Have you ever applied for a small business loan or overdraft? If your answer is yes, then it is highly likely that your bank had asked you to provide a cash flow projection or forecast for few months.
Cash flow projection is an estimate of the cash flows into the business through revenue and borrowings and the expected cash outflow through purchases, expenses and repayments. You may have read that cash flow issue is one of the major reasons why many small business fails before their 5th anniversary. Therefore, cash flow projection, an important financial planning tool should be frequently prepared by any organized business manager.
Cash flow projections are recommended to be prepare on monthly basis and review at least once in every quarter. This will enable you to review the assumptions used in preparing the projection.
This projection is an important tool for the following reason:
- It estimates the amount of cash need to manage the business operations over a period
- It shows to a potential lender such as bank the ability of your business to repay the loan and interest on time.
- It can reveal periods when the cash inflows will not cover the cash outflows. This will help you to arrange alternative funding such as bank draft or better working capital management before the downtime period.
Steps to prepare cash flow projection
It does not matter if you are using a computer or paper copy ledger; the following should help you:
1. Estimate projected monthly revenue with cash flow receipt
This relates to the total projected cash receipt in each month. You have to consider your credit policy and estimate the percentage of cash sales and credit sales e.g. cash sales of 80% and 20% on 30 days’ credit. For existing business, you can use your previous year’s sale information, whiles a startup may use industry ratios.
2. Estimate monthly purchases and cash repayment
This relates to purchase of primary materials or services for the production or delivery of goods and services e.g. purchase of raw materials, finished goods or direct labour. Again you should consider the payment terms from suppliers.
3. Estimate monthly operating expenses cash payments
Operating expenses relates to all other overhead cash payments such as utilities, promotions, rent, office stationeries, repairs etc.
4. Consider any month with fixed asset purchase
If you plan to buy any fixed asset purchase, you have to include it in the month which cash will be paid to the vendor. If you are paying by installment, then reflect it as such.
5. Consider any new loan borrowing or loan repayment
Another source of cash into the business is the borrowing from banks and other lenders. The repayment of the loan and interest will also lead to cash outflow.
The sum of opening cash balance for the month plus cash inflows and minus cash outflows will give you the closing cash balance for that month. If the closing balance is negative, it means you have projected cash shortage in that month. Do not panic, that is the purpose of the cash flow projection. You should start initial discussions with your bankers well in advance after a thorough review of the cash flow projection for second time. If your balance is showing positive, then you are safe and probably think about short term investment products to manage the excess cash.
Nonetheless, the estimated cash balances will most likely differ from actual balance. This is affected by the validity of projected numbers and assumptions. Therefore, the assumptions used in preparing any projection are as important as the projection itself.
It is important you prepare your cash flow projections on an ongoing basis and update it when necessary. If you are not sure of how to go about it, then consult an accountant to help. If you have laptop or personal computer, you could even develop one by using a spreadsheet. However, we have developed a free simple cash flow projection template for our subscribers. You can also read our article on how to improve small business cash flows.