Limitations Of Cash Flow Forecast: Problems & Solutions (2024)

What are the benefits and limitations of cash flow forecasting ?

A cash flow forecast lets businesses anticipate their income and expenses for the coming period. Cash flow forecasts have several advantages, such as helping a company plan for cash flow shortages, control costs, manage receivables, and better invest surplus cash.

But this also leads to tunnel vision, and the forecast might produce inaccurate outcomes in the long term.

This article talks about the limitations of cash flow forecasts, how it affects businesses, and steps they can take to formulate a more accurate statement.

Limitations Of Cash Flow Forecast: Problems & Solutions (1)

Why is cash flow forecasting inaccurate?

As with any forecast, a projection of future cash flows cannot account for all the factors that can affect a business and cash inflows and outflows. Any business operates in an open system, so cash flow forecasts cannot be 100% accurate.

6 Major disadvantages of cash flow forecasting

Although a cash flow forecast is an important tool for businesses to manage and predict their future cash projections, this can also limit a company’s growth prospects. Listed below are the key problems of cash flow forecast:

1. Too much reliance on best estimates

A cash flow forecast’s biggest drawback is its reliance on estimations. Now, this doesn’t mean that the entire statement is a work in estimation. What it doesmean is that while certain numbers are easier to guess and might hold true, others are just best guesses.

For instance, you can predict what your office premises’ rent is going to be in the coming year (based on your contract). This will be a definitive number in most cases, but you’ll have to employ your judgement for the electricity and heating bills.

Predicting these numbers wouldn’t be very tricky since you can keep the past year’s bills as the base and go from there. But estimating your sales is going to be challenging.

Solution: While preparing your cash flow forecasts, try to back the numbers on your statement with cold, hard data. Suppose you experience higher sales in the later half of the year than the first, so account for that and project your numbers accordingly.

Related article: The best cash flow forecasting software in 2023

2. It doesn’t account for unforeseen circ*mstances

A business functions in a dynamic, uncontrollable environment and any number of unforeseen external factors could impact the cash flow forecast.

For instance, change in government regulations, increase in competition, or adoption of new technology all have the power to disrupt your business operations and, by extension, your forecast and its projections.

Solution: While it’s impossible to predict such circ*mstances, businesses can take steps to mitigate the effect such circ*mstances might have on their cash flow. They can build a significant cash reserve to cushion the blow.

Moreover, they can keep reviewing the external environment and making the necessary changes to their business plan to stay ahead of the curve.

3. Dependency on limited and historical information

To prepare cash flow forecasts, accountants rely on the information they can gather from internal and external sources. However, access to limited information often leads to inaccurate cash flow forecasts.

Additionally, they rely on historical data to predict the future. While this serves as a great starting point, depending on historical data can lead to incorrect cash flow forecasts. This presents another challenge for startups since they’ll have to use generic industry data, which would not provide a clear picture of their business.

Solution: Don’t take the information available and historical data at their face value. Review them in line with the business’s future plans and see how that will impact future projections.

Limitations Of Cash Flow Forecast: Problems & Solutions (2)

4. Builds a false sense of financial security

It’s natural to be optimistic about the future, especially when the past year ends on a high note. This could lead you to believe that your future cash flows will be positive too.

But this is dangerous territory as it lulls the business into a fall sense of financial security. This makes it difficult to recognize challenges or bottlenecksthat the business might face in the near future, negatively impacting its future goals.

Solution: Businesses can take a realistic approach, hope for the best, and prepare for the worst. Additionally, they must tally their projections quarterly with the actual cash flow statements for that quarter and adjust the forecast for the rest of the period accordingly.

5. Too much faith in the probability of outcomes

While cash flow forecasts can predict part of the outcome, they still imply a degree of probability. Having blind faith in estimates is going to land you in hot waters since a cash flow forecast’s predicted probabilities have a high chance of being incorrect.

Example

Suppose you manufacture and sell winter clothes. Now, you decide to manufacture more jackets as per your cash flow forecasts, which you’d prepared based on early weather forecasts and historical data. But what would happen if London experienced a mild winter season that year?

This could negatively impact your sales and cause an inventory stockpile, which would lead to additional expenses.

Solution: Don’t follow the most obvious business outcomes. Brainstorm a little and try coming up with multiple scenarios for each outcome. Then come up with a solution to pivot your business rapidly in case any of the scenarios go wrong. Make sure you have a plan of action for different possible scenarios that will allow you to continue to run your business even if your predictions are not met. For instance, consider taking out a bank loan to cover cash flow gaps.

6. Lack of business goals

You can prepare the most accurate cash flow forecast, accounting for all the major hiccups your business can run into. Still, this statement would be of no use if you don’t know how to process its contents in relation to your business goals.

This is mostly the case with startups, as they’re extremely focused on surviving and turning their business into a profitable venture.

Solution: Be intentional with your strategic goals to leverage your cash flow forecast projections.

Limitation of cash flow forecast: Short-term vs long-term

A cash flow forecast is an essential statement for short-term projections. Still, it might not prove beneficial in the long run if they aren’t adjusted per the market conditions and actual financial statements.

