What is Cash Flow Forecasting? A Step-by-Step Guide

Business is stressful enough as it is, and cash flow makes it worse.

Companies find themselves asking, "Do we have enough cash to cover bills in a month?"

With an improper cash flow forecasting process, unplanned expenses can disrupt an entire budget. In fact, nearly 1 in 5 U.S. small businesses risk closure, with 45% of owners skipping paychecks and 22% struggling to cover bills due to cash flow shortages.

The consequence?

Payment delays, struggling to pay employees, and financial instability. Businesses need an accurate cash flow forecast to remain in the black as far as cash flow is concerned and make smart financial decisions.

This is where understanding what is cash flow forecasting becomes essential. This blog will discuss the basics of cash flow forecasting, some of the mistakes that businesses make, and how to establish a system that will be effective.

Why is cash flow forecasting important for any business?

Apart from making sure that a business doesn't go broke, cash forecasting assists them to thrive in other ways, such as:

Aside from ensuring that a company doesn’t run short of cash, cash forecasting helps them prosper in other areas, including:

1. Spotting cash flow problems before they hit

A projected cash flow assists firms in identifying upcoming cash shortages and responding before running short. If you know there’s an approaching shortage of cash balance, you might be able to borrow cash, put off discretionary expenditures, or accelerate accounts receivable to make ends meet.

It's less complicated to adjust finances in advance than rushing about when cash reserves are dwindling already. A short-term cash forecast helps predict future cash flows, ensuring businesses have sufficient free cash flow to cover expenses and liabilities without disruption.

Did you know?

In October 2024, Quasar Constructions, a prominent Australian building firm, entered administration with debts estimated at $60 million. The company's financial troubles were largely due to cash flow problems arising from unpaid contracts and extensive legal disputes over project delays and cost overruns.

2. Making smarter investment moves

If you’re seeing a cash surplus in your cash flow forecast, now is the time to plan ahead instead of making impulse financial decisions. You can decide whether to save, expand operations, or reinvest in growth.

Maybe it’s time for fixed assets like new equipment, a marketing push, or hiring more staff. A forecast keeps you from spending blindly and ensures cash management aligns with business goals. A cash flow forecast tells you when cash surpluses are strong enough for expansion or when to save for unexpected expenses.

3. Preparing for worst-case scenarios

What if sales drop unexpectedly? What if your biggest client delays payments? A cash flow forecast enables you to try various financial planning scenarios, so you're never surprised.

By modeling potential variations in actual cash flows, you can anticipate market downturns, supply chain slowdowns, or rising costs and shift your cash flow financial plan before they affect your cash position. The proactive forecasting process helps manage risk.

4. Cutting unnecessary costs

Watching where your money goes each month makes it simpler to cut back on unnecessary expenses. Cash flow projections make it simpler to dissect monthly spending and forecast cash flow to identify wasteful expenditures.

Perhaps those unused memberships or unnecessary business expenses are siphoning cash. By reviewing cash flow statements, you can make informed decisions, trim excess expenses, and have a healthy balance sheet while keeping key operations humming along.

5. Fixing slow-paying customers

In June 2024, late payments for small businesses reached a post-pandemic high, with invoices being paid an average of 7.3 days late.

Customers love long payment terms—but businesses don’t. If due payments are causing cash shortages, a cash flow forecast will expose the issue. If payments are consistently delayed, it may be time to tighten payment terms, enforce late fees, or send reminders sooner.

Improving cash management ensures positive cash flow, keeping operations running without unnecessary financial stress. By forecasting closing cash balances, businesses can better handle late payments and improve the overall company’s financial health.

Sales vs. cash flow forecasting

A sales forecast enables companies to project future sales. From historical sales, trends in customers, and market conditions, businesses can forecast anticipated cash inflows and make informed decisions on production, hiring, and growth.

Sales forecasts, nevertheless, do not always reflect the extent of cash a company possesses.

Conversely, cash flow forecasting is interested in real cash flows, projecting when and in what manner money will flow in and out of the business. It considers cash outlays like payments to suppliers, wages, and rent, enabling businesses to avoid cash shortages.

Top cash flow forecasting methods

Now, pick the right forecasting method that actually works for your business. Should you track actual cash flows as they happen or take a broader approach using financial statements? Let’s break down your options..

1. Direct forecasting

The direct method gives a realistic cash flow prediction by following actual transactions. Firms account for cash receipts through sales, finance, and accounts receivable and cash payments made for expenses, wages, and payments to suppliers.

The direct method suits short-term finance planning and ensures that companies deal with cash holdings effectively.

2. Indirect cash flow method

The indirect forecasting process estimates future cash flows by analyzing net income, balance sheet adjustments, and working capital changes. It offers a long-term view of financial health, allowing businesses to align cash flow projections with growth strategies.

This method helps companies assess liquidity risks and optimize financial planning, thereby improving the company's financial health over time.

