In Cash Flow Forecasting Continual Monitoring of the Expected Cash Flows of an Entity
Construction companies need a steady flow of income to ensure that their projects and day-to-day operations are properly funded. If the inflow of cash becomes negative – that is, the money coming in is less than the money going out – it can pose serious problems to a company's financial and overall health.
Maintaining a positive cash flow is therefore important, and so is projecting your cash flow path. If you understand what your cash flow looks like at a future date, you put yourself in a better position to address potential issues and to mitigate possible financial difficulties.
Quick links
- Construction cash flow: what is it and why is it important?
- Cash flow forecast vs cash flow projection
- What is a cash flow forecast?
- Why is it important to do a cash flow forecast?
- It helps you assess your business performance.
- It helps you make informed budget decisions.
- It helps you identify potential "pain points."
- Uses of cash flow forecasting
- How to forecast cash flow
- Gather the following information:
- Subtract the estimated expenses from the estimated income
- Add calculated cash flow to the opening balance
- What is a cash flow projection?
- The importance of construction cash flow projection
- How to make a cash flow projection
- Determine the hypothetical variables that you want to consider
- Estimate the projected income and expenses based on the hypothetical variables
- Complete the steps for conducting a cash flow forecast
- Best practices to maintain a strong cash flow
Construction cash flow: what is it and why is it important?
Cash flow refers to the amount of cash that comes in and goes out of your business' pockets. It is an important business metric as it determines how much money you have on hand after you subtract your expenses (money going out) from your income (money coming in).
If, for instance, you made $30,000 in sales at a given period and you spent $25,000 to fund your operations and other business endeavors (e.g., marketing), your cash flow for that period is $5,000. It means that, during this period, you have $5,000 cash on hand.
In construction, a cash flow analysis can also be narrowed down to the project level. During the course of a project, you can compare the amount of money that you receive in payment versus the amount of money that you spend on materials and labor. This will help you stay on budget as well as manage your contractor and subcontractor expenses.
Managing your cash flow properly is key to running a successful construction business. However, it is not enough to simply calculate how much money you have at a given time. It is equally important to understand where your cash flow will stand at a future date. This is called cash forecasting or cash flow projection.
When you forecast or project your cash flow path, you make an informed estimate of what your finances will look like in the future. This is a good way to stay proactive in determining potential budget challenges, managing predicted surpluses, and even analyzing the impact of possible business changes.
Cash flow forecast vs cash flow projection
Cash flow forecasts and cash flow projections are often used interchangeably. They technically follow the same principles and methods, but they also have slight differences that are worth looking at. These differences are summarized in the following table:
- Both cash flow forecasts and cash flow projections are used to have a clear understanding of your cash flow path.
As mentioned, conducting cash forecasts and cash flow projections leads to the same objective: to understand what your cash flow will look like in the future. Forecasting and projecting cash flow both give you an insight into the future financial health of your business.
Say, for example, that you are supplying materials to 10 different projects, seven of which are about to end within the next three months. Three months from now, you will only have 3 projects left, not including the possible new projects that you are currently pursuing.
You can do a cash flow forecast or cash flow projection to determine where your finances will stand, considering those factors.
- Cash flow forecasts take into account historical and current financial data, while cash flow projections also consider other variables.
Both cash flow forecasts and cash flow projections take into account current and historical data to analyze how much money will come and go sometime in the future. The difference between cash flow forecasts and cash flow projections is how the latter also take into account hypothetical variables to project where your cash flow will go depending on different scenarios.
A cash flow projection will, for example, consider the different scenarios depending on how much sales you will make in the future. You can make a cash flow projection based on the best scenario when you secure all the new sales that you are currently pursuing. You can also project your cash flow based on the worst-case scenario when you gain no new projects in the coming period.
- Cash flow forecasts are based on the "most probable" scenario, while cash flow projections may be based on less probable scenarios.
Following the example above, you can make a cash flow forecast based on the "most probably" scenario according to your judgment. For instance, while seven out of 10 of your current projects are ending, you predict that you will gain three new accounts, and you consider this prediction into your estimated cash inflow.
