4 Reasons Why a Cash Flow Forecast is Useful For a Small Business
You’ll be often told that cash flow woes kill small businesses. You’ll see a figure of something like 90% of startups don’t make it past their first year due to cash flow problems.
Whilst we think this number is a bit over-exaggerated, it’s impossible to deny that cash flow problems are a major factor in a startup’s demise.
Seeing the huge number of startups fail, it does make you wonder how crucial a cash flow forecast is to a small business.
But what even is a cash flow forecast?
A cash flow forecast is a plan that shows how much money you expect to receive, and how much you expect to pay out, over a set length of time.
In this article, we’ll go through why a good cash flow forecast is often the solution to avoiding money problems in your business.
1. Know when you’ll run out of cash
One of the problems that startups and small businesses have is that in order to get going, you need to spend money.
It’s a vicious cycle, spend money to make money, then spend the money you make back on the business.
But how does a cash flow forecast help here?
A cash flow forecast in this instance isn’t going to solve your problem, but what it will do, is make it easier to keep track of your cash trajectory, and predict future problems and needs.
An accurate forecast can and will show you when you are going to run out of cash, it’ll show you how many sales you’ll need to make to break even, and when you’ll need to source more cash.
Most startups will begin with savings, a loan or an investment of some kind. The rate at which you use up this initial investment is known as your burn rate.
Your burn rate is a crucial number to understand, as it’ll help you monitor your cash.
There are two kinds of burn rate, both very simple.
- Gross burn rate = monthly spend: the total amount of capital the business spends every month.
- Net burn rate = monthly loss: total capital spent in the month, minus any revenue earned that month.
The period in which you’ll burn cash will vary from industry to industry as it can take some products or services longer to find a route to market, think a plumber versus a niche tech product.
Speaking of taking longer to find a route to market and an audience, we need to talk expectations.
2. Ensure a realistic sales forecast
When planning your business, you have to be realistic about your sales expectations. Will you really reach what you hope for?
Entrepreneurs are, by nature, optimists, so it can be pretty hard trying to be realistic when it comes to sales. Everyone thinks they have the best product or service, a lot do, but reaching the people who agree with you takes time and is never as quick as you think!
So, how does a cash flow forecast help here?
When preparing your forecast, you aim to not only lower your expectations on sales but also build realistic ones from the ground up. This will give you a more accurate picture of when you’ll need to source more cash.
Best practice is to create multiple forecasts for different scenarios. A best case, worst case and a base case is a good place to start, but you can go further based on internal or external factors, such as hiring more staff, or if a global pandemic hits!
I think you’ll start to notice a theme here, a cash flow forecast provides you with some insight into your business’ future, allowing you to make informed decisions today, and prepare for whatever the future will throw at you.
3. A forecast can validate your business model
If you’re planning your business or thinking of changing your business model, a forecast is vital for ensuring it’ll work.
Your business model is essentially how you plan to go about making money, it’s crucial you choose the right one. You can read our full guide on choosing a business model here.
So why is this so important?
A business model is the key to being profitable. Sometimes a particular model just won’t work for your business, for example “low-cost” is a business model many businesses go for, but can often end up being a race to the bottom of the barrel, pricing yourself out of business.
This is why it’s critical you get it right – without a cash flow forecast, you will essentially be guessing whether your business model is going to work long term.
A forecast can help you verify your business model, it can show that it’ll work, in line with your assumptions about customers and costs.
If you plug in your sales forecast and see it takes a long time for you to make money or your sales don’t even cover your manufacturing costs then you might want to rethink your model!
Weigh up all your options and try out different models in your forecast.
One of the strengths of forecasting is you can try things out on paper or virtually before trying them out in the real world.
You can simulate the results of different business models in an afternoon! Rather than using one for a year, only to find out it’s not suitable, wasting time and money in the process.
4. A forecast is essential if you’re selling goods or services on credit
So if you’re selling goods and services on credit, you’ll understand that you won’t be paid straight away, instead, you’ll receive payments in a lump sum a specific period of time later, or in installments.
You need to ensure that you can cover your cost of sales and operational costs whilst waiting for payments from customers.
A cash flow forecast will help you understand when you’ll be paid and how this impacts you.
There is also the unfortunate possibility that when you sell goods and services on credit, you won’t be paid at all.
This is known as bad debt. We’ve been over the concept and impact of bad debt in a previous article.
Of course, selling goods and services on credit allows you to open up your product to more customers and has been proven to increase sales – so it’s not all bad!
But modeling the impact of credit on your cash flow is essential for working out whether it’s a payment option you should offer. For example, you need to ensure you’re not cash poor when a large bill comes in, you might have the money on paper, but then you won’t be able to pay salaries or bills, so it’s important that you ensure you have the money in the short term to cover this.
I think you can tell my stance on a cash flow forecast’s importance by now!
It’s essential for any business but arguably more so for a small business or startup as their cash positions are a lot more volatile and they can’t always quickly source more cash from investors or banks.
Crucially, an accurate cash flow forecast will help you:
- Identify cash shortcomings before they occur
- Validate your business model
- Evaluate your sales forecasts
- And understand what kinds of payment options are viable
Of course, there are many, many more advantages to using a cash flow forecast in any business, it’s not limited to these above.
So now you’ll probably want to go and create a forecast, right?
Well, we’ve written plenty more articles on cash flow and even provide a free template for Excel or Google Sheets which you can use to get started. Ultimately, you will need to create a balance sheet and profit and loss forecast which will need to be linked together.
You can check out all our articles on cash flow and forecasting in general here on our blog, but here’s a list of the articles I feel will be most useful.