Back April 26, 2017

Cash Flow Forecasting Has Its Limits

Cash flow forecasting is a good medicine against ”falling cash flow negative” or worse – bankrupt, but as any preventive treatment, it still needs to be taken with care. It means that even if you do your homework and forecast on a long term, the business is not safe from unpleasant surprises. As effective as it proves to prevent running out of cash, forecasting has its limitations. That doesn’t mean it should be ignored, but “handled with care”. As long as you are aware of these limitations, you can adjust and make it work for your company.

What can go wrong with a cash flow forecast?

Truth to be told, many. Not to worry though, there’s nothing that can’t be managed on the go.
It is only natural that the forecasted cash flow events would not take place exactly as anticipated. It is still a prediction, though based on rather accurate assumptions, but just the best guess, nonetheless. It depends on a sum of both external and internal factors that can change the course of the prediction. This is why cash flow forecasts are more reliable if made for a short and medium term. Longer than that, there is too much insecurity. Because cash flow is about the timing between money coming in and going out, the most forecast inaccuracies tend to be related to changes in income and the occurrence of unexpected (or higher) expenses.

Internal Factors

We’ll start with the ones that are easier to leverage in the company’s favor.

Product-Market mismatch. Though it is more about business strategy, inherently it affects the sales, thus the anticipated income. Such a variation can be observed in good time and more market research can lead to the right positioning. This, however, implies delays in revenue streams. The good news is that the sooner it’s detected, the faster you can make adjustments to expenses and find additional revenue sources so that the cash flow stays positive.

Demotivated team. This is an HR related factor, but it has repercussions on operations and the customer relationship. Demotivated or dissatisfied employees mean a tense working environment, translated into project delays, errors, and unhappy customers. As a result, expenses may increase, while income decreases. Once again, the good news is that it happens right under your eyes and you can take measures before the negative emotions hit the cash flow.

Inaccurate historic data. Cash flow forecasts are usually built upon the expenses and income history of the company. The expenses, especially the recurrent ones, are the most reliable source for a prediction. However, sometimes information may be incomplete or missing. This leads to a second best guess, which may prove misleading. The way to avoid it is to make sure you have a good record of past payments and cashed in invoices (which can be achieved with a constantly updated cash plan).

External Factors

These variables depend on the economic environment and third parties (such as clients and vendors) and are more difficult to anticipate, not to mention control.

Variation in the taxation system. Political changes can lead, often times, to changes in the fiscal system. New taxes may occur; older ones can be increased, depending on the political interest of the governing party. These are hard to predict and they are usually announced shortly before they come into place. History has shown us that taxes go up more often than down, which certainly has a negative impact on the business cash flow. Though it cannot be avoided, if your cash situation is good enough and you manage to stay flexible, there is still some room left to adjust. A good safety net is to have some cash reserves to cover such extra costs or various assets at hand that can be quickly transformed into cash.

Clients paying late or not at all. The cash flow forecast relies on the assumption that certain amounts of money will be cashed in at certain dates, based on previous invoice collecting, signed contracts or negotiations. All is well when it ends well, but sometimes people can’t keep their promises. Some clients, willingly or unwillingly, may be late with the payment, which forces you to use the available cash to cover upcoming expenses. It is not something one can anticipate (unless there is a client history in that sense), but you need to deal with it once it happens. Same as in the previous situation, it is important to have alternative sources of cash to cover costs until the debt is paid.

Expect the unexpected. One saying stated that the only certain thing about life is its uncertainty. It applies to the business environment, as part of life itself. One can hardly tell when something is about to change dramatically, affecting various sectors: natural disaster, wars, political attacks, economic crash, a surprising bankruptcy that triggers a chain reaction…. while some of these phenomena could at most be foreseen as probable by analysts, many cannot. In such situations all a manager can do is to rely on cash or asset reserves, stay flexible and adapt to the new situation.

Bottom line is that variations to what you’ve predicted may and will occur. Some can be observed and anticipated in good time and it’s up to you to take measures; others simply happen out of your control. This, however, shouldn’t be an excuse to catch your business unprepared. Safety nets aren’t just for acrobats. Forecast the cash flow as accurately as you can, but always consider a cash reserve (or an additional and immediate source of cash) for unexpected situations, to get you through the rainy days.

And remember, 100% certainty is an illusion. What helps you to stay in control is forecasting the cash flow as accurate as you can and be ready to deal with what is out of your control.