Step one in creating a cash flow forecast
is to identify the cash a business expects to receive each month.
This is usually money it gets from selling its product but the business
could get money from other sources (refunds from suppliers etc).
The managers will usually predict the level of sales for a month
and use this to estimate the amount of money it will get. The estimate
is likely to be based on market research (customer surveys,
analysing past trends and competitors, etc). The managers don't
want to be too optimistic - remember that mistakes in this work
could lead to failure of the entire business which might mean a
few job losses.
Example
A carpenter expects that his small business will be able to sell
35 chairs a month. Each chair sells at £40. This means receipts
of £1,400 per month. He borrows money from the bank in February
to purchase new tools and equipment for his workshop. The start
of his cash flow forecast is given below:
Receipts
(£)
Jan
Feb
Mar
Apr
May
Loan
0
6,000
0
0
0
Sales
1,400
1,400
1,400
1,400
1,400
Total
1,400
7,400
1,400
1,400
1,400
Payments
The carpenter then needs to estimate how
much cash the business will use on a monthly basis. This will cover
the expenses involved in making the chairs (direct costs of
production such as wood) and also other costs the business will face
(indirect costs such as telephone bills).
Example
Payments (£)
Jan
Feb
Mar
Apr
May
Wood
700
700
700
700
700
Fabric
350
350
350
350
350
Glue
50
50
50
50
50
Tools
0
1,000
0
0
0
Furniture
0
5,000
0
0
0
Wages
1,300
1,300
1,300
1,300
1,300
Drawings
0
0
0
2,000
0
Bills
100
100
100
100
100
Miscellaneous
40
40
40
40
40
Total
2,540
8,540
2,540
4,540
2,540
Net Cash Flow
Hmm, as you can see, the situation
does not look great for our carpenter. His own predictions show that
he is going to spend more cash than he will receive each month.
Don't rush in and start talking about making a profit or losing
money at this stage. Let's keep it simple and just talk about cash
and liquidity.
Step two is to look at which direction cash is flowing for the
business. Is it flowing into the business or away from it? We can
do this with a simple bit of arithmetic:
Jan
Feb
Mar
Apr
May
Total Receipts
1,400
7,400
1,400
1,400
1,400
Total Payments
2,540
8,540
2,540
4,540
2,540
Net Cash Flow
(1,140)
(1,140)
(1,140)
(3,140)
(1,140)
Net cash flow is total receipts minus total payments. In
this example, it is negative for each month. The negative numbers
are displayed in brackets but you could use minus signs instead.
If you were displaying this information on a spreadsheet, you might
even want to show them in red as they are very significant figures.
The negative net cash flow shows us that there is a net outflow
of cash each month. We use the word 'net' to mean the flow of cash
after deductions (payments) have been made.
Is this bad? Well, it's not great and it means that the liquidity
of the business is getting worse each month but we can't
make any final judgement until we actually know how much cash
the business has. What if the business started the year with
£500,000 in the bank? The net cash outflow would reduce this but
our carpenter would not be bankrupt.
The Bank Balance
The final stage in creating our forecast
is to look at the bank balance. That is how much money is in the
bank at any one time. If you have a bank account look at your
bank statements. You should see an opening balance and a closing
balance on the statements. The opening balance is how much money
you have in your account at the beginning of the month and the closing
balance is how much you have at the end of the month. If your own
net cash flow was positive (from saving some of your pocket money
each month), your closing balance at the end of the month will be
higher than the opening balance was at the start of the month.
Let's assume that the carpenter started January with £7,000 in
the business' bank account. This was left over from the year before
and becomes his opening balance for January.
Jan
Feb
Mar
Apr
May
Net Cash Flow
(1,140)
(1,140)
(1,140)
(3,140)
(1,140)
Opening Balance
7,000
5,860
4,720
3,580
440
Closing Balance
5,860
4,720
3,580
440
(700)
January started with an opening bank balance of £7,000. There was
a net cash outflow of £1,140 which left a closing balance for January
of £5,860. As you can see, the opening balance for February is the
same as the closing balance of January - you begin the month with
the same amount of cash as you had at the end of the previous month.
Looking at the figures, we can see that it isn't until May that
the business runs out of cash. There is, therefore, a liquidity
crisis and the business is risking failure. The manager will
need to take decisions to avoid this crisis. This might involve
arranging an overdraft with the bank (a form of short term
loan where a business can overspend by a certain amount) or cutting
costs somewhere.
Overall, it's fair to say that this business is forecasting a cash
flow problem. Remember that this is just a forecast - in
other words it is an attempt to predict the future. The manager
may be able to avoid this crisis by making sensible decisions.
Finally, he can compare his forecast that he made before the period
with the actual figures at the end of May. This will be useful as
he can see whether his forecasting skills were any good.
The Whole Forecast
Below is a full cash flow forecast. It links together the predictions
for the receipts, payments and balances in a fairly standard format.
Cash
flow forecast for Chairs R Us for Jan to May (£)
