What are the disadvantages of cash flow forecasts?
It’s important when preparing cash flow forecasts to step back and look at the disadvantages of cash flow forecasts too.
So what are the disadvantages of cash flow forecasts?
- A reliance on best estimates which may be wrong.
- The probability of unforeseen changes.
- Cash flow forecasts are often based on past results.
- Too much reliance on the probability of outcomes.
- Mistakes in the formulas could prove disastrous.
- The reliance on assumptions.
- Having limited information.
It’s important to consider the above disadvantages when you approach your next cash flow forecast. By know what can go wrong will help you to be more realistic in your approach.
Let’s take a look at each of these disadvantages in more detail.
1. A reliance on best estimates which may be wrong
Cash flow forecasting is mostly about estimating what’s going to happen in the future. There will be certain numbers you can estimate with reasonable certainty, but there are others that will have to be your best guess.
If you begin with what is easy to predict on your cash flow forecasts and work back to the more tricky numbers, this can help.
For example, if you rent your business premises you’ll know how much your rent costs are going to be. Except for any unforeseen factors (see point to below), other costs associated with your premises should be easy to forecast, for example, property taxes, repairs and light and heating bills.
The same goes for other overheads and costs. However, where the problem lies with estimating future cash flow forecasts is predicting sales.
Forecasting your sales is probably one of the most difficult elements to a cash flow forecast. This is real crystal ball gazing. But by understanding these limitations, you should approach this in the right way.
Make sure to backup your estimates with reasoned assumptions. If you work on the basis your forecasts will never be 100% accurate. But also understand that the further out your forecast, the greater the chance of getting it wrong.
Solution: Firstly be realistic with your estimates and run a number of what-if scenarios. Look at best case and worst case scenarios for your business. You can’t usually go wrong by planning for the best, whilst being prepared for the worst.
2. The probability of unforeseen changes
It’s almost impossible to account for unforeseen factors. These can come in all shapes and sizes.
If someone said to me 12 months ago the whole world would be suffering from the impact of a world pandemic, I may not have believed it. But here we are in the Coronavirus Covid-19 pandemic and many businesses are suffering. But equally there are many businesses that are thriving as a result of Covid-19 too.
It is these unforeseen changes or outcomes that can often be missed from a cash flow forecast.
But it’s not only unforeseen changes as drastic as a world pandemic that can completely throw your cash flow forecasts. Changes to government regulations, or changes to technology or competition can impact your predictions equally as much.
Solution: Consider running a number of worst case scenarios for your business. But more importantly, you need to build a cash buffer for your business to help if survive any downturn in business. But also, use a business plan to help you focus your future around remaining competitive and ahead of the competition.
3. Cash flow forecasts are often based on past results
The say that past results are no certainty for the future is true. But you have to start somewhere and using past numbers to forecast the future is a good place to begin.
This is certainly true when you’re looking at your overhead forecasts, as these tend to remain constant, subject to any major expansion plans in your forecasts.
But having said that, if your forecasts show major expansion plans, you’ll be able to use historic data to predict what these will be in your newly expanded business.
Solution: When reviewing historic numbers from financial and management accounts, make sure you consider each expense line carefully. In your review think about how your future plans are likely to impact on each type of expense. But remember this could equally increase costs as it could be to decrease costs.
4. Too much reliance on the probability of outcomes
When you begin to look at any cash flow forecast you will probably consider the probability of certain outcomes. If you bear in mind that the longer the forecast, the higher the risk of the probability of an outcome could be wrong.
For example, weather forecasts are based on probabilities. But you’ll know from experience the further out the weather forecast prediction, the more chances they get it wrong.
There are certain probabilities that will have more impact than others. For example, the probability of having a colder winter which impacts on your heating bills would not be as big of an impact as the impact a warm winter might have if your sales rely on colder winters.
Solution: For each probability of an outcome consider the risks of getting each one wrong. Use the what-if scenarios on your spreadsheet of cash flow software to review the impact of getting these wrong.
5. Mistakes in the formulas could prove disastrous
Cash flow forecasts rely on the fact that whatever method you use to prepare them needs to be done accurately. For example, if your cash flow forecasts include the wrong gross profit margin on your sales, this could give you a completely wrong view of profits and cash flows.
Mistakes of this nature are more likely if Excel spreadsheets are not your expertise. In which case you might be better off buying specialist cash flow forecasting software instead. This way you can spend more time focusing on the numbers themselves, rather than worrying that your numbers add up.
Solution: If you are preparing your cash flow forecasts on a spreadsheet using Excel or Google Sheets, make sure to check your formulas. Also, include a projected balance sheet too, as this helps to make sure the debits and credits are all in the right place too. Whilst it’s not often easy for someone else to check another person’s spreadsheet, get someone else to check it for you. Alternatively, buy specialist cash flow forecasting software to avoid these problems.
6. The reliance on assumptions
Cash flow forecasting is based upon a number of key assumptions. This would include for example interest rates, business taxes, competition, customer payment days, gross profit margins, inflation and economic health.
You have to start somewhere, but keep in mind they are assumptions and these can be wrong.
Solution: Test your cash flow forecasts with different assumptions. For example, test what happens if interest rates increase. Try altering your customer payment days and see the impact this has on your cash flows, and so on.
7. Having limited information
Limited information tends to affect new start up businesses more than it does for more established businesses that will have a core of information to draw upon.
Establish businesses will have historic data from past business and accounting information to use to predict future income and cash flows. Whereas start up businesses may have to rely on more generic industry information.
The real problem starts for a new business that’s invented a completely new product. For this situation the business will need to reply on their best estimates for forecasting future cash flows.
Conclusion to the disadvantages of cash flow forecasts
Whilst I have lists a number of disadvantages of cash flow forecasts, the benefits of cash flow forecasting still outweigh these disadvantages. Which means that you are better to prepare cash flow forecasts for your business than not.
What are the limitations of cash flow modelling?
The main disadvantage with cash flow modelling is your cash flow model is only as good as the information you have available.
But also, cash flow modelling is based upon assumptions and predictions about what’s going to happen in the future, so unless you have psychic powers these are never going to be 100% accurate.
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