Forecasting cash flows and cash flow reporting utilizing actual results are two critical activities that go hand in hand. Cash flow forecasting, also known as cash flow budgeting, forms the core of the financial process of any business.
A cash flow budget guides you to make the right decisions to ensure comfortable liquidity for the business. An accurate and detailed cash flow forecast would help organizations anticipate cash flow issues and resolve them on time.
It must be noted that constant review of this forecast with actual cash flow is crucial for keeping the company afloat. An annual cash flow forecast should be continually adjusted for the timing of actual receipt and disbursement of cash.
A number of steps are required to create a cash flow budget and for controlling cash flow. There are two key factors that go into the preparation of cash flow budgeting: one is the cash inflow (receipts) and the other is the cash outflow. In order to accurately forecast these figures, you might have to make a number of assumptions about how your business will be operating. Read on to find out the steps involved in preparing a cash flow budget.
By forecasting your expenses, you could get an estimate of your total outflows for the year. The selling price of your products or services has to include an amount that would cover these expenses if you want to make profits. Usually, there are three types of cash outflows to consider, although they may vary from one business to another:
These are also known as fixed costs because they do not vary much with the level or volume of sales or they have no correlation to sales. These expenses are usually paid on a monthly basis and include items such as salaries, electricity, stationery, rent, and phone bills. Even though expenses might change during unusual periods, they generally remain within a range. For instance, utility bills might go up during particular seasons.
These expenses change along with the sales volume or the inventory levels. Variable expenses might include raw materials, direct labor, and other such costs. These costs should be forecast as a percentage of sales. For example, assume your cost of goods sold (COGS) is 60% of your selling price and you decide to keep a quarter’s supply of goods on hand. Suppose you forecast $200,000 of sales in the first quarter, you would need $120,000 worth of goods (at cost) as part of inventory before the quarter begins. However, this does not take into account the cash paid for such inventory. Costs associated with inventory are several and might not be paid at the same time. For instance, direct labor, if you run a manufacturing firm, would have to be paid early, while raw materials can be obtained on credit ranging from a week to 90 days or more.
Some other expenses might require you to pay cash. However, they might not be incurred regularly or could be a one-time expense. These would include expenses like the purchase of machinery or equipment, dividends, insurance premiums, or training programs. These also need to be taken into account for accurate cash forecasting.
It is evident that an organization's success lies in finding a successful balance between producing profits and effectively managing its cash flows. Cash flow management is the core of any successful business and effective cash flow management depends on forecasting with accuracy.