Showing posts with label Cashflow forecasts. Show all posts
Showing posts with label Cashflow forecasts. Show all posts
Cash flow forecasts
Why Startups Struggle with Cash Flow Problems
Start-ups and small businesses are especially vulnerable to cash flow problems. Here are some of the main reasons:
It can be a while before the business makes its first sales – the pre-trading period often involves incurring costs without getting any revenue in return
Suppliers may demand immediate or early payment from the start-up as the business has not developed a track record for paying bills on time
A new business usually has to spend up-front on expenses such as marketing and product development.
The new business will not have reserves of cash built up from profitable trading – an important source of cash known as "retained profits".
During the early months of trading, therefore, a start-up business faces its most significant challenges in managing cash flow. Without careful management and planning of cash, the business may run out of money. You can probably see why cash flow problems are a major cause of business failure amongst start-ups.
Why Cash Flow Forecasting is Important for a Startup
Cash flow is the life-blood of a small business. So you can probably seen that it makes sense for a start-up to forecast (predict) what is going to happen to cash flow to make sure it has enough to survive. If a business runs out of cash and fails, then it would be a shame if the entrepreneur hadn't at least seen it coming.
Identify potential shortfalls in cash balances in advance – think of the cash flow forecast as an "early warning system". This is, by far, the most important reason for a cash flow forecast.
Make sure that the business can afford to pay suppliers and employees
Spot problems with customer payments – preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note – this is not really a problem for businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale
As an important discipline of financial planning – the cash flow forecast is an important management process, similar to preparing business budgets.
External stakeholders such as banks may require a regular forecast. Certainly if the business has a bank loan, the bank will want to look at cash flow forecasts at regular intervals
Limitations of Cash Flow Forecasting for a Startup
It is important to remember the limitations of a cash flow forecast. They are not always reliable, largely because businesses need to make assumptions about the future. When commenting on any cash flow forecast in the exams, take a look at which figures are estimates and try to assess whether the entrepreneur has built in some contingency or safety margin.
Common reasons why cash flow forecasts prove unreliable include:
Sales prove lower than expected
It is too easy to make optimistic assumptions about sales, particularly before the business starts trading. Market research may help an entrepreneur estimate potential sales volumes and prices that customers will find acceptable. However, there is no substitute for actually starting to sell. Only by trading does the entrepreneur discover whether the product is attractive to customers, the price they will pay and what seasonal and other factors actually affect demand.
Customers do not pay up on time
This is an issue for businesses that allow customers a period of credit before paying for their purchases. Many small businesses suffer significantly from slow or delayed payment by customers. It is not unusual for a small business to have to wait 30-60 days before invoices are settled – sometimes much longer.
The cost of raw materials and other inputs prove higher than expected
This can happen in several ways. For example, the business may underestimate the price that has to be paid for each supply. Alternatively, the quantity of raw materials required may be under-estimated, perhaps because the production process doesn't turn out to be as efficient as expected.
Certain costs are not included
A common problem for start-up, particularly if the entrepreneur does not have experience of the market in which is it launching. New entrepreneurs are often surprised by the type of costs that a small business incurs, often unexpectedly high.
Given the limitations of cash flow forecasting outlined above, how should an entrepreneur respond?
A good way is to create two different versions of the cash flow forecast:
- (1) A "base case" version which is the expected or hoped-for version
- (2) A "downside" or "worst case" version, which takes a pessimistic view of what might happen.
Which forecast should be used? It depends on who is reading it. The bank manager is probably best given the "downside" version so that his/her expectations are managed.
Sources of Information to Help a Startup Forecast Cash Flow
The main sources for the assumptions used in the cash flow forecasts for a start-up will be:
Entrepreneur experience – there is no substitute for experience of running a small business. Some of the assumptions will be based on "gut feel" and instinct. A cash flow forecast produced by an inexperienced entrepreneur has to rely much more heavily on other sources.
Market research into key aspects of sales and costs – e.g. seasonal fluctuations in demand, average selling prices and quantities in the market, typical gross profit margins, the lead-time between marketing campaigns and orders etc
Suppliers – a great source of information on costs and also the timing of payments. What are the industry norms for paying suppliers in the market?
Advisers – it makes sense for start-ups to get help from advisers when putting the cash flow forecast together. The advisers might be from Business Link or other government-funded agency. It could also be the local bank manager or accountant – whose help is particularly useful when it comes to making sure the forecasts are complete & mathematically sound.
If you would like to learn more about this topic then have a look at out key topic video!
Cash flow forecast
The cash flow forecast predicts the net cash flows of the business over a future period.
The forecast estimates what the cash inflows into the bank account and outflows out of the bank account will be. The result of the cash flow forecast is an estimate of the bank balance at the end of each period covered (normally this is for each month). An example of a simple cash flow forecast is shown below:
A business uses a cash flow forecast to:
- Identify potential shortfalls in cash balances – for example, if the forecast shows a negative cash balance then the business needs to ensure it has a sufficient bank overdraft facility
- See whether the trading performance of the business (revenues, costs and profits) turns into cash.
