A cash flow forecast is a financial tool that helps businesses predict the amount of cash they expect to receive and spend over a specific period, usually a month or a year. Here's a step-by-step example to illustrate how it works:

Identify Starting Cash Balance:

Begin with the current amount of cash your business has on hand. This can include funds in the bank and any other liquid assets (easily converted to cash).

Estimate Cash Inflows:

List all the sources of cash your business expects to receive during the forecast period. This could include sales revenue, loans, investments, or other income.

Determine Cash Outflows:

Identify and list all anticipated expenses and payments your business will make during the same period. This includes rent, utilities, salaries, loan repayments, and other operational costs.

Categorise Cash Transactions:

Organise your cash inflows and outflows into categories such as operating activities, investing activities, and financing activities. This helps in analysing where your cash is coming from and where it's going.

Calculate Net Cash Flow:

Subtract total cash outflows from total cash inflows to determine the net cash flow. A positive net cash flow indicates more money coming in than going out, while a negative net cash flow signals potential liquidity issues.

Monitor Changes in Cash Position:

Regularly update and review your cash flow forecast as actual transactions occur. This allows you to compare your forecasts with real-time data, helping you identify any discrepancies and make informed decisions.

Adjust and Plan Accordingly:

If discrepancies arise or if there are significant changes in your business environment, adjust your forecast accordingly. This proactive approach enables better financial planning and management.

Example:

Let's say your starting cash balance is £10,000. You expect £20,000 in sales revenue and anticipate £15,000 in various expenses for the month. Your net cash flow would be £20,000 (inflows) - £15,000 (outflows) = £5,000. This positive net cash flow indicates a healthy financial position for the month.

Remember, a cash flow forecast is a dynamic tool that requires regular updates to reflect the evolving financial landscape of your business.

Cash flows into and out of a business on a regular basis. A cash flow statement tries to predict in advance what and when these cashflows will be. Having a healthy cashflow is crucial to the survival of businesses. A healthy cashflow means that a business will have enough cash at any one point in time to be able to meet demand for short-term cash outflows. Imagine what would happen if at the end of the week a manager turned to the business's employees and said "Sorry, I haven't got enough cash to pay your wages this week."

By forecasting cashflow in advance, a business can identify where there might be shortages and either try to prevent this from happening or put plans in place to deal with it.

Net cash flow is the difference between all the company's cash inflows and cash outflows in a given period. It's a key indicator of a company's financial health.

Cash inflows or receipts are the money coming into the business from various sources which include:

• Cash sales- The customer pays at the time of purchase.

• Credit sales- The customer pays in a pre-agreed period after the sale, for example 30 days.

• Loans- Bank loans to fund the purchase of assets such as machinery and vehicles

• Capital introduced- Money invested from entrepreneurs or shareholders when a business is first set up or looks to expand

• Sale of Assets- The sale of items owned by the business which are no longer needed in order to bring in short term cash

• Bank Interest Received- Interest paid by the bank on credit balances.

A cash flow forecast is a simple statement showing opening balance, cash in, cash out and closing balance. It is normally shown on a monthly basis and drawn up for a 12 month period. The opening balance is the amount of money available to a business at the start of a set time period, for example a month and the closing balance is how much it has left at the end of the month.

Closing balance=Opening balance + cash inflows - cash outflows

This is the length of time given to customers to pay for goods or services received.  These have two major influences on a business's cash flow. The business must consider how long it gives its custoemrs to pay. If it accepts cash sales only this will not be a problem but it may have to offer credit to ensure a sale. The longer the credit period, the slower the money comes in. If a green grocer gives one month's credit for a sale made in January, they will not see cash flowing into the business until February. Yet the green grocer may have to pay for the stock up front.

Credit periods affect the ability of the business to gain credit from its suppliers. If a business can secure supplies on credit, then this will slow down the flow of cash out of a business. The longer the credit period, the later the cash flows out. Some businesses can secure credit periods of 30,60 or even 90 days.

If a business both sells on credit to its customers and buys on credit from its suppliers it needs the first to have a shorter credit period than the second. Otherwise it will not be able to but stock.

The opening balance at the start of the year will be a true reflection  of the business's bank balance, whereas the closing balance will be based upon forecasts of inflows and outflows throughout the year.

One of the key purposes of the cash flow forecast is to highlight in advance any months there is a risk of a negative cash flow, as this allows the business to make arrangements to try to avoid this.

A business with a negative closing balance is often said to have liquidity (Measures a firm's ability to meet short-term cash payments) problems and is in danger of becoming insolvent (When a firm is unable to meet short-term cash payments).

