5 steps to great cashflow forecasting

Published 05/08/2013 by Michael Ford – Castaway Forecasting 

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The most important goal when building a cashflow forecast is to model reality as closely as possible. The more realistic the model, the more reliable the results, so business decisions can be made with the best information available. To help you get there, we’ve boiled down the 5 principles of building a great cashflow forecast:

1. 3-way is the only way

Put simply, if you’re serious about forecasting business cashflow, a 3-way forecast is the only approach you should consider. A 3-way forecast is a special type of model where the Profit & Loss, the Balance Sheet and the Cashflow Statement are all integrated. This means that banks love 3-way forecasts, because they know the cashflow numbers have ‘accounting integrity’. They also provide a great sanity check to make sure you haven’t missed anything in your forecast workings.

2. Invest time to get the details right

To get the most realistic results from your cashflow forecast, the settings, assumptions & calculations you use for every line must match the real world as closely as possible. For example, the cashflow pattern for, say, Electricity Expenses will be different to the cashflow pattern for Staff Wages, or Rent, or Stock Purchases and so the model must reflect these differences. Of course this means you need to invest little more time in setting up the forecast, but the increase in accuracy & reliability is well worth it.

3. Build a dynamic forecast model using operations activity drivers

A great forecast is designed with deliberate intent to communicate (direction), to motivate (behavior) and to instigate (action). Done well, forecasts can be powerful tools for driving the business forward. The best forecasts we see are built as dynamic business models, with related lines linked together (eg COGS set as a % of sales revenue), with KPIs built in as assumptions, (eg inventory modeled at 45 days on hand) and extensive use of operations activity drivers (eg numbers of tonnes, kilometres, hours, etc).

Once built, these dynamic models are ideal for performing what-if analysis, for comparing different business scenarios and for modeling the outcomes of possible business decisions. They are also more easily understood & managed by operations staff, which can only increase the chance of achieving budget.

4. If it’s not up to date, it’s out of date

In business, the only certainty is change. Customers come and go, prices and margins shift, the business environment changes. As the world changes around your business, it is important that your cashflow forecast changes to match it. We encourage our clients to review the forecast often, (at least monthly), and update it where necessary so that it always reflects the ‘best view of the future’. An out of date forecast is at best misleading and at worst dangerous as a tool for making business decisions.

5. Play with different scenarios

As economic times become more uncertain, our approach to forecasting needs to become more sophisticated. Once you have a robust cashflow forecast in place, don’t stop there. Create several copies of the forecast and model the impact of different scenarios, so you can see the effect on cashflow, profit and returns. You could do different forecasts to model general sales growth or decline, gaining or losing specific customers, taking on new product lines, buying new assets, or whatever is on your mind.

Remember, the point of forecasting is not to try to predict the future perfectly. Rather, it is about working out what the future would look like if a given set of assumptions were to take place and then figuring out a game plan to deal with the situation.

Michael Ford – Castaway Forecasting, www.castawayforecasting.com

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For Accountants

The official account of For Accountants, an online resource specifically designed for accountants in public practice.