This article originally appeared in Forbes.
Effectively managing cash flow is one of the most critical skills business leaders must possess if they want their companies to grow profitably. A well-thought-out strategic plan doesn’t mean a thing if you haven’t created a cash flow forecast that anticipates the cash needs of the company.
I speak from experience. The company I founded, NationLink Wireless, nearly went out of business when we had a cash flow crisis, and I was forced to create an accurate forecast to manage every dollar. That meant sitting down with my finance and accounting chief and going through, in painstaking detail, our income and cash flow statements to determine how money was cycling through our company. Once we did that, I could better manage the business and find ways to generate more profit.
Creating an accurate cash flow forecast is complicated because it involves measuring and monitoring many variables and making educated guesses about the performance of the company. For business leaders who want to be directly involved in forecasting cash flow for their companies, here’s how you get started:
Too many business leaders rely on the monthly profit and loss (P&L) statement to gauge cash flow. Your P&L is important, but it’s not an accurate picture of the cash flowing into and out of your business.
The cash flow statement is the go-to document to understand the cash needs of your business. That’s because it factors in noncash expenses, such as depreciation and amortization. It also reflects cash outflows and inflows from operating activities (accounts payable and accounts receivable payments), investing activities (purchases of fixed assets of plant, property and equipment) and financing activities (sales of equity or bank borrowings). You can’t create a useful cash flow forecast until you first learn the ins and outs of your business’s cash flow statement.
Understanding your company’s cash conversion cycle — the amount of time it takes for a dollar spent to make its way back into your bank account — is essential to managing and maximizing your cash flow. Business leaders should spend time with their finance and accounting chiefs to comprehend how money is flowing into and out of the company from vendors and clients. Review variable costs (labor and raw materials, for example), fixed costs (rent, utilities, certain salaries and business insurance) and other significant expenses (investments in equipment or software, for instance). The accuracy of the forecast depends on knowing the timing and amounts of revenue and expenses that affect your cash flow.
Chances are your business experiences some seasonality. There are bound to be months when clients are more active in purchasing your company’s products or services. Seasonality can have a material effect on the cash flow of your business. A good cash flow forecast will anticipate when cash outlays and cash receipts are higher or lower so you can better manage the working capital needs of the company.
To succeed, business leaders should prepare for market changes. Craft a few different cash flow scenarios so you are not caught off guard if client demand slows. Having a couple of models will help you act decisively — rather than react defensively — to mitigate any adverse effect on your company’s cash if revenue slows. Conversely, if sales pick up, the forecast will help you to better allocate resources to grow the business.
Stay one step ahead of the game and build cash flow forecasts for the short (weekly or monthly), medium (quarterly) and long (yearly) term. The needs of the business will dictate which time frame is the most valuable. Monthly or quarterly forecasts generally are more useful for stable, established businesses. Weekly projections will be essential for companies scaling up or going through significant changes, such as a restructuring or merger/acquisition.
Once you build a forecast, review it often, and revise as needed. I’ve worked with a lot of business leaders who haven’t looked at their cash flow forecast in months. The needs of your clients are always shifting, and the economy is ever-changing. Revisiting the forecast will help you respond and adapt faster than the competition.
Building a business requires cash, and having a reliable forecast allows you to make better decisions on how to maximize the return on invested capital. Follow these tips, and you will be able to better predict the cash needs of your business and better position your company for future growth.