Long-term cash flow forecasts, such as a 12-month cash flow forecast, have a higher probability that the estimated outcome might be wrong compared to short-term periods, such as one to three months.

Key Takeaways:

Cash flow forecasting can be misleading and may not produce the expected results. Entrepreneurs may encounter a number of problems when planning cash flow, such as failing to correctly estimate future customer demands and overestimating sales of new products. Nevertheless, on closer look, cash flow management can bring many benefits to companies seeking to determine the financial health of their organisation. Although cash flow forecasting does not guarantee success, it does help to anticipate different scenarios.

Limitations Of Cash Flow Forecast: Problems & Solutions (3)

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Limitations Of Cash Flow Forecast: Problems & Solutions (2024)

FAQs

What are the limitations of a cash flow forecast? ›

Drawbacks. The limitations of cash flow forecasts include being unable to account for changing costs, and the accuracy of when money comes into the business. Miscalculations will affect the business which could result in debt.

What are the limitations of the cash flow statement? ›

As a cash flow statement is based on a cash basis of accounting, it ignores the basic accounting concept of accrual. Cash flow statements are not suitable for judging the profitability of a firm, as non-cash charges are ignored while calculating cash flows from operating activities.

What are the causes of cash flow problems and solutions? ›

Some common causes of cash flow problems are poor management, making a loss, and offering customers too long of a term to pay. The methods of solving cash flow problems include rescheduling payments, using an overdraft, cutting costs, and finding new sources of cash inflows.

What are the two factors that could make a cash flow forecast inaccurate? ›

For example, two situations that will significantly affect your cash flow forecast include late payments and increased sales. If an invoice has exceeded terms or a new product is performing better than expected, update your forecast to reflect this.

What are the challenges in cash forecasting? ›

While challenges such as forecasting unexpected expenditure, capturing unpredictable flows and modelling external influences are common to most companies, large multi-location companies who operate a centralised process encounter a range of other forecasting challenges.

What are the most common causes of cash flow problems? ›

5 Biggest Causes of Cash Flow Problems
  • Avoiding Emergency Funds. Businesses — like individuals — need to be prepared for the unexpected. ...
  • Not Creating a Budget. ...
  • Receiving Late Customer Payments. ...
  • Uncontrolled Growth. ...
  • Not Paying Yourself a Salary.
May 3, 2023

What is the problem with cash flow statement? ›

Some common problems with the cash flows statement are the following: Classification differences between the operating statement and the cash flows statement. Noncash activities. Internal consistency issues between the general purpose financial statements.

What are the 5 limitations of financial statement analysis? ›

5 Limitations of Financial Analysis
  • The financial analysis does not contemplate cost price level changes.
  • The financial analysis might be ambiguous without the prior knowledge of the changes in accounting procedure followed by an enterprise.
  • Financial analysis is a study of reports of the enterprise.

What are the two limitations of funds flow statement? ›

Limitations of Funds Flow Statement

It does not take into account other characteristics from the Balance Sheet and Profit and Loss Account. As a result, it must be examined alongside the Balance Sheet and Profit and Loss Account. The fund's flow statement does not show a company's cash situation.

What makes cash flows difficult to predict? ›

To prepare cash flow forecasts, accountants rely on the information they can gather from internal and external sources. However, access to limited information often leads to inaccurate cash flow forecasts. Additionally, they rely on historical data to predict the future.

How do you solve free cash flow problems? ›

The simplest way to calculate free cash flow is by finding capital expenditures on the cash flow statement and subtracting it from the operating cash flow found in the cash flow statement.

What are the solutions to cash flow management? ›

To manage the cash flow efficiently, the company needs to either renegotiate payment terms with creditors, or speed up the realization of inventory and debtors. If they cannot do these things, there will be a deficit. Business owners will have to take out a business loan to reach a true cash balance.

What are the 2 errors of forecasting? ›

The forecast error can be positive or negative, depending on whether the forecast overestimates or underestimates the actual value. A positive forecast error indicates that the forecast was too low, while a negative forecast error suggests that the forecast was too high.

How to make a cash flow forecast accurate? ›

How to forecast your cash flow
  1. Forecast your income or sales. First, decide on a period that you want to forecast. ...
  2. Estimate cash inflows. ...
  3. Estimate cash outflows and expenses. ...
  4. Compile the estimates into your cash flow forecast. ...
  5. Review your estimated cash flows against the actual.
Feb 14, 2024

What are the limitations of cash flow forecast GCSE? ›

Disadvantages of cash flow forecasts: Forecasts can be wrong. You might make bad decisions. Not enough information.

What are the limitations of cash budgeting? ›

One of the main drawbacks of using a cash-only budgeting system is that it can be inconvenient and risky. You have to withdraw cash frequently, which may incur fees or limit your access to your money. You also have to carry cash around, which can make you vulnerable to theft or loss.

What can businesses avoid by forecasting cash flow accurately? ›

An accurate cash flow forecast helps companies predict future cash positions, avoid crippling cash shortages, and earn returns on any cash surpluses they may have in the most efficient manner possible.

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