What are the key factors to consider when forecasting cash flow and working capital?

1 Cash flow vs. working capital

Cash flow and working capital are related but not identical concepts. Cash flow is the amount of money that flows in and out of your business over a period of time, such as a month or a quarter. Working capital is the difference between your current assets and current liabilities, such as cash, inventory, accounts receivable, and accounts payable. Working capital measures your ability to meet your short-term obligations and fund your daily operations. A positive working capital means you have more current assets than current liabilities, and a negative working capital means the opposite.

2 Cash flow cycle

When forecasting cash flow and working capital, the cash flow cycle is a key factor to consider. The cash flow cycle is the time it takes for your business to convert its inventory and receivables into cash, and pay its payables and expenses. A shorter cycle is better for cash flow and working capital. To forecast the cycle, you must estimate the average number of days it takes to sell your inventory (inventory turnover days), collect your receivables (accounts receivable days), and pay your payables (accounts payable days). The cash flow cycle is calculated by adding the inventory turnover days and accounts receivable days, then subtracting the accounts payable days. For example, if your inventory turnover days are 30, accounts receivable days are 45, and accounts payable days are 60, the cash flow cycle is 15 days (30 + 45 - 60).

3 Revenue and expenses

When forecasting cash flow and working capital, it's important to consider your revenue and expenses. Revenue is the amount of money earned from selling products or services, while expenses are the costs of running a business, such as rent, utilities, wages, and taxes. To forecast revenue and expenses, you need to take into account the demand for products or services, their price, the cost of inputs such as raw materials and labor, and the fixed and variable components of expenses. Historical data, market research, industry trends, and assumptions can be used to forecast revenue and expenses. Additionally, different scenarios such as best-case, worst-case, and most-likely can be employed to account for uncertainty and risk.

4 Cash flow statement

A cash flow statement is an essential financial statement that tracks your cash inflows and outflows for a given period of time, such as a month or a quarter. It helps you monitor your cash flow and working capital, and spot any potential gaps or surpluses. A cash flow statement is divided into three sections: operating activities (cash flows related to core business operations, like sales, purchases, wages, and taxes), investing activities (cash flows related to long-term assets like equipment, property, or investments), and financing activities (cash flows related to debt and equity such as loans, repayments, dividends, or equity injections). To forecast your cash flow statement accurately, you need to project each section based on your revenue and expense forecasts, your cash flow cycle estimates, and any planned investments and financing activities.

5 Working capital ratio

A working capital ratio is a financial ratio that measures your working capital relative to your current assets or current liabilities. It helps to assess liquidity and solvency, as well as compare performance with industry benchmarks or competitors. Two common ways to calculate the working capital ratio are the current ratio and the quick ratio. The current ratio is the ratio of your current assets to your current liabilities, and a value of 1 or more means you have enough current assets to cover your current liabilities. The quick ratio is the ratio of your current assets minus your inventory to your current liabilities, and a value of 1 or more means you have enough liquid assets to cover your current liabilities. To forecast the working capital ratio, you need to project your current assets and liabilities based on cash flow statement forecasts, then apply the formula for either the current ratio or quick ratio.

6 Sensitivity analysis

A sensitivity analysis is a technique that helps you assess the impact of changes in key variables or assumptions on your cash flow and working capital forecasts. It can help you evaluate different scenarios, such as changes in demand, price, cost, or payment terms. Additionally, it can identify the most critical variables or assumptions that affect your cash flow and working capital, so you can prioritize them for monitoring and control. To conduct a sensitivity analysis, you need to select the key variables or assumptions to test, define the range of values or scenarios to apply to each variable or assumption, calculate the resulting changes in your forecasts for each value or scenario, and compare the results to draw conclusions.