Are you getting lost in the financial planning for your small business? You’re not alone, according to the Small Business Development Corporation of Western Australia
“The lack of planning and control of cash resources is the reason often given for the failure of many small businesses in Australia”
Particularly, in financial planning for the future, many small business owners confuse cash flow forecasting with scenario planning. It’s an easy mistake to make, as cash flow forecasting and scenario planning have the same outcome; they are both used to reduce uncertainty and provide confidence.
It’s important to understand the difference so you know when to apply the different tools in your small business. Do you know when to forecast and when to scenario plan?
What is cash flow forecasting?
Cash flow forecasting involves taking known financial information and planning the profit and cash flow plan based on these numbers. It is the forecasting of when cash is going to enter and exit your business, the accuracy of which is based on the quality of the information you use to make the forecasts.
No matter how much time and energy you invest into making your forecasts, they cannot predict the future. What they can give you is a backbone to structure your resourcing decisions on for the next 12 – 24 months. In turn, this gives you a strong base to pivot from when changes occur.
When would you use cash flow forecasting in a small business?
Every business should have an up-to-date cash flow forecast at all times, as there is a large difference between when you buy and sell goods and services and when you receive actual money. Cash flow forecasts allow you to allocate your limited financial resources where they can have the maximum return.
One of the most common situations in which businesses review their cash flow forecasts is when lending or borrowing money on terms. Having an accurate cash flow forecast is an essential component to securing a loan either from the bank or suppliers.
The absence of a cash flow forecast is a common reason even the most profitable businesses go bankrupt, as businesses can make a profit on paper, but run out of cash before they get payment. For this reason, a small business cash flow forecast should be updated weekly, or at the very least monthly, as it gives the business a clear vision for their future.
What is scenario planning?
Scenario planning, on the other hand, is a ‘What If’ cash flow experiment. Scenario planning is conducted by changing some of the key assumptions or business drivers of your cash flow forecast to see how this may affect your future cash flow.
Scenario planning uses your well-constructed cash flow forecast and changes some of the components to see how this may affect your future cash flow. It gives you the ability to clearly think and prepare for possible changes in your business environment. The good use of scenario planning will mean you are rarely unprepared for anything business can throw at you.
When would you use scenario planning in a small business?
Scenario planning is used to plan for “Known Unknowns”, the big key drivers in your business that have a degree of uncertainty about them. For example:
- For a farmer a known unknown may be yield or grain price.
- For a projects-based business known unknowns might include projects won each month and average project value.
- For an importing/exporting business a known unknown would be the exchange rate.
A small business would use scenario planning to help reduce the uncertainty of known unknowns and prepare both structurally and mentally for these eventualities if they occur.
How are they linked?
Consider your cash flow forecast as ‘plan A’ for your small business. A scenario plan takes this ‘plan A’, and asks ‘What If?’ in regards to a key financial driver. The outcome of this questioning creates a ‘Plan B’, and by continuing this process with other financial drivers, you create a ‘Plan C’, ‘Plan D’ and so on.
Do you have scenario plans and cash flow forecasts in place at your small business? Reep software allows you to plan for your financial future in a user-friendly, timesaving way.