BIF058 How to Forecast Cash Flow

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1 How to Forecast Cash Flow Business Information Factsheet BIF058 October 2014 Introduction A cash flow forecast is an important management tool that helps you plan ahead and make important decisions about the operation of your business. A cash flow forecast predicts the flow of money in and out of your business bank account over a specified time. This factsheet explains the importance of a cash flow forecast and describes its structure and content. It explains how to prepare a forecast and how to use it to monitor your cash flow. It also introduces key accounting concepts including fixed, variable and capital costs, working capital and cash cycle. What is a cash flow forecast and why is it important? A cash flow forecast shows how and when you expect your business to receive and make 'cash' payments over a given period of time. 'Cash' includes Direct Debit and BACs payments to and from your business bank account. The forecast is usually projected over a period of six or twelve months, although you can look at shorter periods, such as a week or month, if this is necessary. You can use your cash flow forecast as a management decision-making tool to help you to identify: How much initial cash investment your start-up business requires. When your business may need other finance, such as an overdraft or loan. What level of loan repayments you can afford to pay each month. When your business will be able to spend cash in the future, for example, for taking on a new employee, or paying for a marketing campaign or the purchase of capital equipment. When cash flow problems may occur once your business is trading and as it grows. A cash flow forecast details how your business will operate in cash terms. If you wish to apply for funding, or ask your bank for a business loan or overdraft facility, you will need a realistic cash flow forecast to support your application. Here is a commonly used layout for a cash flow forecast: Page 1 of 9

2 (Figures in brackets denote a negative balance.) The forecast consists of three main sections: Receipts This section shows the income received. Receipts are always recorded in the month when you expect your business to receive the money. If you offer your customers a period of credit, there will be a delay between issuing your invoice and receiving the money in your bank account. For example, if your customers have 30 days to pay, you would expect the money from sales invoiced in January to be paid into your account in February. You would record these payments under February on your cash flow forecast. If your business is registered for Value Added Tax (VAT), the VAT charged on your sales and paid by your customers should be included in the receipts. (VAT is money you have collected on behalf of HM Revenue & Customs (HMRC). You need to put it aside and account for it later when you submit your VAT return.) You can record expected income from non-trading sources under 'other receipts'. These can include bank loans, your own investment, grants and bank interest for cash on deposit. Payments This section includes all the cash payments made by your business. You need to record when you expect to pay your suppliers for their goods and services, which may be on a cash-with-order basis or on agreed credit terms. Page 2 of 9

3 The example in Table 1 provides five payment categories, but you can change or add to these categories to suit your particular business. For example, you could further divide these categories as follows to help you identify the different costs you have: Credit purchases - payments to suppliers and subcontractors, and marketing activities (advertising, publicity, PR and merchandising). Wages - production staff, administration staff, Pay As You Earn (PAYE) and National Insurance (NI) and training costs. Office expenses - rent, business rates, telephone and Internet, utilities, insurance, stationery and post. Capital expenditure - office equipment, furniture and cars. Finance and tax payments - bank charges, loan repayments, quarterly VAT payments and lease payments. Net cash flow/closing cash balance The net cash flow figure shows the total receipts minus total payments for each month. Net cash flow is added to the opening balance to give the closing cash balance at the end of each month. The closing cash balance is the amount of cash your business has available at that point in time and should correspond with what you see on your bank statement. In the example in table 1, the business receives 2,000 of sales income in January as well as a 10,000 cash injection, but pays out 15,000 in costs, resulting in a negative (or overdrawn) balance of 3,000 at the end of January. As the business trades, it continues to suffer a negative cash flow over the next two months and shows a maximum cash deficit of 5,000 at the end of March. It is only in April that receipts start to exceed payments and the business starts to generate a positive cash flow and it takes until June for there to be a positive cash balance. For this business to be able to trade, it would need an additional 5,000 of cash invested when it starts trading or the owner would have to make arrangements with their bank for an agreed overdraft facility of at least 5,000. What do you need to consider when preparing a cash flow forecast? There are several factors that you need to consider when preparing a cash flow forecast: Sales forecast To forecast your cash receipts accurately, you need to predict what your sales will be on a weekly or monthly basis. For a start-up business this will be based on your market research and your business plan. If your business has been trading for some time you will have historical sales data on which to base your forecast as well as a clearer picture of the market as a whole. How quickly sales are turned into cash depends on whether or not your business offers credit to its customers. See BIF 236, How to Forecast Sales for further information. Page 3 of 9

