What is a cash flow statement?
The cash flow statement is one of the more common reports used by accountants. It is a measure of all the incoming and outgoing cash activity of the business and is usually estimated at a monthly level. You may think that all that matters is your profit margin but it’s critical to understand and know how to forecast your cash flow.
The key difference between a cash flow forecast and another report like the income statement (aka profit & loss) is that it’s all about timing. When cash is parted with or received is vitally important. It will not take into account future sales received on credit. It’s a true reflection of your bank accounts inflows and outflows. Not what might be, but what is.
Why do I need to forecast my cash flow?
Simply put, you can be a highly profitable business but still go bankrupt. Why? Your cash flow goes negative.
As I said above, cash flow is all about when transactions happen. Here is an example. You could be taking thousands of pounds worth of orders but if you don’t actually receive the money for another 60 days due to your payment terms then you might not have enough money to pay your rent next week!
Let me show you this in a chart. If you look at the chart below you can see a 12 month cash flow forecast with totals for the year at the top. I finish the year with £1295 in the bank. I’m in the green! Unfortunately not. Some big bills at the end of 2017 sent me into negative cash in December. The business is bust by Christmas.
Cash flow problems cause a huge amount of businesses to fail, so you can begin to see why it’s important. Having a clear picture of your cash flow is critical to operating your business long term and understanding it’s financial health. You need to plan so you can see any shortfalls coming a mile off and find a way to plug the gap before it’s too late. You may have a perfectly viable, growing business but if you don’t have one eye on the future it could all go wrong!
Where should I start?
It may seem like you need to be an expert accountant to work out your cash flow but it’s simpler than it first appears. The ingredients are actually quite basic.
- Decide how far you will plan into the future
- Estimate your sales
- Estimate your costs
- Plan when you will pay or receive money
The length of your forecast should be at least 12 months in detail. The further you get into the future the more uncertain it gets and it will largely depend upon the type of business. For example, if you are a software business building apps with a 2 year development cycle you will want a longer planning horizon.
Once you have chosen a duration for you forecast you should make a comprehensive list of all the financial activities of the business before you even start thinking about the numbers. This exercise alone is good for highlighting what your business is doing.
Now, I will be demonstrating how to make this using Brixx business plan software. This is the Brixx planning blog after all! However the financial advice here applies whether you are using Brixx, a spreadsheet template or the back of a napkin (I totally recommend Brixx, it’s free, didn’t you know? Followed by napkin…).
I’m going to break this task down into the following:
- Cost of sales
- Operation costs
- Asset purchases
- Loan drawdowns and repayments
Plan your income
How detailed should you plan your sales forecasts?
Now we move on to estimating your revenue forecast. The first question you have to ask is how much depth you want to go into. You could just create one line for all your revenue, nice and quick. This makes it very easy to compare against your actuals. However, it provides little insight into the performance of individual products or services and it will be harder to make accurate forecasts going forward when you don’t know which items contribute the most or are performing better.
So, you could add a row for every type of item you sell. Maximum detail, maximum insight? Not quite. For example, if you are a cafe owner you might be selling coke, diet coke, coke zero, Pepsi, diet, Pepsi etc. It would take far too long to actually work out individual sales forecasts for every item if you sell a lot of different things, it makes it unmanageable. You’ll give up in a week. The added value of having that level of detail is limited when forecasting. If you have a lot of products you probably want to consolidate them into one line such as ‘cold drinks’.
The cafe might break all it’s sales down into the following lines:
- Hot drinks
- Cold drinks
- Catering events
You could go into more rows if you want but hopefully, you can see that it’s about striking a balance between keeping it practical but also retaining a useful level of detail. It will all depend on how many different items you sell and how much time you have.
How do you estimate your sales forecast?
Next, you need to actually put some numbers down and estimate your forecast. This will be easier if you have some existing figures to extract a trend from but may be harder if you are just in the planning phase of your business. As a startup, you need to extrapolate your likely sales. A simple way to get started with this is to use the following technique:
- Calculate potential reach per day/week/month (The size of the market you can target)
- Calculate the proportion that will view your products
- Calculate the proportion of viewers that will make a purchase
- Multiply this by an average purchase price.
An example would be a shop set up in a shopping centre:
- The shopping centre has a daily footfall of 2000 people (reach).
- 5% enter the shop leading to 100 viewers.
- 20% of the viewers purchase a product averaging £80.
- This leads to a daily income of £1600 and a monthly revenue of £48,000
Then you need to factor in seasonality and other marketing efforts that might affect traffic. You can use this method for all types of businesses no matter what you sell. There are always a lot of factors that will affect how much you actually sell every day but you can start to build up an impression using this method.
Sales Ramp Up Period
As a new startup you’ll also need to factor in your ramp up period. This is the time it takes to grow from zero sales up to the level you anticipate reaching as a fully operating business. It’s unlikely you will hit it big the first day of sales. You need to allow time for your brand to become known, for your marketing efforts to do their work and for a stable customer base to be established. It’s vital you plan this growth period on your cash flow since it will dictate when you run out of cash. If your ramp up period is too long, you may need to seek new funding to cover your on-going costs.
