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The importance of cash flow forecasting and financial modelling

14 October - 7 min read

Business is inherently about two things — people and numbers. Without the numbers, however, and a tried and true process that establishes strong financial foundations now and into the future, you won’t have a profitable business. In what may seem like a chicken and egg situation, you arguably can’t have the people in your business — your employees, your suppliers and your customers — if you don’t get the numbers right.

With the right tools, systems and processes in place, you can develop cash flow forecasts and financial models that improve your business’s profitability and longevity. In this article, we take a look at the importance of cash flow forecasting and financial modelling and how this can improve your profit, day-to-day decision making and ability to realise your long-term goals and objectives.

What is cash flow forecasting?

As business owners, and their accountants in particular know, cash flow is the movement of money in and out of the business. When a company has more cash incoming than outgoing, it is in a positive cash flow position. In contrast, when more money is going out of the business than coming in, it is in a negative cash flow position. While most business owners understand the importance of cash flow, some may not have robust processes in place for reliable forecasting.

Cash flow forecasting helps a business owner understand what their cash position is now and into the future by analysing upcoming income and expenses. A critical component of analysing future income is assessing the source and probability that it will be realised. This will help you understand your business’s financial position moving forward and allow you to be proactive if you see a shortfall coming.

What is financial modelling?

Financial modelling takes things a step further. With an income statement, balance sheet and cash flow statement, you can model your business’s expected performance over the longer term. This is known as a three-statement model.

Financial modelling helps business leadership make informed decisions

While you may use cash flow forecasting to proactively manage your business’s cash on a short to medium-term basis, you can use financial modelling for longer-term objectives such as accessing debt, acquiring another company or securing investment.

Why are cash flow forecasting and financial modelling important?

Just as having a strong sales and marketing strategy for your business is important in helping you understand where and how you’d like to attract new customers and reach new markets, cash flow forecasting and financial modelling are critical for strong financial management. Think of cash flow forecasting as the ability to manage your business’s capital in the short to medium term, which then becomes the building blocks for realising your longer-term goals.

Your longer-term goals may involve large financial transactions and will need a financial model. The strength of this model and quality of opportunities you can find will be impacted by how well your business manages its finances in the short, medium and long term. This highlights why getting cash flow forecasting and financial modelling right is so important.

Forecasts and models are only as good as the data

A survey by the Australian Bureau of Statistics (ABS) found that almost 50 per cent of Australian businesses have been negatively affected by the COVID-19 pandemic, with most of these businesses citing cash flow issues as a significant problem. Now, more than ever, it’s critical that you understand cash flow and how to manage it properly.

Understanding cash flow is more important than ever

To be proactive about your cash flow management, your business should prepare and update its cash flow forecast on a quarterly rolling basis. You will need to include three critical pieces of data:

  • Cash balance: Your cash balance at the start of the quarter.
  • Inflows: Sources of cash including cash sales, online sales and receivables.
  • Outflows: Expenses to be paid such as electricity and gas bills, loan payments, rent, payroll and other operating expenses.

These data points are relatively straightforward; however, the quality and reliability of your cash flow forecast are dependent on the quality of the data you have available. Without a real-time view of the data your business needs for day-to-day operations and longer-term financial forecasting, you can’t make strong commercial decisions.

Spenda resolves the complexity of data problems for businesses with an integrated platform of tools and products that improve payment processes and data flows. As a result of addressing payment and data issues in your business, you’ll be empowered to make other big changes that improve your profitability.

Allowing your business to prioritise profit

Mike Michalowicz, in his 2017 bestseller, Profit First, outlined how business owners can transform their company from a “cash-eating monster to a money-making machine”. Focusing on human behaviour as a basis to reframe how businesses view their finances, Michalowicz states that business owners need to tip the typical profit formula upside down. The typical profit formula is:

Sales – expense = profit

Using the Profit First formula, it becomes:

Sales – profit = expenses

Some may argue this shift has negligible impacts; however, the behavioural change it drives can greatly improve your business’s profitability. It links back to Parkinson’s Law, where people will use the resources available to them.

If you prioritise profit using the formula above, you will reduce the amount of money left for expenses. As a result, you’ll become more thoughtful about your business’s spending, which can also promote innovation and creativity. Of course, it’s important to note that if your business isn’t currently profitable, you need to use tools and resources that help you identify the issues impacting your profitability.

When you have strong data for your cash flow forecasting and financial modelling, it not only enables your business to become more profitable, but you allow yourself the flexibility to implement different approaches such as Michalowicz’s Profit First formula.

Spenda will strengthen your cash flow forecasting and financial modelling

With real-time, accurate data across your business, you can see how your business is tracking at a glance. Not only will this help you make better day-to-day decisions, but this data is critical for the quality of your cash flow forecasting and financial modelling.

Ensuring your business’s forecasts are accurate also strengthens your ability to realise your long-term goals and objectives. Perhaps you’re thinking of acquiring similar businesses, or maybe you’re ready to start putting an exit strategy in place. Having the right data available has a significant impact on empowering you to think about and strategise these parts of your business as well.

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