You can also make a cash flow projection to assess where your finances will stand a few months down the road, but this time you do not have to consider only the "most probable" scenario. You can make projections based on the best-case scenario in which you earn 10 new projects. You can also project based on the worst-case situation in which you get zero new clients.
- Cash flow forecasts help you identify potential bottlenecks, and cash flow projections help you plan for the best and worst-case scenarios.
Cash flow forecasts can help you identify potential periods in the future when your cash flow would go negative. When your cash flow forecast tells you that you are likely to lose money sometime in the future, you can prevent this scenario from happening by strategically re-allocating your budget and taking other necessary measures.
Cash flow projections can also help you identify possible financial bottlenecks, but they can also help you prepare for different scenarios. This becomes important, especially when dealing with economic and political factors that may be beyond your control. For example, you make cash flow projections assuming that prices of raw materials will increase in the future, and you can build business strategies around that projection.
Now that you understand the small differences between cash flow forecast and cash flow projection, the next step will be to look into these two different cash flow prediction methods.
What is a cash flow forecast?
A cash flow forecast is a document that analyzes and predicts your future cash flow based on your current and historical financial data. By looking at where your finances currently stand and your historical financial activities, you are able to determine where your cash flow will stand at some point in the future.
Why is it important to do a cash flow forecast?
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It helps you assess your business performance.
A cash flow forecast is largely based on your current financial status. If the forecast tells you that you are poised to maintain a positive cash flow, it could mean that your business is performing well. It implies that you are acquiring enough cash inflow and managing your expenses effectively, so you do not spend more than what you earn.
Your cash flow forecast can also show a negative cash flow in the future, which could mean that your business is underperforming. In this case, cash flow forecasting can help you evaluate your current business practices to determine how you can improve your cash flow.
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It helps you make informed budget decisions.
Cash flow forecasts are not set in stone. They can change depending on many factors, including how you decide to spend your money and how you manage your relations with your clients. You can also use a cash flow forecast to help you decide how to spend your budget in the coming months.
If your forecast shows that you have a surplus coming in the coming months, you can make sure that you put that money in the right places and not misspend it. If your forecast shows that you may have a deficit in the next quarter, you can adjust accordingly to ensure that the negative cash flow does not turn into a major financial issue.
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It helps you identify potential "pain points."
When you look at a cash flow forecast, you want to look at the parts that say you are bound to lose money. Those negative cash flow predictions mean that you need to either prevent them from happening or to ensure that their impact on your finances is kept to a minimum.
When addressing a negative cash flow forecast, it is best not to just look at short-term solutions. You should also understand whether the negative cash flow is due to a temporary drawback or if it indicates a deeper problem in how you manage your finances.
Uses of cash flow forecasting
- Identifying the impact of making changes in business
Cash flow forecasting can help you identify the effects of potential changes in business, such as hiring a new employee, buying new equipment instead of leasing, or investing in software that will automate some of your business processes.
- Proving to lenders your ability to repay loans
Lenders often ask for proof that you can pay off a loan, so preparing a cash flow forecast is one way to convince them that your finances are well-positioned to handle more credit in your account.
- Monitoring a project's progress
During the course of a project, projecting or forecasting the inflow and outflow of cash will help you spend your money strategically to avoid going over your budget.
How to forecast cash flow
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Gather the following information:
- Opening balance
The opening balance is the net amount of cash you have from the previous period after subtracting your expenses from your income from that period. For example, if you had an income of $10,000 in the previous quarter and you spent $9,000 during that quarter, your opening balance is $1,000.
- Estimated income
Estimated income is the amount of cash you are poised to earn in the coming period. This estimate must include credit sales, loans, and other sources of revenue. For example, if you predict to earn $3,000 in credit sales and you are bound to receive $5,000 funding from a lender, your estimated income is $8,000.