Take a look at the chart below.
In the example above, the startup received a loan in March 17 which covered the initial period of costs. The company starts taking sales a year later but the predicted sales ramp up is not quick enough to cover the business’s costs and the company goes out of business soon after. This is another case where cash flow has killed a potentially great business. As you can see, later on the business does fine! It just took too long to get there and the company ran out of money.
Plan your cost of sales
Once you have decided the level of detail, listed out the products or groups of products and entered some figures you’ll need to enter your cost of sales. These are costs that vary based directly upon the volume of sales. Common cost of sales would be the cost of purchasing or making a product, or the cost of packing and shipping it. It’s useful to do this at the same time as your income forecast since it is so closely related. The timing here is important. You may buy a product a month before you get the income from selling it whilst the shipping cost might be paid after a customer has purchased the product. You may buy a bulk amount of stock to last you several months or you might only order stock as customer requests come in. These variations can mean life or death for the business so plan them right!
The other factor you need to consider is if you are a VAT registered business. You won’t find VAT on a profit & loss forecast because it doesn’t affect profits. Your customers pay you an extra 20% for your products which you then hold for a while before passing on to the Government a few months later. It does make a difference to your cash flow however because it shifts around how much cash you have at any one time. You’ll be collecting more from your customers but every so often you may have a large VAT bill to pay which can catch some businesses by surprise. All the more reason to plan your cash flow!
Planning your operational costs
Next, we’ll look at your business overheads, the costs you’ll always be paying whether you make £1 or £10000. These are often easier to forecast with accuracy. Why? Well, whilst you may have a good idea of your sales forecast in the next 12 months it can be quite an unknown quantity, especially as a fledgeling startup. Who can really predict whether your sales will explode in the first year or be a slow burn over the next two? Your costs, on the other hand, are, unfortunately, somewhat more predictable.
You will have fixed amounts setup for rent, utility bills, phones and the rest of the day to day running costs of the company. These are known quantities with no guess work involved. Check out your direct debit agreements in your bank for a good picture. Include salaries here too, they are all part of your overheads. Think carefully, it’s very easy to forget about hidden costs such as insurance, admin costs and credit card charges. Take your time, get it right.
Once you have all these together you’ll have a pretty good impression just how much money you’ll need to make just cover the operating costs of your business. Also, you should start to get some awareness around when the big costs hit. Do you pay bills monthly or do you get hit with a big sum once a year? Is there a specific month that is higher than the rest you need to be careful around? Make sure you get the timing of these payments correct to ensure an accurate cash flow.
Ready to start planning your cash flow the easy way?
Put simply, these are the items you have to buy to run your business that also retain a value after the initial cost. They are often items you will physically own. It’s worth thinking about these costs separately to your normal operating costs since they can often be large purchases (vehicles, computers etc) that will have a big impact on your cash flow.
If this were a balance sheet guide then I’d expand on this more but here is an example that most people would recognise; the purchase of a car. You have an initial cost (this hits your cash flow) but then it also has value after the purchase. So unlike a cost such as rent, the value goes on your balance sheet, which, in the case of a car, immediately starts reducing over time due to depreciation. Depreciation does not appear on your cash flow because it’s not actually money leaving your bank account. Finally, a few years down the line you may sell it (or write it off). The sale is at the depreciated value, which then appears on your cash flow. Simple!
Asset purchases will vary a lot depending on the type of business. If you are a cars sales garage then it will be very important! An office based company might have computers, desks and other equipment that are refreshed every few years. A retail outlet may have shelving units, storage areas, cash tills and crucially, inventory. They all have purchase timings that will affect your cash flow and often they will be large purchases that need to be planned for in advance.
Loan drawdowns and repayments
You could probably have included this in your overheads section but it’s useful to think about funding separately. You need to be aware of the repayment agreement on your loan as this will affect your cash flow substantially. There are a lot of different policies out there varying from interest only to fixed monthly payments to bullet loans where everything is paid back at the end of the term. This should be a fairly consistent number hitting your cash flow each month. The exception might be a bullet loan where you pay back the entire sum at the end of the loan leading to a massive hit on your cash flow, watch out!
Bringing it all together into a report and chart
All of the above can be divided up into the inflows and outflows. At the basic level:
- Product/Service Sales
- Asset sales
- Loan drawdown or other investments.
- Operational costs and salaries
- Cost of sales
- Asset purchases
- Loan repayments
The net of all this should be a forecast of the balance in your bank account at the end of each month.
Setting up a spreadsheet cash flow forecast
- In a new spreadsheet, set up the months as column headers along the top.
- Add a total column at the end of each year.
- Setup rows for your inflows and outflows.
- Break them down into individual rows as described in the article
- Add a total at the bottom of Inflows and a total at the bottom of outflows
- Add a total at the bottom of the entire report which calculates the net of Inflows – outflows.
- Create a cash flow chart using the totals to visual your forecast. (optional)
Create a free account with Brixx, which will do all of this for you and far, far more.
This just about covers the basics, I hope this has been helpful for you. Please leave a comment below and tell us what you think of this article or the experience your have with planning your business, let us know!