4 Types of business costs When preparing your cash flow forecast, you need to be aware of the three main types of costs your business incurs: Variable costs, which alter directly in relation to the sales you make. These include raw materials used in your production processes or the goods you buy in and then resell, all of which can be linked to your sales forecast. Fixed costs, which do not vary directly in relation to your sales. These costs may be incurred on a regular monthly basis, such as wages and salaries, insurance, rates or a car lease, or they may be paid quarterly in advance, such as property rental payments. Capital costs, which relate to the purchase of business assets (such as computers or a vehicle) and occur relatively rarely. Credit terms Many small business owners offer some form of trade credit to their customers, with trade accounts normally operating on a 30- to 60-day credit period. The length of time it takes your customers to pay has a significant effect on your business' cash flow. Your business can also benefit from obtaining credit from your suppliers. You need to define your credit policy clearly to your customers and understand what credit terms you are able to get from your suppliers, so you can predict when you will receive cash and when you will need to make payments. See BIF 67, A Guide to Establishing a Trade Credit Policy for further information. Cash is not the same as profit Profit is an accounting concept, but for the practicalities of running a business on a daily basis, having sufficient cash to pay for purchases and expenses is always the single most important issue. For example, Mr Jones runs a furniture store. He pays 250 in cash for a table and sells it to a business customer for 500 on credit. On this transaction, Mr Jones has a made a gross profit of that is, the difference between the cost price of the item and its selling price. However, his business can only benefit from this profit when and if the customer actually pays him cash for the goods. The need for working capital In the example above, Mr Jones has paid 250 to his supplier, but he also needs to fund the daily costs incurred in running his business and paying for further stock. If these costs amount to 200, he needs a total of 450 to operate his business before his customer pays him. This is the 'working capital' required by his business and equates to the cash needed to fund its day-to-day operations. Cash cycle The cash cycle is a term used to describe the connection between working capital and cash movements in and out of a business, and is usually measured in days or months. Small firms typically purchase goods and services before they are in a position to make a sale to their customers; this is particularly evident in production-led firms. Suppose that a firm buys raw Page 4 of 9

5 materials on one month's credit and then holds them in store for one month until they are used by the production department. The production cycle is very short, but finished goods are typically held for one month before they are sold. Customers usually take two months to pay their invoices. The cash cycle would be: There would be a gap of three months between paying your supplier for the raw materials and receiving cash from your customer. A few dates might clarify this point. Suppose the business purchases its raw materials on 1 January. The sequence of events would then be as follows: The cash cycle is the period of three months from 1 February, when payment is made to suppliers, until 1 May, when cash is received from debtors. This will determine the amount of working capital required by the business. If you can shorten the cash cycle, you can reduce the amount of money needed by your business to fund its working capital. How to set up the forecast You can use a variety of methods to set up your cash flow forecast: Manual preparation. Spreadsheets. Forecasting tools. Accounting software. Page 5 of 9

