Anyone who has ever managed a checking account, scheduled a bill payment, or waited until a paycheck is deposited to make a purchase already knows the basics of cash flow forecasting. In simple terms, cash flow forecasting is about predicting the inflows and outflows of money for a given entity, be it a person or a corporation. Of course for a corporation, there’s a lot more to it. In fact, planning and managing a corporation’s cash touches on just about every business area, making it the backbone of any successful company. And while rooted in a seemingly simple concept, cash flow forecasts are comprised of weighty considerations and complexities, often times making it difficult for finance teams to maintain optimal cash forecasting processes. Here are some key considerations to help you break down your approach into three general steps.

Why is cash flow forecasting so critical to your business?

First, the basics. At the heart of cash flow forecasting is an understanding of the state of your business; that is, liquidity versus solvency – and its impact on operations. In other words, what is your company’s ability to pay for the outflows with the inflows? This determination is critical across all business segments, and along with it come significant implications for your organization including:

• Legal aspects. Is there enough cash on hand for payroll? And enough cash to pay interest on outstanding loans and assure covenants are fulfilled? If your company lacks the liquidity to cover these aspects, there can be a number of serious legal ramifications. 

• Performance within terms. Does the company need to postpone payment of invoices, especially at year end? Is there enough liquidity to ensure vendor goodwill, which in and of itself is an intangible asset that could impact the cost of doing business and as such company’s cash flows?

Taking these aspects into account, and understanding the impact they have on your decisions and financial forecasting process, is important in your approach to cash flow management. Next, we’ll discuss some key steps for your approach and considerations within each step.

Step 1: Fine-tune your overall cash forecasting goals.

While cash flow management may require a more detailed analysis on a departmental level, the following high-level goals should drive your overall approach.

• Ensure smooth operations. When you think about it, finance teams cannot exist on their own; they are designed to support your company’s core functions – which in turn, cannot successfully exist without finance support. The same symbiotic relationship holds true for cash flow forecasting and operations: cash flow management is required to support operations and ensure everything is running smoothly and efficiently from a cash-flow standpoint. In other words, your operations can only be sustained when you do the following:
  • Ensure liquidity for your operations, short- and long-term
  • Fulfill covenants to remain on good terms with lenders
  • Pay your liabilities (payroll, interest, dividends, etc.)

• Maintain stable relationships. For publically traded corporations, cash flow forecasts are made available to the shareholders by law. For non-publicly traded corporations, such forecasts are usually made available to key stakeholders – for example, banks that are providing a loan or line of credit, or potential business partners considering a joint venture - serving as needed evidence that your company is financially stable. Ultimately, accurate forecasting of your cash inflows/outflows provides transparency thus lowering the cost of doing business for your company.

• Drive strategic decisions. At the end of the day, your cash flows reveal key insight on your company’s profitability – and using this, your company will make long-term business decisions. For example, let’s assume your company has accumulated cash over the last three years and you predict that this trend will continue. Now key decisions must be made about how to use that asset. Will you acquire a new business? Give shareholders larger dividends or buy back shares? Grow your R&D spend? Expand overseas? Conversely, in the event of a shrinking cash balance, will a divestiture be a wise option? These are just some of the decisions that are directly based on your cash flow forecast.

Step 2: Increase accuracy by using the right mechanisms.

Just like any other financial planning and analysis tool, your cash flow forecast is not a perfect science. But when you carefully evaluate and balance the components that make up your forecast, it can greatly improve your accuracy. Here are key elements to consider:

• Time period: Do you want to forecast daily, weekly, or monthly? This decision is largely reliant on your type of business as well as its size. For example, a small manufacturing company may evaluate cash-flow projections on a daily basis while a large Fortune 500 retailer may forecast monthly or even quarterly.

• System data: Assess what data is available from the systems your company already has that can be incorporated into your forecasting model. This “true” data can serve as a more accurate input for your cash-flow model, so it’s important to understand how frequently, and in what ways, you can leverage it to make the model more accurate.

• Assumptions: In addition to the systematically available data described above, you will also have to make assumptions. These assumptions must be clearly specified in your forecasting model and it’s important to periodically reassess them.

• Variance analysis: How do you know when to reassess the assumptions described above? This is where variance analysis comes in. When there is a consistently large variance between your actual and forecasted cash flow, then it’s time to reassess. Keep in mind, your variance can fluctuate often – but as a rule of thumb, shoot for a variance around 5 percent, and no greater than 10 percent.

• Feedback from the end user: Any given forecasting model contains massive amounts of data – but that data is basically useless without clearly understanding how it will be used and who, exactly, will be using it. In other words, the data that’s presented must be specifically tailored to the end user. This model varies greatly from one business to another, so it’s extremely important to solicit this type of feedback to ensure business impact.

Step 3: Consider the operational setup of your banking structure.

Whether an established Fortune 500 company or a small start-up, your banking structure should contain the right balance of elements to ensure that it’s efficient, streamlined and servicing your business at the lowest cost. In many cases, finance departments lack the expertise required to truly find that optimal balance, prompting the need for third-party consulting expertise. There is no one-size-fit-all solution to your set-up – the elements will vary considerably based upon a variety of factors:

• Foreign currencies: Do you operate in foreign country? Do you need accounts that accept foreign currency?
• Trust accounts: These can be an effective way to manage cash for a given type of corporations that typically operate as privately held partnerships.
• Controlled disbursement accounts: This options works best when you want to tightly control your cash. With this structure, you can understand your company’s next day’s cash position at the end of each day, making it a good option for smaller corporations without deep cash reserves.
• Depository accounts: This set-up serves as a tool that gives multiple people access to deposit checks without being able to withdrawal that money.
• Fees/sweeps: During the initial set-up, you’ll want to assess and evaluate fees associated with your banking structure, and conversely, sweeps may be an effective way to earn extra interest on your cash.

Additional Notes on Forecasting

Within each of these operational set-ups, there are a number of important elements to consider. And while these general steps to cash flow forecasting provide a framework for your approach, there are several critical decisions to make along the way. If you'd like to learn more, consider downloading our financial forecasting process guides:

If you're your interested in getting more in-depth experience and expertise, you can also contact us at 8020 Consulting. We'd be happy to discuss any questions you may have.

About the Author

8020 Consultant Ellen Vayner has over 20 years of experience in management consulting and project management. She has worked with several multi-national and cross-functional teams to achieve a variety of results, including an international manufacturing facility move, the establishment of an invoice-to-cash process and the creation of a new reporting package for an executive office. She has worked with clients in entertainment, manufacturing, oil and gas, biotechnology, banking, consumer products and real estate, and her specialties include corporate strategy assessment and development, corporate finance, business case development, and project management. She holds an MBA in Finance and International Business from Carnegie Mellon’s Tepper School of Business, attended London School of Economics as well as took courses at universities in the Soviet Union, Germany, the Czech Republic and Slovakia. She also holds a Project Management Professional certification from the Project Management Institute.