- Analyse whether the business is achieving the financial objectives set out in the business plan (which will almost certainly include some kind of cash flow budget)
Why the cash flow forecast is so important
If a business runs out of cash and is not able to obtain new finance, it will become insolvent. It is no excuse for management to claim that they didn't see a cash flow crisis coming.
So in business, "cash is king". Cash flow is the life-blood of all businesses – particularly start-ups and small enterprises. As a result, it is essential that management forecast (predict) what is going to happen to cash flow to make sure the business has enough to survive.
Here are the key reasons why a cash flow forecast is so important:
- Identifies potential shortfalls in cash balances in advance – think of the cash flow forecast as an "early warning system". This is the most important reason for a cash flow forecast
- Makes sure that the business can afford to pay suppliers and employees. Suppliers who don't get paid will soon stop supplying the business; it is even worse if employees are not paid on time
- Spot problems with customer payments – preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note – this is not really a problem for businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale
- As an important discipline of financial planning – the cash flow forecast is an important management process, similar to preparing business budgets
- External stakeholders such as banks may require a regular forecast. Certainly if the business has a bank loan, the bank will want to look at cash flow forecasts at regular intervals
Cash flow forecasts
WHAT IS A CASH FLOW FORECAST?
A cash flow forecast is an estimate of the amount of money you expect to flow in and out of your business and includes all your projected income and expenses. A forecast usually covers the next 12 months, however it can also cover a short-term period such as a week or month.
WHAT CAN YOU USE IT FOR?
Cash flow forecasts can help predict upcoming cash surpluses or shortages to help you make the right decisions. It can help in tax preparation, planning new equipment purchases or identifying if you need to secure a small business loan.
You can also use it to see the effect of an upcoming business change or decision. If you're considering hiring a new employee for example, you'd add the additional salary and related costs into your forecast. The new figures in your cash flow forecast will tell you whether hiring that additional employee is likely to place your business in a stronger position and help you decide whether to hire them or not.
Including best, worst and most likely case scenarios allows you to see how your business will fare if you suddenly hit tough times or better than expected trading conditions. Knowing how this effects your cash position allows you to make informed and educated decisions, and you'll be more confident of running your business.
IS YOUR BUSINESS MEETING EXPECTATIONS?
You can use your cash flow forecast to check if your business is meeting your expectations. Comparing your actual income and expenses with your forecasts can identify areas where your business is over or under performing. Reviewing your actual performance against your forecasts alerts you to any variance so you can investigate and find out why there is a difference.
If your sales are higher or lower than forecast for example, you'd want to find out why. Are your forecasts too high or too low? Has a competitor changed strategy or has a new competitor entered your market? Do you have a customer service or quality control issue? Using forecasts in this way allows you to actively manage your business. It empowers you to ask the right questions, and ultimately make the right decisions.
HOW TO PREPARE A CASH FLOW FORECAST
Cash flow forecasts are easy to prepare:
Estimate your likely sales
The first step is to estimate your likely sales for each week or month. Use your previous sales history from the last couple of years to get a good idea of the level of weekly or monthly sales you can expect. It's unlikely that your sales will be constant so include seasonal patterns and one-off events such as trade shows, in your projections.
If you're only just starting a business, you'll need to estimate your forecasts based on information from customer surveys, suppliers, industry experts such as your NAB Small Business Banker, and the performance of similar businesses.
Don't forget to factor in your future plans, and current market conditions and trends. If you're planning a new marketing drive or launching an exciting new product you'll need to put these increased sales expectations into your sales forecasts. Similarly if a new competitor has just entered the market you might want to drop your forecast figures a little to allow for the fact they may gain some of your market share.
Estimate your payment timing
The next step is to estimate when you expect to receive payment for your sales. If you operate a cash sales business forecasting is relatively easy since payment occurs at the time of sale. If you sell on credit you'll need to factor the likely delay in payment into your cash flow forecasts. If your terms are 30 days you can then expect to receive payment between one to two months after the sale has been made.
Now that you know how much income you expect, and when you expect it, all that is left is to put these figures into the correct columns in your cash flow forecast.
Estimate your likely costs
Your costs are likely to be made up of fixed and variable costs. Fixed costs are those you will have to pay regardless of your level of sales and include costs like rent and salaries. Variable costs vary – usually according to sales. For example, you wouldn't have to pay delivery fees for stock if you weren't ordering any in.
Use your forecast sales levels to work out the amount of stock or raw materials you'll need to buy in to meet your sales figures.
Identify other bills you'll need to pay and when you'll need to pay them. It's a good idea to go through your historical payment records to make sure you don't forget to include annual or erratic expenses like accounting fees or business taxes.
Once you have identified the payments you need to make and when you need to make them, add these to your cash flow forecast.
Use your forecasts
Now that you have your weekly or monthly income and expenses in your cash flow forecast its ready to use. Simply add in an opening bank account balance, and add the revenue less the expenses for each weekly or monthly period to find out your likely cash position.
The usefulness of your forecasts will depend on how accurate and up to date they are. It's important to update them against your actual business performance on a weekly or monthly basis. This will ensure that your information is accurate and allow you to adjust future forecast figures as soon as it becomes clear that they're likely to differ from your initial expectations.
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