Noah is currently the COO at Palo Alto Software, makers of the online business plan app LivePlan.
How to Manage Cash Flow With an Accurate Cash Flow Forecast
10 min. read
Updated October 29, 2023
If you’ve built a budget and forecast for your business, you’re already one big step ahead of most businesses. In fact, just by taking this step, you’ve already improved your chances of success by up to 40%.
But, you can’t just rest on your laurels – you need to put that budget and forecast to work for your business. In fact, you can use your financial forecast to actively manage your business and improve your chances of success and growth.
A key benefit of using your forecast as a management tool is that you’ll be able to significantly improve how you manage your cash and cash flow. This will give you clarity about the health of your business, highlight growth opportunities, and help you avoid pitfalls.
Why is cash flow management important?
Businesses operate on cash. This is probably an obvious and unnecessary statement for anyone who’s in business, but it’s important to remember. By cash, I don’t really mean physical coins and bills, but money in your bank account that you are able to spend. You need cash to pay your bills, purchase inventory, meet payroll, and generally keep your business running. And this is true for nonprofit organizations as well.
Having a cash flow management system in place is a critical part of building a successful business. This is due to the simple fact that most businesses need to wait for customers to pay while at the same time needing to purchase more inventory, pay payroll, or fulfill other obligations. Cash doesn’t always show up in your bank account the moment you make a sale and, for most businesses, you need to spend money on your product or preparing your services before you actually make that sale.
Cash flow management example
For example, think of a company that sells high-end stainless steel water bottles. The company needs to pay for the materials to make their bottles, invest in manufacturing, and then pay for shipping to deliver the bottles to retail stores around the country.
Even though the company has spent money on all of this, the retail stores probably won’t pay the company for the water bottles they ordered for a while — probably several months. Meanwhile, if sales in the retail stores go well, they may order even more water bottles from the company, perhaps doing this before they have paid for the first shipment.
The company now needs even more cash to make more water bottles and ship them out. Eventually, the company will get paid, but it may take months before cash actually comes in the door, long after manufacturing and shipping have been paid for.
This may sound extreme, but ask anyone who’s ever distributed a product to retail stores and they will tell you that this is much more the rule, rather than the exception.
A cash flow management system that shows you historical payment and spending patterns and predicts future cash spending and cash deposits can help ease the pain. With a system, your business will be better prepared to handle the ups and downs of cash flow and keep enough money in the bank to continue to operate healthily.
How to manage cash flow
There are three parts of a successful cash flow management system that you need to know in order to build a healthy business.
1. Know your cash position
You can’t start managing cash without first knowing your immediate cash position. You need to know how much money you have in the bank so that you can pay your bills and other immediate expenses.
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2. Understand your cash flow statement
Your cash flow statement shows you how cash is moving in and out of your business and if your business is generally accumulating cash over time or rapidly using up cash reserves. This historical look back at your cash flow helps you identify trends and better understand how your business is actually doing.
3. Develop your cash flow forecast
Lastly, you need a cash flow forecast that predicts your future cash flow and shows you how much money you’ll have in the bank in the coming months. A cash flow forecast helps you figure out if there will be points in the future where you may run low on cash and need a loan or line of credit. Your forecast will also help you figure out when it might be the right time to expand, buy a new piece of equipment, or hire more employees.
How to create a dynamic, more accurate cash flow forecast
The key to a better cash flow management system is bringing together the three key ingredients of cash flow management.
Your accounting system should be able to generate your historical cash flow statement for you. You’ll use this to see how your business has performed, based on your actual results. These are the financial facts of your business, based on your actual sales, expenses, loans, purchases, etc.
You’ll also want to create a cash flow forecast to predict what your future cash position will look like each month for at least the next 12 months. You can certainly create a cash flow forecast using spreadsheets, but you’ll save hours of your time and potential headaches by using a forecasting tool like LivePlan. Tools like LivePlan can also connect to your accounting software to give you direct access to your cash flow statement so you have all your information in one place.
However, the day you create your cash flow forecast is, unfortunately, the same day that it goes out of date. Let’s look into why this happens.
Why your cash flow forecast goes out of date
As your business operates, you make sales and have expenses. These sales and expenses are never exactly what you predicted when you created an initial forecast. Predicting the future is nearly impossible, so it’s perfectly understandable that your forecast and actual results are different.
