19 January 2023

What is a three way cash flow forecast and why does it matter?

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What is three-way forecasting?

All business owners know the importance of forecasting but knowing the difference between a profit forecast, a cash flow forecast and a balance sheet can dictate how successful -or unsuccessful- your business will be. Business owners who understand these three key terms and how they interact with each other are more likely to have a fruitful business. In essence, companies need three things to thrive and survive: – be profitable, have a healthy cashflow, and have strong balance sheet. If you want to see how your company’s finances are doing at a point in time, then you need to understand these three key elements, and how they affect each other.   Sometimes referred to as a 3 statement model, change any one of the three inputs and all the aspects in all three reports will be automatically changed.

 Let’s take a look at the three elements of a three way forecast: –

 Profit and loss statement

This is one of the most important financial statements for a business to get to grips with as it reveals the ability of a business to generate a profit. However, it does not reveal the number of assets and liabilities required to generate a profit, AND its doesn’t show cashflow generated by the business. Therefore, this statement when used on its own is showing an incomplete picture- which can be dangerous.

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Balance Sheet

A balance sheet sets out the business’s assets, liabilities, and owner’s equity at a specific point in time. When the balance sheet is paired with the profit and loss statement it can reveal the amount of investment needed to support sales and profits.

Cash Flow forecast

Late payments place businesses under risk of failure. So having a grip on cashflow is key. When you know how much cash you have available, you stop overspending, overtrading and putting the financial health of the business at risk. So cashflow health is a key success indicator along with profit and balance sheet.

So why do you need a three-way forecast?

Even when you’re making good profit, if there’s no reliable cashflow or revenue, then you will struggle to re- invest and grow the business.

Being able to see the profit, cashflow and balance sheet all linked together is key to really understanding this ability to grow and see how robust the company is financially. Seeing profit, real time cashflow data and balance sheet all together highlights any future financial situations enabling you to ensure that the business can afford to pay suppliers and employees and even invest in the future.

You can identify any potential roadblocks before they become a problem – and allow for proactive interventions early on. It also gives your cashflow numbers greater accounting integrity, because they’re driven by the real-time data in your balance sheet and P&L.

When do I need a three-way forecast?

There are quite a few times in a business life cycle when its useful to have an up to date three way forecast. For example, you and your management team may need to be confident about your cash position ahead of a significant purchase or recruitment drive. Or you may be looking to attract a potential investor or lender where a robust financial outlook is important.  Or you may simply want to ensure you’re able to bring financial stability to your company, now and in the future. Ideally you should always have an up-to-date view which can be provided by using forecasting software.

Pleasing the lenders and investors

Banks and other lenders often ask for an integrated forecast because of the holistic picture it gives. It is the level of detail they need to ensure that a business is viable.  Before they provide any funding, they will often set criteria (also known as covenants – which are made up of ratios that must be hit) as a combination from these three linked reports.

What happens if you just provide a cashflow or profit only forecast?

Focussing just on just one element is likely to lead to distortions and inaccuracies in the true picture of a company’s future finances. Only a three way integrated forecast will provide an accurate and actionable financial forecast model.

How do you create a three-way forecast?

Due to the linked nature of an integrated forecast, it is more complex than creating a standalone cashflow forecast, profit forecast or balance sheet forecast. it’s like building a 3-legged stool – if any one piece is missing, it won’t be stable! The forecasts can’t be produced independently and then stuck together, somehow hoping they balance.  The model must fundamentally be designed to accommodate an input feeding through to all three elements. But you don’t have to get into a muddle with multiple spreadsheets or even employ an accountant. Three way forecasting software such as Clearview automatically integrates and calculates all three forecasts for you. You can amend or update any one of the three elements as often as you like and Clearview will update the entire forecast accurately without the need for manual calculation.

Forecasts should be updated with live data on a regular basis, and so using forecasting software removes the need to start from scratch each time on the three separate forecasts. This in turn saves time and reduces the risk of any potential errors too.  At its core, forecasting is all about predicting future trends. And only when a company is forecasting correctly and with the fullest picture, is it optimising its chances of future success.