- Estimated expenses
The estimated expenses pertain to the amount that goes out of your pockets to pay for your project expenses and other operating costs. This includes rent, utilities, payroll, insurance, raw materials, etc. For example, if you typically spend $3,000 in operational costs and another $3,000 in project expenses, your estimated expenses are $6,000.
- Opening balance
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Subtract the estimated expenses from the estimated income
To get the estimated cash flow, you need to subtract your estimated expenses from your estimated income:
cash flow = estimated income – estimated expenses
Following the examples mentioned in the previous step,
cash flow = $8,000 – $6,000 = $2,000
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Add calculated cash flow to the opening balance
To get the closing balance forecast, you simply need to add the calculated cash flow to your opening balance
closing balance = opening balance + cash flow
closing balance = $1,000 + $2,000 = $3,000
The table below shows another cash flow forecast example over the course of four quarters:
What is a cash flow projection?
A cash flow projection is similar to a cash flow forecast. It is also a document that shows where your cash flow will stand in the future, except it takes into account hypothetical variables such as possible price changes or potential project closures.
The importance of construction cash flow projection
- It helps you prepare for best and worst-case scenarios
A cash flow projection considers hypothetical scenarios, including the best and worst possible scenarios according to your judgment. Preparing cash flow projections can therefore help you understand where your cash flow will stand in the future, depending on which of the possible scenarios occur.
- It helps you stay on budget
Like a cash flow forecast, a cash flow projection also helps you stay on budget under specific circumstances. If, for instance, you projected that your expenses would increase 10% if the prices of lumber increase, you will be prepared to adjust your budget once the price increase happens.
- It helps you make better business strategies
Business growth and expansion can be challenging. As your company grows, you become more susceptible to mismanaging budget surpluses or overpromising to your clients. Preparing cash flow projections is one way to help you build better strategies. It helps you understand the different paths that your business can take to ensure that you make the right business decisions.
How to make a cash flow projection
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Determine the hypothetical variables that you want to consider
Projected cash flows are based on specific hypothetical scenarios. You should therefore ask yourself what kinds of scenarios you want to consider when predicting your future cash flow.
For example, you may want to understand where your cash flow will stand if new tariffs are imposed on certain raw materials. You may also want to project what will happen to your cash flow if you hire a new employee or if you invest in a new mechanics lien management software. The results of your cash flow projections will differ depending on which scenarios you consider.
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Estimate the projected income and expenses based on the hypothetical variables
When estimating your projected income and expenses, you must consider the factors that you determined in Step 1. If lumber prices increase, for example, your expenses on raw materials will also increase, and this must be reflected in your cash flow projection. Note that your projects do not necessarily have to be based on the most probable scenarios. It is up to your judgment to determine which scenarios are worth studying.
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Complete the steps for conducting a cash flow forecast
Completing a cash flow projection is the same as completing a cash flow forecast. The only part that will change is the estimated income and the estimated expenses. These two factors will reflect the specific hypothetical scenario that you are trying to study. Otherwise, you can make a cash flow projection in the same way that you will do a forecast.
Best practices to maintain a strong cash flow
- Revisit your cash flow forecasts and projections
To ensure that your cash flow forecasts and projections are accurate, it is important to re-evaluate and update them every now and then. If you do a monthly review of your cash flow forecasts and projections, you can take into account new factors and adjust your predictions accordingly.
- Ensure that your invoice management practices are efficient
Your cash flow can be directly affected by poor invoice management. If you send out your invoices late and if you have no policies to monitor whether they have been paid or not, your cash flow forecasts will be inaccurate, and the health of your cash flow will be compromised.
- Secure your lien rights where possible
Late payments are common in the construction industry, and some clients may not even pay at all. If this happens, the best course of action is to file a mechanics lien. You should therefore ensure that your lien rights are protected in every project. You can do so by serving the required notices, such as the preliminary notice and the notice of intent to lien, among other requirements.
Futher reading
- How to Reduce DSO and Improve Cash Flow for Material Suppliers
- How to Optimize the Construction Order-to-Cash Process
- Strengthening Customer Relationships as Construction Revenue Protection Strategy
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