Why a cash flow forecast is your most important business tool

Most small business owners worry about cash flow more than anything else. Having a regularly updated cash flow forecast will help ease those worries and allow you to make informed business decisions.

Cash is reality

“Revenue is vanity, profit is sanity, and cash is reality” is an often-used quote to highlight which numbers are the most important when running a business.

Revenue is your top line sales number and is simply how many of your product or service you have sold and at what price. You will hear business owners congratulate themselves for hitting $1m in revenue, or $5m, or $10m. That’s great, and possibly vanity, but the next question an experienced Chief Financial Officer (CFO) would ask is, so how much profit did you make from those lofty revenue numbers?

Your profit is how much is left from revenue number after deducting all your costs, those directly relating to your sales e.g. materials and labour, and those overheads necessary for running your business e.g. office rent, insurance, admin staff. The sanity is how much is left after all your efforts, a number which is hopefully at least positive and not a loss.

The third step is the most important and one that confounds small business owners all the time. Your business is making a healthy profit, but this is not turning into stronger cash balances in the bank. This is where the reality of cash flow management comes in.

Why profit does not equal cash flow

Your profit and loss statement (P&L) shows items in the month in which they were incurred or used in the business. This is not necessarily the same month in which they were paid for. The following are examples of differences:

• Sales – most businesses have to wait to get paid by the customers. This could be 7 days, 28 days or much longer in the construction industry.

• Cost of goods – raw materials, production costs, inwards shipping and taxes are all paid for weeks or months before the item is sold and recorded in the P&L as an expense.

• Inventory – businesses that carry inventory have most likely paid for these items in advance, tying up limited cash resources.

• Accounts payable – the flip side of the sales delay in getting paid translates into not having to pay your suppliers until their invoices are due.

• Superannuation – incurred with each pay run but likely only paid over to super funds on a quarterly basis.

• Insurance – often paid annually in advance.
  

In addition, there are other transactions that occur in a business that have a cash flow impact but do not appear in your P&L at all. These include:

• Quarterly GST payments

• Loan repayments and drawdowns

• Investments in fixed assets – machinery, tools, cars, office equipment

With all these timing differences between profit and cash, it is vital that all business owners have the reporting tools they need to have visibility over cash flow.

Cash flow statement v Cash flow forecast

A cash flow statement is a backward-looking report that sits alongside the P&L and the Balance Sheet and reconciles between profit and cash for a given period. This is great looking at past performance but of no use for understanding future cash flow needs. This is the role of the cash flow forecast.

The cash flow forecast looks forward, ideally on a rolling 12-month basis, and predicts future cash inflows and outflows taking into account known periodic payments and estimates based on past performance, including:

• Average days it takes customers to pay

• Average days suppliers are normally paid

• How much is maintained in inventory

• Known payment dates for BAS, superannuation, income tax instalments

• Expected loan repayments

• Expected asset purchases

• Changes in budgeted sales or other costs
  

The cash flow forecast is an integral part of the budgeting process and is the most important report produced to assist in business planning. If you have a budget but not a cash flow forecast, you could be putting your business is at serious risk.

Why the cash flow forecast is your most important business tool

Ensuring Liquidity

The most important reason a cash flow forecast is crucial for any business is to ensure liquidity. Liquidity refers to the ability of a business to meet its short-term obligations, such as paying suppliers, employees, and other operational costs. Without adequate liquidity, even profitable businesses can face insolvency. A cash flow forecast helps business owners anticipate periods of cash shortages and surpluses, allowing them to plan accordingly. By identifying potential cash flow gaps in advance, you can take proactive measures such as securing short-term financing or adjusting payment schedules to maintain positive cash balances.

Supporting Decision-Making

Effective decision-making is at the heart of successful business management. Cash flow forecasts provide valuable insights that inform strategic decisions. For instance, you might be considering expanding operations, purchasing new equipment, or launching a marketing campaign. A cash flow forecast can help assess the financial feasibility of these initiatives by projecting their impact on cash reserves. You can also tweak the forecast assumptions to show the changing impact on cash balances, thus reducing the risk of overextending resources and encountering financial difficulties.

