Forecasting Collections – A Key Element of Your Cash Flow
The Ins and Outs of Forecasting Future Cash Balances
Cash forecasting is the process used for projecting how much cash you will have on hand in the future. Short term cash forecasting is usually done for every week of the forecast period, typically the current month. Longer term cash forecasts are also prepared for each month, with a focus on the next 3 to 6 months as an operational necessity. Longer term forecasts are useful for planning.
Cash forecasting is critically important unless your firm has a huge amount of cash sitting in the bank. Forecasts predict if you will have enough cash to meet your expenditures. Should you forecast a cash shortage at any point, you will then have time to:
Devise ways to increase your cash inflow, often involving more aggressive collections of your accounts receivable
Plan which expenditures can be reduced and/or delayed
If all else, fails you can apply for additional financing, but this can be expensive and self-defeating in a high-interest rate environment unless you are realizing substantial growth
Running short of cash can be a disaster! The consequences of not being able to meet payroll, and/or tax installments, employee health insurance, rent, lease and key supplier payments can seriously impair your firm’s operations, both immediately and well into the future. Late payments can incur significant late fees and penalties.
Getting caught up in a cash crunch, furthermore, will preempt other critical activities (like tending to customers) until the emergency is resolved. The impact on your workforce if you delay payroll, in today’s labor tight market, can seriously deplete your workforce not to mention the morale of those who stay — and it probably won’t be your best people who stay.
How is Cash Forecasting Done? Conceptually, cash forecasting is simple. Precisely forecast all cash receipts and disbursements (both amount and timing) and you’ll have a functional cash forecast. In practice, it’s not so easy.
Forecasting your cash outflow is relatively easy. Some outflows (like rent, leases, taxes, payroll & benefits) are easy to forecast accurately. Payments to all your other suppliers can be a bit of a challenge if you don’t have an automated Accounts Payable (AP) operation. Whether you have automated AP or not, you’ll need to generate a comprehensive listing of all vendor invoices with their amounts and due dates, which you can then sum up into weekly or monthly payment forecasts.
Forecasting cash inflows, however, can be difficult…
Read on to learn:
The ins and outs of forecasting the collection of AR
The need for continuous improvement, and
The added benefits you will realize from developing cash forecasting capabilities
Building Insights Concerning Cash Inflows
Cash inflows are the expected cash receipts for each period you forecast. The primary source of cash inflows for most firms are the receipts from payments of open customer invoices - i.e., your Accounts Receivable (AR). This is the inflow most difficult to forecast. Other common inflows may involve rent you charge, royalties, and financing, all of which are easy to forecast.
Forecasting cash receipts from AR starts with a listing of every invoice owed you by every customer (net of any payments already made and credit memos issued). If you have an accurate AR Ledger - also known as an AR Trial Balance - you’re in good shape. If not, you’ll have to create one that captures all the receivables owed you.
Using the AR Ledger, you then forecast when you will receive each item owed you. Each customer’s payment history should guide this forecast - do they pay on time, or if not how many weeks late. An AR Ledger coupled with payment history insights for each customer will facilitate a more accurate forecast and reduce the time required to make a forecast. If you don’t have any AR Ledger, choose your top 10 or 20 customers to forecast individually, then forecast the cash receipts for all the other customers (conservatively).
You will also need to account for a certain level of disputed invoices. Disputes will delay their payment for weeks or months. Again, previous customer dispute patterns will help inform any adjustments you make for disputes.
Sample Weekly Forecast Using Average Days to Pay and Your AR Ledger
The more information you can incorporate in your AR forecast the more precise you can be. This example uses Average Days to Pay rather than just due date. Using promises to pay, when available, would be the next step in accuracy.
The final step involves compiling your actual cash flows for the past six months.
Use this data to compare to your forecast to determine if any large deviations from past performance are valid. The source of cash receipt and expenditure data is your bank account. Review, sum, and analyze all the cash flows for the previous 6 months (12 months if your business is cyclical) and you’ll have a good feel as to where the cash has originated and been disbursed. The next step is to determine what these inflows and outflows will be in the future. Chances are, they will be similar to the immediate past.
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The Need for Continuous Improvement
While cash forecasting appears to be relatively straightforward, it’s the nuances that will throw your forecasts off. Track the accuracy of your forecasts, both in total and the key components. Then go back and determine why you missed. This will enable you to adjust and improve your forecasting over time
The most difficult item to forecast is the receipt of AR. Not only are you dealing with the vagaries of your customer payment patterns, but also mail and even the weather.
Help from Automation: The reporting features of Collection Software and Electronic Invoice Presentment and Payment (EIPP) platforms provide valuable visibility into your customer payment patterns. These automated solutions can save you a lot of time compiling your forecast. They also take much of the guesswork out of when customers will pay by capturing customer payment promises, which can then supersede the use of due date or average days to pay. They also record disputes, giving you a more accurate feel for the impact of disputes on cash flow.
Please feel free to share this newsletter with your small business customers . . . it just might help them pay you sooner!
The Added Benefits of Cash Forecasting
Cash forecasting is extremely important in managing any business. It will help you avoid cash shortages, which can have a snowballing effect on your operations. It can also help you avoid unnecessary:
Borrowing and interest expense
Withholding of payments to suppliers
Deferral of investments in your business
Possibly the most important benefit of a rigorous, ongoing cash forecast is a greater understanding your business operations and how they all fit together to generate profits. That’s a long term benefit that will pay dividends in numerous ways as time goes on.
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