People often use the terms cash flow forecasting and cash flow modelling interchangeably. However, to some people, a cash flow model is a tool and the output is a forecast, whilst to others, the difference is about whether you are planning at an operational level (using a cash flow forecast) or a strategic level (using a cash flow model).
Whichever interpretation you use, you should be clear about the purpose of the exercise and make sure everyone is using the same language. At Business Clan, we agree that cash flow models are tools to produce cash flow forecasts. However, we tend to talk about cash flow forecasts for operational and tactical planning, and refer to cash flow models when we are developing forecasts for strategic planning:
- Cash flow forecasting is about predicting how much cash will be coming in and how much cash will be going out of your business from normal operating activities taking into account the peaks and troughs in the next 6 to 12 months. Examples include accounting for seasonal fluctuations, quarterly VAT, corporation tax, quarterly rent, planning bonus payments etc and making assumptions or predictions about other variables.
- Cash flow modelling is about planning for growth, acquiring or investing in new assets, restructuring or remodelling your business, and how that growth will be financed in the next 6 months to 5 years, or a period of time relevant to the nature of your business.
In both cases, the purpose of cash flow forecasting and cash flow modelling is to help you make more informed business decisions. The difference is whether you are planning at an operational, tactical or strategic level.
Cash Flow Forecasting
Cash flow forecasting is fundamental to understanding whether you are and will be solvent in the future i.e. whether you will have enough cash to pay off your liabilities as and when they become due. In most cases, it is focused on current operating activities and therefore uses historical data and current information to best determine future cash in and cash out.
A cash flow forecast is usually presented in spreadsheet format, or graphically with the time periods along the x-axis and cash on the y-axis as shown in the diagrams below.
Healthy Cash Flow – Scenario 1
The duration of the time periods (on the x-axis) will depend on what you are forecasting and why. If you need to manage cash flow because more cash has been going out than has been coming in e.g. you have a problem with late payers, then you may need to analyse cash flow at daily or weekly intervals, rather than monthly, and view the forecast over a three or six month period. If your business is seasonal, then a rolling twelve-month forecast on a monthly basis may be appropriate.
A cash flow forecast may group together fixed income streams and non-discretionary expenses (on the y-axis). For anything that is variable (because either you don’t know what the value will be or when it will happen or both), you will want more visibility so that you can see and test the impact of different values and timings of cash in and cash out.
An understanding of past patterns and trends can be useful, but it is not necessarily an indication of the future. However, it is best practice to produce both trend and variance analysis to strengthen learning and forecasting capabilities. In addition, it is advisable to have a contingency plan (or two) e.g. a pre-agreed overdraft facility or loan facility or perhaps business interruption insurance (which may cover some curve balls).
Whether you use a spreadsheet or a cash flow forecasting tool, you will often want to forecast for different scenarios e.g. best and worst case. This will help you to focus on what matters most and therefore where to prioritise your time to make sure you have positive cash flow. Managing cash flow is as important as making a profit because without cash to pay off your liabilities when they become due, you are at risk of trading insolvent. Trading whilst insolvent is wrongful and is a civil offence. Deliberately trading whilst insolvent is fraudulent and a criminal offence. As the saying goes, “Revenue is vanity, profit is sanity, but cash is king.”
For more hints and tips, read our article on How to Prepare and use a Cash Flow Forecast in 6 Easy Steps.
Cash Flow Modelling
Cash flow modelling is what you do when you produce a cash flow forecast whether it’s for operational, tactical or strategic planning purposes. However, the term is more often talked about in the context of strategic planning i.e. when you need to make business decisions about how and when you might make key strategic investment and funding decisions. A cash flow model should be based on your financial business model. Together, the models help you to determine whether you will be able to achieve your business goals.
Whilst the reporting period for operational cash flow forecasts might be daily, weekly or monthly, the forecast horizon in cash flow models used for strategic planning is likely to be quarterly or annually. In addition, because strategic cash flow models are considering medium- and longer-term objectives, the level of granularity required in such models is not usually as detailed as in operational cash flow forecasts.
The other difference between cash flow forecasts for managing operational activities and cash flow models for strategic planning is that operational cash flow forecasts typically use historical data and current information to predict what will happen in the future, whereas cash flow models for strategic planning purposes often examine different scenarios where you have no historical data.
There is no one-size fits all
A well-designed cash flow forecast for operational cash flow management will be unique and tailored to the short- and medium-term risks and opportunities of the business. Likewise, a well-designed cash flow model for strategic planning purposes will be unique to the business and tailored to its precise medium and longer-term business objectives.
Cash flow forecasting and modelling tools
Many businesses use spreadsheets for cash flow forecasting and modelling. The key advantage is that spreadsheets are very flexible, and you can map any logic you like into the design. The main disadvantage is that when it comes to updating the information, it typically requires the manual input of data, and this is prone to error. Therefore, especially for operational cash flow forecasting, it is preferable to use a tool that will integrate with your actual and hopefully accurate (historical) data. As the saying goes, “Garbage in, garbage out”. Insights are only useful for decision-making if the data upon which they are based is accurate and up to date.
There are many cash flow forecasting tools, such as Fluidly, that integrate with standard accountancy software packages such as QuickBooks and Xero. In fact, QuickBooks and Xero both include cash flow forecasting functionality, albeit (at the moment) not as sophisticated as that of other software providers.
Some cash flow forecasting tools also use AI and machine learning. This means that they use sophisticated algorithms to find patterns and relationships that a human might never be able to assimilate. The more data you have, the more useful these tools are and the more reliable they are likely to be. It is also often much quicker to use the functionality of a forecasting tool to create multiple what-if scenarios, allowing you to gain multiple perspectives on risk and opportunity and further insights.