• Introduction
• Importance of cash flow forecasting
• Best practices for cash flow forecasts
• Key assumptions for software businesses
• Cash basis not accrual
• Revenue
• Costs
• One-off items
• Cockpit view
• Things to watch out
• In a nutshell

Introduction

Cash flow forecasting is a critical aspect of financial management for small and medium-sized software businesses. Understanding and projecting your cash inflows and outflows over a 52-week period can be instrumental in maintaining financial stability, making informed business decisions, and ensuring operational continuity. In this article, we'll delve into the importance of cash flow forecasting, best practices, potential pitfalls, and key assumptions specifically tailored to software businesses.

Importance of cash flow forecasting

Cash flow forecasting is akin to a financial road map that enables software businesses to:

• Plan and manage operations: Predicting cash flows helps in planning daily operations, managing expenses, and identifying periods of surplus or shortfall. Software businesses often experience seasonal fluctuations due to project cycles or marketing campaigns. A cash flow forecast helps identify these periods of higher and lower cash inflow, enabling businesses to plan accordingly, whether it's securing financing or adjusting resource allocation.
• Manage short-term debt and avoid liquidity crises: Cash flow forecasting allows businesses to identify potential cash shortages and proactively manage their debt obligations. This proactive approach helps avoid liquidity crises that can cripple operations and jeopardise business growth.
• Business decision-making: It assists in making informed decisions about investments, expansions, hiring, and managing debt.
• Safeguard against shortfalls: Anticipating cash gaps allows for proactive measures like securing lines of credit or adjusting spending to prevent financial crises.

Best practices for cash flow forecasts

• Gather accurate financial data: A robust cash flow forecast relies on accurate financial data, including historical sales figures, payment terms, and projected expenses. Ensure data is up-to-date and consistently reviewed to reflect the latest business developments.
• Break down forecast into granular categories: Divide cash flow into distinct categories, such as revenue from different projects, recurring sales, and essential operating expenses. This granularity provides a clearer understanding of the cash flow dynamics within the business.
• Consider seasonal fluctuations: If your business experiences seasonal variations in revenue or expenses, incorporate these patterns into your forecast. This will help anticipate periods of potential shortfalls and allow for proactive planning.
• Use historical data as a guide: While forecasting future projections, consider historical trends and patterns in cash flow. This historical context provides a baseline for evaluating future expectations and identifying potential deviations.
• Update regularly: Cash flow is a dynamic aspect of business, so the forecast should be updated regularly to reflect changes in sales, expenses, and other factors. Regular updates maintain the forecast's relevance and accuracy.
• Consider multiple scenarios: Develop best, worst, and moderate-case scenarios to prepare for unexpected situations, such as market fluctuations or customer payment delays.
• Engage key stakeholders: Involve relevant teams or individuals from sales, finance, product and operations in the forecasting process to gather diverse perspectives.

Key assumptions for software businesses

There are three broad elements required to build a 52-week cash flow forecast.

1. The income the company expects to receive over the 52-week time frame along with an assessment of how likely and secure the income is.
2. The payments the company will have to make over a set time frame.
3. The opening cash available to service the net losses which is also recalculated every end of week to reflect the deficit/surplus.

Cash basis not accrual

The focus shifts from accrual to cash-based forecasting. Cash here refers to all forms of liquid monetary receipts and payments. For all forecasting purposes, record only those income and expenses that can be recovered or paid out in full.

The timing of cash flows is critical. If you are not sure either about the timing of a cash receipt or a payment, you should take a more conservative estimate.

Revenue

The first step is to understand the different revenue streams and break them out as recurring and non-recurring/project-based revenues for each major customer.

• Subscription renewals and churn rates: Account for subscription-based revenue incorporating renewals that are certain. Estimate churn rates based on historical trends.
• Revenue growth rates: Project sales growth to reflect can significantly impact cash inflow.
• Customer payment terms: Assumptions regarding the timing of customer payments should be in line with payment terms agreed with customers. If there are any known delays or prepayments then factor for them.

Costs

• Costs of sales: Factor in all costs of sales corresponding to each revenue stream separately. The cash outflow shall correspond to the supplier credit terms which is typically 45-60 days from the date of invoice.
• Compensation and benefits: This includes salaries, pensions and defined benefit contribution expenses such as national insurance and other employee benefits. A good practice is to list out all the personnel and know exactly what is paid to whom to back up the costs forecast in the cash flows. Additionally, you should include all contractor payments which are typically paid out within 30 days of the invoice.
• Administration costs: This shall include the long list of essential general administration costs that include IT costs, premise lease rentals, marketing, subscriptions, insurance, travel and entertainment, and professional fees. In an insolvency scenario, you will have to weigh in on every cost line item in this bucket to ensure that it is necessary.
• Exceptional costs: Remember to separately include exceptional items such as management fees into your model.

One-off items

Now that you have set out all income and costs related to the business you need to factor the cash outflow from the unwinding of existing on balance sheet creditors, accrued liabilities and taxes as these are liabilities that need to be settled.

• Creditors unwinding: The first step is to break all creditors by vendors. The unwinding of creditors follows the agreed credit terms with the individual vendors. In insolvency cases, the payout would be agreed upon by the insolvency provider.
• Unwind taxes: Taxes (corporation or employee-related or otherwise) are to be paid out to the government/tax authorities by due dates which shall be the date of unwinding. In insolvency cases, they will still take priority over other expenses.

Cockpit view

All these calculations that you have done so far are to calculate the ending weekly cash balance with the intent of knowing the peak cash outflow over a 52-week period. This is done by simply summing up the opening cash and the changes in cash (Revenue - costs - one-off items) to arrive at the closing weekly cash balance. The peak outflow will give you an indication of the revolver/overdraft limit requirement of the business. In an insolvency scenario, one would also know the budget tweaking that is required and the extent of financing required to run the business through the 52-week period.

Things to watch out

• Overlooking seasonal variations: Failure to account for seasonality can lead to inaccurate forecasts, affecting cash flow management during peak and off-peak periods.
• Ignoring accounts receivable and payable: For software businesses, managing receivables and payables is crucial. Failure to track these can skew the forecast.
• Underestimating expenses: Unexpected expenses or cost escalations can impact cash reserves. Always leave room for unforeseen costs.
• Sensitivity analysis: Conduct sensitivity analysis to test the impact of varying assumptions, such as changes in sales or expenses, on the overall cash flow projection.
• Regularly updating forecasts: Continuously update forecasts as new financial information becomes available to maintain their accuracy.

In a nutshell

A meticulously crafted 52-week cash flow forecast is indispensable for the financial health and sustainability of small and medium-sized software businesses. By embracing best practices, and staying vigilant about potential pitfalls, companies can navigate uncertainties, make informed decisions, and ensure a robust financial future. Remember, cash flow forecasting isn't a one-time task; it's an ongoing process that demands attention, accuracy, and adaptability to steer your software business toward sustained success.