Liquidity is an up-to-date measure of a business’s ability to quickly convert assets to cash. Some assets are more liquid than others:

Current assets are the most liquid. They can be used for transactions almost instantly. Of the current assets considered highly liquid, cash ranks at the top of the list. Other kinds of assets, such as marketable securities, accounts receivable, inventory and prepaid expenses, are less liquid because they need to be sold to be converted into cash.

Fixed or long-term assets are considered less liquid because converting them to cash can take months or even years. They also tend to be assets the business needs to function, such as equipment or buildings. These may hold a lot of potential value, but they are not easy to convert into cash.

Liquidity improves when a company generates more in current assets than it does in liabilities

Positive Liquidity:

• Think of positive liquidity as having enough cash or assets that can quickly be turned into cash when needed.

• It's like having money readily available in your wallet or bank account.

• In business, positive liquidity means that a company can easily cover its short-term obligations (like paying bills or salaries) because it has enough cash or assets that can be quickly converted to cash.

Negative Liquidity:

• On the other hand, negative liquidity is when a business doesn't have enough readily available cash or assets to meet its short-term financial commitments.

• It's similar to not having enough money in your wallet when you need to pay for something urgently.

• In business, negative liquidity might lead to difficulties in paying bills, meeting payroll, or handling unexpected expenses.

In summary, positive liquidity is having enough financial flexibility and resources, while negative liquidity is facing challenges due to a lack of readily available cash. Maintaining positive liquidity is crucial for a business to smoothly handle its day-to-day financial responsibilities.

In the next section we look at some methods available to avoid negative closing balances. The cashflow forecast shown below  represents a sole trader's first four month of the year.

A cash flow forecast can help to identify where there are potential shortfalls but might also indicate where there are large amounts of cash left at the end of a month or year. Although you might think this is a good thing. If the cash balance at the end of each month is high it might be an indication that the business is not taking advantage of opportunities, could it use this cash surplus to expand or improve the business?

Cash flow forecasts are just that, a  forecast, and should be monitored alongside the actual cash flow to see how accurate the predictions are for inflows and outflows.

Planning- Businesses can use predictions and past data to plan how their cashflow might pan out across a set period of time.

Monitoring- Businesses can compare what is actually happening on a month by  month basis and compare with their plans updating as necessary.

Control- Businesses can intervene and take action when necessary ensuring they have they necessary cash flow to operate efficiently.

Target Setting- Businesses can set targets in relation to increasing income or decreasing expenditure throughout the year and use the cash flow forecast to analyse their performance.

Problems occur with the cash flows when the business's outflows are greater than the opening balance plus the inflows, as this will result in a negative closing balance. This means that the business will not have enough cash to meet payments that are due.

Very few businesses have consistent cash flows throughout the year; they are likely to experience busy times and quiet times. These fluctuations are known as the cash flow cycle. For some businesses, particularly those in a seasonal industry, these fluctuations can be quite severe. Someone who owns a small bed and breakfast in a seaside town will have to pay costs like rent, heat and light, insurance and bank charges throughout the year. In season, they will also have additional costs like wages and stock, but it might only be in the summer months where there are any cash inflows.

If a business has predicted cash flow problems in advance, then there are a number of possible solutions. These are outlined below.

Overdraft arrangements-

A business with a fluctuating cash flow cycle should be able to show the forecast to the bank and make arrangements for periods of negative cash flows. Banks sometimes offer free overdraft facilities to help businesses through these periods, but only if they are prearranged. Going overdrawn on a bank account without prior arrangement can be a very expensive option.

Negotiating terms with creditors-

Creditors are people or businesses that a business owes money to, normally because goods or services have been bought on credit as opposed to cash purchases. A business with cash flow problems could try to negotiate a longer payment term with its suppliers-for example, an increase from 30 to 60 days. This would slow down the flow of cash out of the business. A negative effect of this, however may be the loss of any discounts offered for prompt or early payment.

Reviewing and rescheduling capital expenditure-

Having identified cash flow problems, the owner or manager could review what cash outflows were being spent on. Such a review might identify areas of expenditure that could be cut or postponed. It is difficult to do this if the expenditure is on revneue items- for example, replacement stock- but more achievable if it is capital expenditure. A business could for example, postpone plans to replace machinery or buy a new van. 

An alternative here could be to consider leasing an item of capital equipment rather than buying it outright. This can be more expensive in the long term, but means the business can make many smaller payments over time instead of one big payment.

Advantages

• Encourages planning for cash inflows and outflows

• Enables cashflow to be monitored and corrective action taken if necessary

• Can be used as part of a business plan to help raise finance

• Identifies in advance times of negative closing balances allowing the business to plan for these

Disadvantages

• Based on forecasts and therefore may be inaccurate

• Cannot plan for unexpected events such as a rise in the cost of raw materials

• Time taken to create cash flow forecast could have been better spent perhaps.