Five reasons accurate cash flow forecasting is so important

Accurate cash flow forecasting is essential. Cash is king, especially in a small, fast-growing business that may not yet be profitable. Staying on top of your cash flow helps you figure out how long your funds will last so you can make smart decisions about where to invest and where to pare back your spend.

But if knowing your cash position is paramount, how do you forecast your cash position in the months and years ahead, and the impact of your investments or revenues on that cash position?

In today’s post, we’ll go over five reasons behind the importance of accurate cash flow forecasting. But first, let’s get on the same page.

What is cash flow forecasting?

A cash flow forecast is an estimate of the money you expect to flow in and out of your company. It includes all your projected income and expenses and usually covers an entire year, although it can also cover a shorter period such as a week or a month.

How do you prepare a cash flow forecast?

Preparing a cash flow is a complex process with a lot of moving parts that’s based on 7 fundamental steps:

1. Pick your cash flow forecasting method: direct or indirect? The direct method is based on actual cash transaction records, while the indirect method starts with the income statements and then adjusts it for non-cash items. Most smaller companies use a direct approach, which is more straightforward and easier to reconcile against bank transactions listed in your accounting system or bank records. Larger organizations with a lot of transactions often find it simpler to use an indirect approach. (For this blog, we’ll assume direct.)  
2. Mock-up your cash flow forecast template in your spreadsheet. It’s usually easier to build your model in reverse, so you can make sure you design it to generate the result you want. Make sure you divide your cash flow in rows into 3 categories:
   1. Cash flow from operating activities
   2. Cash flow from financing activities
   3. Cash flow from investing activities

This is important because it helps you distinguish between the core day-to-day operating activities distinct from investments you’re making—in CAPEX, for example—that you hope will pay off over time and from financing.

3. Import your bank transaction records into a separate tab of the model (as a CSV extract) and create a category column that matches the accounts on your Cash Flow main tab. Hint: you can use smart VLOOKUP logic to automatically categorize certain transactions based on the description of the transaction; this will save you time.
4. Link your bank transaction record tab to your Cash Flow tab to automatically align and compare actual cash flow and forecasted cash flow. SUMIFS formulas are very convenient for this.
5. Use driver-based formulas to forecast all your cash flow accounts. This will save you time on manual inputs and reduces the risk of formula or data entry errors. Consider the following common drivers to start with:
   1. Operating activities
      1. Debtors (Customers) – Receipts
      2. Creditors (Vendors) – Payments
      3. Payroll (Headcount level)
      4. Other Opex (like Rent, Marketing, Sales, G&A, etc.) – Payments
      5. Corporate Taxes Paid
   2. Investing activities
      1. Capex – Acquisition and Disposal
      2. Investment – Purchase and Sale
   3. Financing activity
      1. Funding equity and debt – Drawdown and Repayments
      2. Financing costs
      3. Dividends
6. Unit test your model. Cash flow forecasting is a fairly intricate process. Like any complex process, testing pieces early and often will increase quality and speed up production. In software development, this practice is called unit testing: checking that each piece of functionality works as you expect it to. Here are some examples you should test:

• If I change the forecast frequency of one of my cash accounts, does the formula calculate the right results?
• Is the ending balance and net change of cash consistent with the sum of cash inflows and outflows?
• Are there any #REF! errors anywhere?
• If I add a new CSV import of my bank transactions, does it flow into the right categories on my cash flow tab? Does the total match?

7. Build consistency controls where you can. Testing once is good; continuous testing is better!

Congratulations—your model is ready to use! Analyze your delta at the end of each month, build the habit of reforecasting and keeping an eye on your runway (eg your “oxygen”).

5 reasons an accurate cash flow forecast matters for your SaaS business

Given how important stable cash flow is for any company (especially for unprofitable SaaS businesses investing to grow), let’s dive into the impact of having an accurate forecast of cash flow.

1. Helps your business understand how your decisions impact cash flow, and vice versa

An accurate cash flow forecast is crucial for understanding the consequences of the key decisions your company makes. It allows them to identify cash balance red flags like a negative balance and react before it’s too late. It also allows you to forecast short-term financing needs and plan when you need further investment.

With an accurate overview of your inflows and outflows, you can take remedial action on problem areas. For example, if certain customers are slow to pay, you can double-down on your collection efforts, or shorten payment terms in your contracts.

Accurate cash flow forecasting also helps answer questions such as:

• Can you afford to hire if churn doesn’t reduce? 
• What can you spend on marketing? 
• How long is your runway at current spend?

2. Helps you understand your burn rate, which is critical for companies in growth mode

Accurate cash flow forecasts give you a better overview of your runway at your current burn rate and the steps you need to take to position yourself for success. If you know that you can’t get further investment for another 12 months but your cash will only last 10, you know you have to find ways to reduce burn to extend your runway. 

Burn rate also helps you understand when your business needs to start looking at funding options for your next round of investment. You can combine that knowledge with how long it’s historically taken to close an investment round to  make sure you don’t run out of cash.

3. Gives investors and lenders comfort

When you accurately forecast cash and give regular updates to your investors/lenders, that increases trust gives them more comfort in the safety of their investment or loan, and can improve the terms you can negotiate.

As we’ve mentioned in the previous section, managing cash burn and knowing when your next investment round will take place is crucial. If you can demonstrate to investors/lenders that you can accurately forecast this, their comfort in your management abilities will go up and they’ll be more likely to invest in your business in the future.

4. Helps prioritize your use of cash 

In situations where you have limited cash or your burn rate is higher than expected, accurately forecasting cash allows you to prioritize the order in which creditors are paid. If you do a bad job forecasting cash, that may lead to paying low-priority creditors first. As a result, you can end up in a situation where a mission-critical creditor hasn’t been paid and your funding is cut off.

Having accurate forecasts also helps you prioritize payments to minimize interest while maintaining liquidity. As an example, let’s say you have substantial cash and can repay a loan in advance. Confidence in your cash flow projection and knowing you’ll be covered in the future will give you the confidence to repay the loan early. 

5. Helps improve working capital management 

An accurate cash flow forecast will show you the impact working capital has on your cash position so you can determine if you should focus on reducing it. Reducing your working capital will also reduce your need for cash so you can carry a lower balance or delay future investment activities.

Conclusion

Projecting cash flow is complex and requires agility, as things can change so quickly for your business. But the more accurate you can make a cash flow projection, the more powerful they become and the more confidence they give you in the decisions you make to help your business thrive.

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Ed note: Want to dive deeper into essential FP&A topics? Check out OnPlan’s most popular posts of all time here:

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• How to use a headcount planning model to determine your next office location
• Best practices for building a remote-first workforce planning model
• Bookings vs billings vs revenue: What’s the difference?
• What does the SaaS magic number mean for business growth?
• How CFOs can prepare for the Great Resignation