Best Practices to Accurately Forecast Cash Flow

Legendary UCLA basketball coach John Wooden once said, “When you fail to prepare, you’re preparing to fail.” That is especially true when it comes to financial performance, and why cash flow forecasting is vital. It helps you predict your future financial status, avoid critical cash shortages, and plan for growth. In particular, it tells you about your free cash flow. That is, the amount of cash your organization has after operating and capital expenditures for a given period.

Cash Flow Forecast – The process of obtaining an estimate of a future financial position.

However, a cash flow forecast is only as good as the data and work that goes into it. There are several key practices you should keep in mind when creating a forecast to ensure its accuracy.

How Far Ahead Should I Look?

Different types of forecasts provide different insights. When creating one, you’ll first need to determine if you want to make a short, mid, or long-term forecast. As a best practice, it’s important to create all three, because each helps you manage and plan for different things.

• Short-term forecast - typically looks no more than a month or so ahead. It helps with liquidity planning in your immediate future.
• Medium-term forecast – a forecast that looks two to six months into the future. This can help you create strategies to reduce debt and manage risk.
• Long-term forecast- estimating 6-12 months into the future, this forecast is the foundation of annual budgeting. It is vital to have this data when investing in or planning for growth strategies.

It is also good to remember that, while a forecast uses hard data as its basis, it still makes assumptions about how things will happen in the future. That means there is inherent variability in the accuracy of the forecasts. As a rule, shorter forecasts are the most accurate.

What Method Should I Use?

When it comes to creating a forecast, there are two primary methods. The first is known as the direct method, which is built on the cash collected and spent over a given time. It requires you to rely on receipts and other documentation that documents when cash changes hands. Total cash payments are subtracted from total cash receipts. The result is your net cash flow. Items factored in should include:

• Employee salaries
• Cash paid to vendors
• Cash received from customers
• Income as a result of interest and dividends
• Tax and interest payments

Forecasts created using this method tend to be the most accurate, but they are incredibly time-consuming and less helpful for long-term planning. With that in mind, the direct method is best used to create short-term forecasts.

The second is the indirect method and it uses forecasted income statements alongside balance sheets. While this method is useful for long-term planning and strategy, it is not as precise or accurate as forecasts made through the direct method. As such, it is less useful for daily cash management.

Expect the Unexpected

Uncertainty is a constant in the world of business and finance. There are two primary variables that you will encounter. The first is internal factors like changes in policy and employee turnover. External factors such as sudden changes in the market, regulatory changes, or an economic downturn are all issues that can throw off your forecast. While you can’t ever say for sure what’s going to happen, it is useful to plan for contingencies. That means creating multiple forecasts that factor in the impact of potential challenges.

A simple way to do this would be to create “best case scenario” and “worst case scenario” forecasts, providing yourself with a spectrum of possibilities. Because circumstances are always changing, it is also important to make cash forecasting a regular practice so that your forecast is based on the latest information.

Embrace Automation

One of the simplest ways that accounts receivable can facilitate better cash flow forecasts is to embrace automation in the process.

Through automated communications, a customer self-service portal, and other customer-centric features, automation software makes it easier for customers to make payments. This, in turn, facilitates faster payments, lowering your days sales outstanding (DSO) and increasing your cash flow, making the forecasting process simpler and more accurate.

By automating, you also eliminate the possibility of typos and other simple errors that can plague the data entry process. The software integrates with the rest of your tech stack, and data is shared directly from system to system.

Finally, an automation solution that embraces AI and machine learning can help you have a better idea of when customers are likely to make payments. By identifying accounts that are likely to pay late, your AR team can proactively go after high-risk accounts to reduce the odds of late payments or bad debt. This, in turn, helps you have a better understanding of your organization’s cash position.

An accurate cash flow forecast provides some of the most important data your organization needs to plan for the future. To learn how Quadient Accounts Receivable by YayPay helps you get the most out of your data, download the whitepaper Best Practices to Improve Data-Driven Decision Making.