Managing Seasonal Variations

Many businesses experience seasonal fluctuations in revenue. Retailers may see increased sales during the holiday season, while tourism-related businesses might thrive during specific times of the year. Cash flow forecasts allow businesses to plan for these variations by projecting cash flow during peak and off-peak periods. By understanding these patterns, you can ensure you have enough cash to cover expenses during slower periods and can capitalize on opportunities during busier times.

Giving Confidence to Lenders

For lenders, a detailed cash flow forecast provides confidence that the business can meet its financial commitments, increasing the likelihood of securing financing or acceptance of an ATO debt reduction plan.

Identifying Potential Problems Early

One of the most significant advantages of cash flow forecasting is the ability to identify potential financial problems before they become critical. The key point here is that the cash flow forecast must be maintained and updated regularly. By regularly reviewing your cash flow forecast, you should be able to spot trends and patterns that may indicate trouble ahead. For example, if a forecast shows a consistent decline in cash inflows, it could signal issues with sales or collections. Recognizing these warning signs early allows you to take corrective action, such as improving credit control procedures, revising sales strategies, or cutting unnecessary costs, thereby averting a potential crisis.

Optimizing Cash Management

With a regularly updated cash flow forecast at hand, you should have visibility over the levers to pull to optimize your cash management. This includes managing working capital, scheduling payments to take advantage of early payment discounts, and timing cash outflows to align with cash inflows. By optimizing cash management, you can reduce borrowing costs, improve profitability, and improve the amount of cash available to you the business owner.

Building Confidence and Reducing Stress

Running any business is stressful, particularly when it comes to managing finances, but these stresses are even more acute for small business owners who do not have the support and resources to fall back on when cash flow gets tight. A cash flow forecast provides a business owner with a sense of control and confidence by offering a clear picture of their financial future. This reduces anxiety and uncertainty, allowing business owners to focus on what they do best – running their business.

How an outsourced CFO can help

CFO is short for Chief Financial Officer, and this is the most senior and experienced finance professional in most big businesses. A CFO provides high quality finance, accounting, commercial and operational advice to a business. Not surprisingly, a CFO comes with a hefty salary and cost to the business, and so it is usually only larger businesses that hire a full-time CFO.

Smaller businesses, particularly those that are looking to grow and expand services, also need the advice and services provided by a CFO but not on a full-time basis. This is where an outsourced option comes into play. An outsourced CFO could work on a one-off project or on a retainer, for a much smaller number of hours per month. This means the cost is substantially lower than hiring a full-time resource.

An outsourced CFO would be able to build your company cash flow forecast and ensure that it is regularly updated to ensure that it is embedded as the business’s most important decision-making tool. In addition, they would be able to advise on ways to improve business profitability and cash flow, and work with you, the business owner, on strategic growth plans.

Why should I choose GearChange Business Advisory?

At GearChange Business Advisory, our passion is supporting business owners to turn their dreams and goals into an actionable business plan that gives you the best chance of success, and the future you deserve for you and your family.

Our business is led by Steven Nicholson who has over 30 years of experience helping small and growing businesses achieve their business goals by advising and supporting business owners with commercial advice and insightful financial information.

Steven’s extensive experience has taught him two key things that ensure a successful outsourced CFO engagement:

1.      All businesses are different. Rather than a one-size-fits-all solution, Steven will always tailor the services to meet the specific requirements of each client, ensuring that their financial strategies align with their business objectives.

2.      Build a trusting relationship with the business owner. Steven’s relaxed and honest communication style allows him to lower barriers quickly and show the value he can add as a trusted business advisor. This is critical to understanding the true worries and drivers of a business owner and ensuring that these are front of mind in any solutions provided.

What should I do next?

By outsourcing cash flow forecasting to an expert in the field, you can focus on what you do best – running and growing your business.

Get in touch with GearChange Business Advisory for a no obligation chat to see if we can help your business move up through the gears.

Initial free CFO consultation