Working out an accurate cash flow projection is one of the most fundamental aspects of good business financial management and financial planning.
Why is this activity so important? It can alert the business to possible financial problems on the horizon. While important in any business, the forecasting of potential financial problems is especially critical for small and medium sized businesses that typically do not have cash reserves set aside to weather a financial storm. Since cash flow is the lifeline of every business, even a temporary slowdown of incoming income can spell disaster for the unprepared business.
In forecasting cash flow, it is wise to conservatively estimate the amount of incoming income and accurately record all expected costs. In addition, predicting the future needs of the business that could add to costs is critical if the business is to experience expansion. Nothing stays stable for very long. Expansion and contraction constantly occur. A business that is not expanding will eventually start to contract. Expansion costs money; sometimes a lot of money. The future cash needs of a business must be anticipated to meet future demands and protect the solvency of the business.
A cash flow projection can be particularly useful as an early warning signal that there may be a shortfall of cash in the business. Forewarned is forearmed, and action can be taken to lower costs and beef up advertising and sales activities to avoid the predicted shortfall. This is, perhaps the most important use of the projection. It allows the business owner to look at the debts and upcoming expenses of the business and to take action in anticipation of the shortfall.
It can also help the business owner realize that changes in their financial policies are needed, especially if the business invoices their customers and waits for payment. Careful review of how the company extends credit to customers, and who they extend it to, can lead to some positive changes in getting incoming cash flow in the door at a faster rate. A simple change like demanding an upfront deposit rather than financing the entire purchase, or setting qualification standards for receiving credit can enhance cash flow. These changes in policy can then be incorporated into the estimation of how fast the money will come in on the projection itself.
Building an accurate budget will help tremendously with the cash flow forecast. A budget is the calculation of how much income is needed to run the company and achieve all of its financial goals, including business expansion, and even the eventual retirement of the business owner. Since it is necessary that the financial management team predicts the projected income and expenditures of the business accurately, they must ensure that the business can survive and grow.
Anticipating dangers and planning for them are easier with both a budget and a projection. The financial management team needs to get it right. No guessing is allowed on anticipated receipts of income or on expenses. Especially anticipated increases in costs. The cost of doing business goes up about 8% to 12% a year, so that needs to be taken into consideration. That also means last year’s projection needs to be re-forecast for this year’s anticipated increases.
The cash flow projection is a dynamic, working document. It needs to be evaluated at the end of each quarter and adjusted for changes that happened so that it remains the most accurate forecast possible. Likewise the budget needs to be updated every quarter as well. Waiting till the end of the year, only to realize that the company is in trouble because nobody was paying attention can result in financial catastrophe. With the evolution of technology in the last decade or so, preparing budgets and projections manually is a thing of the past. Using cash flow management software is very popular in terms of producing accurate and dynamic budgets and projections and greatly reducing the time needed to do the job.