6 The most common method is to use a standard spreadsheet, which allows you to change the numbers quickly and easily as you refine your forecast. There are seven key steps to take when setting up the forecast: Step 1 - Produce a sales forecast for the next 12 months. Estimate the split of credit and cash sales and the credit period taken by your customers so that receipts are put in the correct month. Step 2 - Establish whether any other cash will be received. This includes money you are investing in your business, as well as loans and grants if applicable. Step 3 - Determine the goods/stock you need to buy so that you can reach your sales forecast. Your suppliers may want to receive cash payments with the order initially, but after a month or two you should be able to set up a trade account and benefit from credit payment terms. Step 4 - Identify your other regular monthly cash payments. These include payments of salaries, marketing costs, operating costs, vehicle running costs and any other sundry expenses. Step 5 - Identify any one-off expenditure, such as fixed asset purchases. Step 6 - Set out the cash flow forecast month by month for a full year. Always ensure your figures correspond to when you expect payments will actually be made. Step 7 - List your assumptions as a reminder of how you have reached your figures - for example, payment terms and cash cycle length used. Most lenders will want to spend time reviewing your assumptions, as these will help them to identify whether your figures have been thought through in detail. How to use the forecast in practice - variance analysis Once you have completed your cash flow forecast, you need to compare it to what happens in reality. At the end of each month you should compare your forecast values and actual results. In the cash flow forecast that follows in Table 4, the difference (variance) between the forecast value and actual result for receipts and payments has been recorded. Where the actual result is worse than the forecast value, this is shown as a figure in brackets. Page 6 of 9

7 By comparing your actual cash flow with the forecast figures, you can see whether your assumptions remain valid. If there are significant differences, you should reforecast your cash flow using revised assumptions. When you first start trading, you should consider revising your cash flow forecast every month to reflect what is actually happening. If you are running an established business, you should still consider revising your cash flow forecast every three to six months to reduce the risk of cash flow becoming a problem. Page 7 of 9

8 Hints and tips Use 'what if' scenarios, for example, what would happen to your cash flow if sales were 10% higher or lower than your forecast. Be cautious, especially in the first few months of trading, about how quickly your customers will pay you. It is better to expect slow payment and receive the cash more quickly. Aim to have a contingency reserve of cash to cover unexpected costs or a sudden shortfall in receipts. Be aware that a monthly forecast does not take account of timing factors within each month. This means that during a month that shows a small positive cash balance at the start and finish, you may suffer a large negative balance in the middle if a large payment has to be made before sales income has been received. Further information To access hundreds of practical factsheets, market reports and small business guides, go to: Website: BIF 4 A Guide to Writing a Business Plan BIF 30 How to Keep a Manual Cash Book BIF 38 Choosing and Using an Accountant BIF 40 A Summary of Sources of Finance for Starting a Business BIF 51 A Guide to Controlling Costs BIF 54 A Guide to Costing and Pricing a Product or Service BIF 67 A Guide to Establishing a Trade Credit Policy BIF 236 How to Forecast Sales BIF 260 An Introduction to Preparing a Budget BIF 275 A Guide to Choosing and Using Accounting Software BIF 387 A Guide to Avoiding Cash Flow Problems BIF 422 An Introduction to Credit Control Books 'Cash Flow Analysis and Forecasting' Timothy Jury 2012 John Wiley & Sons Useful contacts The Institute of Chartered Accountants in England and Wales (ICAEW) is a membership organisation for accountants. There is a searchable directory of accountants on its website. Tel: (01908) Website: The Institute of Chartered Accountants of Scotland (ICAS) is a membership organisation for accountants in Scotland. Its website includes a directory of Chartered Accountants in Scotland. Tel: (0131) Website: Page 8 of 9

9 Chartered Accountants Ireland represents accountants in Ireland and offers a 'find a member' facility on its website. Tel: (028) (Northern Ireland office) Website: The Association of Chartered Certified Accountants (ACCA) is a membership association for accountants. It offers a 'find an accountant' facility on its website. Tel: (020) Website: DISCLAIMER While all reasonable efforts have been made, the publisher makes no warranties that this information is accurate and up-to-date and will not be responsible for any errors or omissions in the information nor any consequences of any errors or omissions. Professional advice should be sought where appropriate. Cobweb Information Ltd, Unit 9 Bankside, The Watermark, Gateshead, NE11 9SY. Tel: Website: Page 9 of 9