What are the benefits and limitations of cash flow forecasting ?
A cash flow forecast lets businesses anticipate their income and expenses for the coming period. Cash flow forecasts have several advantages, such as helping a company plan for cash flow shortages, control costs, manage receivables, and better invest surplus cash.
But this also leads to tunnel vision, and the forecast might produce inaccurate outcomes in the long term.
This article talks about the limitations of cash flow forecasts, how it affects businesses, and steps they can take to formulate a more accurate statement.
Why is cash flow forecasting inaccurate?
As with any forecast, a projection of future cash flows cannot account for all the factors that can affect a business and cash inflows and outflows. Any business operates in an open system, so cash flow forecasts cannot be 100% accurate.
6 Major disadvantages of cash flow forecasting
Although a cash flow forecast is an important tool for businesses to manage and predict their future cash projections, this can also limit a company’s growth prospects. Listed below are the key problems of cash flow forecast:
1. Too much reliance on best estimates
A cash flow forecast’s biggest drawback is its reliance on estimations. Now, this doesn’t mean that the entire statement is a work in estimation. What it doesmean is that while certain numbers are easier to guess and might hold true, others are just best guesses.
For instance, you can predict what your office premises’ rent is going to be in the coming year (based on your contract). This will be a definitive number in most cases, but you’ll have to employ your judgement for the electricity and heating bills.
Predicting these numbers wouldn’t be very tricky since you can keep the past year’s bills as the base and go from there. But estimating your sales is going to be challenging.
Solution: While preparing your cash flow forecasts, try to back the numbers on your statement with cold, hard data. Suppose you experience higher sales in the later half of the year than the first, so account for that and project your numbers accordingly.
Related article: The best cash flow forecasting software in 2023
2. It doesn’t account for unforeseen circumstances
A business functions in a dynamic, uncontrollable environment and any number of unforeseen external factors could impact the cash flow forecast.
For instance, change in government regulations, increase in competition, or adoption of new technology all have the power to disrupt your business operations and, by extension, your forecast and its projections.
Solution: While it’s impossible to predict such circumstances, businesses can take steps to mitigate the effect such circumstances might have on their cash flow. They can build a significant cash reserve to cushion the blow.
Moreover, they can keep reviewing the external environment and making the necessary changes to their business plan to stay ahead of the curve.
3. Dependency on limited and historical information
To prepare cash flow forecasts, accountants rely on the information they can gather from internal and external sources. However, access to limited information often leads to inaccurate cash flow forecasts.
Additionally, they rely on historical data to predict the future. While this serves as a great starting point, depending on historical data can lead to incorrect cash flow forecasts. This presents another challenge for startups since they’ll have to use generic industry data, which would not provide a clear picture of their business.
Solution: Don’t take the information available and historical data at their face value. Review them in line with the business’s future plans and see how that will impact future projections.
4. Builds a false sense of financial security
It’s natural to be optimistic about the future, especially when the past year ends on a high note. This could lead you to believe that your future cash flows will be positive too.
But this is dangerous territory as it lulls the business into a fall sense of financial security. This makes it difficult to recognize challenges or bottlenecksthat the business might face in the near future, negatively impacting its future goals.
Solution: Businesses can take a realistic approach, hope for the best, and prepare for the worst. Additionally, they must tally their projections quarterly with the actual cash flow statements for that quarter and adjust the forecast for the rest of the period accordingly.
5. Too much faith in the probability of outcomes
While cash flow forecasts can predict part of the outcome, they still imply a degree of probability. Having blind faith in estimates is going to land you in hot waters since a cash flow forecast’s predicted probabilities have a high chance of being incorrect.
Suppose you manufacture and sell winter clothes. Now, you decide to manufacture more jackets as per your cash flow forecasts, which you’d prepared based on early weather forecasts and historical data. But what would happen if London experienced a mild winter season that year?
This could negatively impact your sales and cause an inventory stockpile, which would lead to additional expenses.
Solution: Don’t follow the most obvious business outcomes. Brainstorm a little and try coming up with multiple scenarios for each outcome. Then come up with a solution to pivot your business rapidly in case any of the scenarios go wrong. Make sure you have a plan of action for different possible scenarios that will allow you to continue to run your business even if your predictions are not met. For instance, consider taking out a bank loan to cover cash flow gaps.
6. Lack of business goals
You can prepare the most accurate cash flow forecast, accounting for all the major hiccups your business can run into. Still, this statement would be of no use if you don’t know how to process its contents in relation to your business goals.
This is mostly the case with startups, as they’re extremely focused on surviving and turning their business into a profitable venture.
Solution: Be intentional with your strategic goals to leverage your cash flow forecast projections.
Limitation of cash flow forecast: Short-term vs long-term
A cash flow forecast is an essential statement for short-term projections. Still, it might not prove beneficial in the long run if they aren’t adjusted per the market conditions and actual financial statements.
Long-term cash flow forecasts, such as a 12-month cash flow forecast, have a higher probability that the estimated outcome might be wrong compared to short-term periods, such as one to three months.
Cash flow forecasting can be misleading and may not produce the expected results. Entrepreneurs may encounter a number of problems when planning cash flow, such as failing to correctly estimate future customer demands and overestimating sales of new products. Nevertheless, on closer look, cash flow management can bring many benefits to companies seeking to determine the financial health of their organisation. Although cash flow forecasting does not guarantee success, it does help to anticipate different scenarios.
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