Why Should You Have Cash Flow Projections?

The importance of a cash flow projection

Several studies conducted over the last few years have listed a company running out of cash as one of the reasons for failure. This is because some entrepreneurs – especially first-time entrepreneurs – do not adequately grasp the difference between profit and cash flow. Businesses can be tremendously profitable, showing exceptional net profits and margins, and still run out of money. This is because the components of cash flow and net profitability are different. Sales and profits are recorded when the transfer of product ownership occurs or when the service is provided to the customer. Cash is only generated when the deal is converted into physical cash received by the customer. If there is a big-time difference between when you pay your suppliers and when you receive the money from your customers, you could be showing an adequate net profit but inadequate cash balances. 

What is a cash flow projection?

A cash flow projection is a list of cash inflows and outflows that you expect in each period (usually forecast on a month-to-month basis). There are always several advantages to having an updated cash flow projection. Suppose businesses can predict their future cash positions with a reasonable degree of accuracy. In that case, it helps them understand how to manage their working capital better and when to tap into new sources of funding. It also provides key decision-makers with a greater level of visibility on upcoming payments, obligations to suppliers, lenders, government taxation, etc., so they can plan accordingly. Cash flow projections are used even during fundraising as lenders often ask borrowers to provide cash flow projection documents to determine whether they can make interest and principal repayments on top of their other present obligations.

Main methods of cash flow projection

When forming cash flow projections, there are two main types of methodologies that can be followed: (i) the direct method and (ii) the indirect method.

The direct method is used to predict a business’s inflows and outflows at specific dates. This means that payment is recorded only when it is received in cash and not when the invoice is sent out to the client. This methodology uses historical results to make these judgments and predictions and is better for short-term planning. Because this method works best when there are a small number of transactions, it is often the favoured method for start-up businesses.

The indirect method entails using the balance sheet and P&L statement (income statement) to predict cash flow. Once these statements are prepared, the net income must be adjusted to reflect cash inflows and outflows from operating activities. This means that non-cash expenses such as depreciation and amortization and/or asset impairments, as well as changes in working capital items (namely accounts payable, receivable, and inventory), are added back to the net income. This method is helpful for longer-term planning and is the preferred method for most companies because of its simplicity.

How to calculate cash flow projections for business?

When developing cash flow projections, it is essential to follow a logical and structured process. Below, we have listed the fundamentals of how to create accurate cash flow projections for your business:

  • Select how long you want to project the cash flows

Cash flow planning can be used for as little as a few weeks to multiple years. Depending on how far you can forecast with a reasonable degree of accuracy, select the time period that the cash flow projection will cover. 

  • List your inflows

For each time period in your forecast, make a list of all the inflows coming into your business and their predicted amounts. This starts with sales, where you can use data from previous years (if available) to make an informed judgment about the future. Bear in mind that this should only include cash sales. As such, you should use your historical accounts receivables schedules to determine when cash typically is paid for sales by particular clients. Next, add in other inflows that your business may have received. This can include proceeds from a bank loan or equity raise, government grants, and/or other subsidies. Once you have all of the inflow items listed that directly impact cash levels, add them up. This will form your total inflows for the time period you are projecting for.

  • List your outflows:

Once you know the total inflows for the period, it is critical to ensure that these will be sufficient to cover the outgoing obligations you have in the same period. If not, then you can take steps accordingly to raise funds as needed. Outgoing expenses usually include items such as payments to suppliers, salaries and wages, raw materials, bank interest, insurance, taxation, marketing expenditures, etc. Once you have added up all the items, that should give you your total net outflows. 

  • Total cashflows

The last step is to subtract the outflows from the inflows. If there is a positive amount each month, you are clear and may consider using that excess cash generated to expand. If you consistently see a few negative months, it may be worth exploring a revolving credit facility or other options to allow you flexible access to funds. Alternatively, you may also decide that your current payment terms to debtors are too lenient, and therefore tighten them up to convert your sales to cash quickly. 

While cash flow projections are not a complex process per se, they are paramount to a business’s success. A negative cash balance across multiple periods can signal the end of otherwise solid companies, and therefore it is imperative to use a professional for ideal results.

At Prasad & Company LLP, our highly-skilled team has helped hundreds of businesses make better financial decisions through prudent and reliable cash flow projections. Reach out to us today to get started!