3. Rolling cash flow forecast

A rolling cash flow forecast continuously updates financial projections, keeping companies one step ahead of cash flow fluctuations. Instead of relying on fixed-period forecasts, businesses revise their cash flow statement as new data comes in.

This ensures companies can adjust spending, forecast cash flow with precision, and make informed decisions to mitigate risk and optimize free cash flow for upcoming investments.

4. Bottom-up and top-down approaches

The bottom-up cash flow forecast goes into full detail, calculating cash movements transaction by transaction. The top-down forecast, however, uses historical data and revenue patterns to estimate future cash flows.

While bottom-up is super detailed, top-down gives a broader perspective—both methods work together to improve financial decision-making.

So far, we’ve explored various cash flow forecasting methods, but when it comes to actually calculating cash flow, businesses typically follow one of two methods—direct or indirect.

Direct vs. indirect cash flow forecasting

Direct cash flow forecasting gives businesses a real-time view of incoming capital, cash outflows, and cash position. It’s ideal for short-term financial planning, ensuring there’s enough liquidity for accounts payable, payroll, and operational expenses.

Indirect cash flow forecasting, however, provides a macro perspective. It relies on income statements, net income adjustments, and working capital changes to predict future cash flows. This method is crucial for long-term financial strategy, helping businesses plan future investments, mitigate risk, and maintain a strong financial position.

Understanding cash forecasting methods is great, but the true benefit is when you can actually produce a forecast that is effective for your company.

How to prepare cash flow forecasts for your business?

If you're at a startup, you've got enough surprises on the horizon—your cash balance shouldn’t be one of them. Here is how to forecast cash flow:

1. Identify your cash flow goals. Break them down into short-term, medium-term, and long-term objectives.
2. Choose the right forecasting period. Decide if you need short-term (2-4 weeks), medium-term (2-6 months), or long-term (6-12 months) projections.
3. Select the right forecasting method. Choose between the direct method (real-time cash tracking) or the indirect method (using historical data).
4. Gather your data sources. Include bank accounts, accounting software, receivables/payables, and loan repayment schedules.
5. Estimate incoming cash. Identify sources like sales revenue, loans, and investments.
6. Estimate outgoing cash. Account for payroll, rent, loan repayments, and inventory purchases.
7. Calculate net cash flow. Subtract outgoing cash from incoming cash to determine your financial position.
8. Review and update regularly. Update short-term forecasts weekly, medium-term monthly, and long-term quarterly.
9. Prepare for unexpected scenarios. Keep a cash surplus for emergencies and adjust forecasts regularly based on market conditions.

You’ve built your cash flow forecast!

To make the process easier, you can use a cash flow forecast template to structure your estimates and track cash movements accurately

But before you sit back and relax, let’s make sure it’s actually useful by following cash flow forecasting best practices.

Cash flow forecasting mistakes to avoid

Some of the common  cash forecasting mistakes include:

1. Optimism bias

If your cash flow forecast looks perfect every time, chances are it's too optimistic. Businesses, especially startups, often assume incoming capital will match their best-case scenario. Unexpected cash outflows happen.

An ideal cash flow forecast considers market shifts, operating costs, and economic downturns, ensuring businesses don’t get caught off guard.

2. No cash reserves for unexpected bills

If cash reserves aren’t part of your cash flow planning, unexpected expenses can create negative cash flow. Setting aside funds in a separate bank account protects against sudden cash deficits.

Whether it’s emergency repairs, supplier price hikes, or payroll adjustments, a cash surplus strategy helps businesses stay financially stable.

3. Ignoring tax changes

Assuming tax liabilities remain the same is a common cash forecasting mistake. Businesses need to account for changing tax laws, payroll taxes, and government fees in their projected cash flow.

Regular financial strategy meetings with a tax consultant help businesses plan for tax outflows, avoid penalties, and ensure financial health.

4. Poor communication & expense management

If employees don’t know the spending rules, even your day-to-day cash will disappear quickly. A cash flow forecasting process should include expense approval policies, ensuring business units manage incoming and outgoing cash effectively.

Regular team check-ins help control spending habits, ensuring net cash movement remains positive.

5. Static assumptions in receivables

Cash inflows should never be based on fixed payment assumptions. Customers don’t always pay on time, and relying on past data alone may cause forecasting errors.

Using real-time analytics and adjusting for due payment trends leads to more precisely prepared cash flow forecasts, preventing unexpected cash shortages.

Start preparing cash flow forecasts with AI

A solid cash flow forecast holds the key to the right financial decisions and avoiding potential pitfalls. Knowing where your cash balance stands helps you plan for future investments, manage cash payments, and keep your business financially healthy.

But cash flow forecasting isn’t always easy—unexpected expenses, delayed payments, and inaccurate estimates can throw things off.

Forecastia, an AI-powered financial forecasting software, automates your cash flow planning, tracks actual cash flows, and provides real-time projections so you always know where your finances stand.