the executive and department managers to fully understand why it is so important to have accurate forecasts. By ensuring this understanding, the various stakeholders involved in creating them are more likely to take it seriously.
Define a forecast process
The financial department should have clear instructions on when to begin each forecast, when to deliver, and where to obtain the necessary data. The processes of collaboration should also be well-defined. Other departments should be briefed on what they must do in order to contribute their part. For instance, this would involve department budgetary requirements. There should also be a technology stack in place to power the workflow and collaboration processes.
Define the data process
Data is the key business asset for any cash flow forecast. Therefore, optimal data management is a prerequisite. This covers sourcing, recording, storing, transferring, and analyzing data.
Commit to variance analysis
After the fact, your startup can compare and contrast a forecast to what happened in reality. This positions you to identify exactly where each forecast varies - such as insufficient or inaccurate data - which can help produce forecasts with greater accuracy in the future.
Regularly update forecasts
As business conditions can and do shift, so too must a startup’s planning. Running into cash flow problems is quite typical for new companies. For instance, a customer may default on an expected payment. Should such a scenario occur, the forecast should also be amended to provide a new cash flow prediction that factors in new data and information.
Forecast right with Abacum
Abacum empowers startups to produce precise cash flow forecasts easily and quickly, and all from a centralized digital environment and with a single, streamlined workflow. With Abacum, your startup can embed fast, collaborative processes across the company and manage data flows in an optimized way, all to support a best-of-breed cash flow forecast process. Moreover, Abacum is designed to make forecast updating and reporting simple and convenient.
If you are looking to streamline your startup cash flow forecasting processes, request a consultation to see how Abacum can help.