This all means that the actual cash that you have in the bank at the end of the month is going to be a different number from what you forecasted. Unfortunately, your forecast bases the next month’s predictions on that now-inaccurate number that you predicted, as well as several other numbers that are now also inaccurate.
Over time, as your forecast and reality diverge, your forecast becomes less and less accurate. If your sales each month are less than expected, for example, you’ll be working off an incredibly optimistic forecast that could lead to cash flow problems.
Fortunately, you can combat this by updating your forecasts at the beginning of every month. When you do this, you’ll update all of the assumptions in your forecast with real data that will make your future predictions more accurate.
How to update your forecast
The easiest way to update your forecast is to replace last month’s predicted numbers with the actual results. You’ll update your sales forecast, expense budget, the amount of money you received from customers (Accounts Receivable), and the amount of money you paid to your vendors (Accounts Payable). If you received money from a loan or investors or paid out any other cash to purchase assets or pay down debt, you’ll want to update those numbers as well.
For example, if it’s the beginning of June, you’ll want to go into your forecast and replace all of the numbers that you predicted for May with your actual results. Assuming that you’ve created a forecast with linked formulas or are using forecasting software, your cash flow forecast will automatically update to provide a more accurate prediction of the future.
All of this doesn’t have to be a lot of work. If you update your forecast at the beginning of every month, it will only take you a few minutes and you’ll immediately have a smarter, more accurate prediction of the future.
Based on your past results, you should also update your own predictions for sales and expenses. If sales are consistently beating your expectations, revise your forecast up. If expenses are higher than predicted and look like they will stay that way, make changes to your budget.
Adjusting your forecast on a monthly basis is part of good management and should be a normal part of your monthly financial review.
Some people think that once you create a forecast for the upcoming year, you should never change it. Sure, it’s interesting to look back and see what you thought the future looked like several months ago. But, that doesn’t really help you run a better business because you aren’t adjusting your predictions based on what’s really happening in your business and in your market.
After all, you shouldn’t continue spending according to an outdated budget if conditions have changed. Instead, adjust your budget and communicate those changes to your team.
If it makes you feel better, an easy solution is to have it both ways. Save your original forecast from the beginning of the year and then create a new forecast scenario that’s a copy of the original. Edit and update the copy and keep your original predictions as well to maintain a historical record. This way, you can look back at your original predictions and see how right or wrong you were and also create a dynamic forecast that actually helps you run your business better.
Smarter cash flow predictions
With a cash flow forecast that is being updated on a monthly basis, you’ll have a more accurate prediction of what your future cash position will look like. You’ll understand your cash burn rate and runway which is a critical prediction of how long your cash will last. More importantly, you’ll identify trends so that you can work on improving your cash flow and figure out how to avoid cash flow problems in the future.
Creating a cash flow management system may seem complex at first, but it actually doesn’t take much time and the value it will bring to your business is immeasurable. Imagine having solid predictions of how much cash you’ll have in the bank in the coming months so that you can make smart decisions about your business today. That’s the magic of dynamic, live cash flow forecasting.
Additional benefits from adjusting your forecasts
Revising your forecast on a monthly basis doesn’t just give you more accurate predictions of cash flow. You’ll also get smarter predictions of future sales and more accurate budgets to guide your spending.
Knowing this information, even helps you set more effective goals for your team. For example, if sales are going better than originally planned, increasing your sales forecast helps motivate your team and impacts your predicted profitability.
With updated profit projections, you should revise your expense budget to reflect the direction your sales are going. With increased sales, you may want to invest more in marketing or consider additional hiring. Or, if things aren’t going quite as well, you can tighten your budget and ensure that your team doesn’t continue to spend based on the original plan.
You may notice that big, public companies do this all the time. They are constantly releasing new forecasts — they just call it “guidance”. This strategy doesn’t have to be just for big companies, though. You can revise your forecasts in under an hour every month, and create a smart forecast that will help you grow your business with confidence.
Doing all of this in Excel is certainly possible, but I strongly recommend using a tool like LivePlan. You can spend more time focusing on how to run your business better instead of figuring out the right formulas and making sure you didn’t make a mistake.