A 3-way financial forecast is a combination of the key (accounting) financial statements - profit and loss, balance sheet and cash flow, all integrated into a single, integrated spreadsheet. Here's why and when you'll need one.
Getting started - P&L + Cash
The P&L is used to show whether, over time, you are making a profit or loss.
Cash position is self explanatory!
Most business owners very clearly understand the core aspects of how they generate revenue, and the expense components of their business - in an accounting sense this is all reflected in the Profit & Loss (P&L) statement.
When your business is just getting started, keeping an eye on the P&L and the actual bank balance is enough. We work with many businesses at this level in operating through a P&L and simple cash forecasts, for as long as possible.
Next step - Compliance, Accounts Receivable, Payable, Loans and the Balance Sheet
The Balance Sheet is used to show your net worth (Assets less Liabilities, technically), at a given point in time.
If you are trying to predict future cash needs especially as a startup or in cash juggling growth periods you quickly start to realise the other elements that affect cash that are not immediately driven or apparent from just looking at the P&L Examples of this include:
Timing of compliance based payments
- (Net) GST / VAT that you collect from customers, less GST / VAT you pay to suppliers. Net GST / VAT is typically payable (or receivable) as part of your quarterly BAS / VAT return, so timing matters for cashflow planning. See more.
- PAYG/PAYE, which are the taxes you withhold from your employees, is also payable quarterly (Australia) or monthly (UK). See more.
- If you’re at the stage of making a profit, planning for annual tax payments or (in Australia) quarterly PAYGI instalments. Or, if you’re accessing the R&D tax incentive forecasting to receive a refund from the ATO/HMRC.
- In Australia, superannuation is also payable quarterly while in the UK pensions are paid monthly
- In Australia, if you’re big enough you also have the joy of paying state-based Payroll taxes
While you’re probably aware of most of these, ask any small business owner of the quarterly “gotcha” impact of these so you want to make sure you can see that you’ve got these covered, in advance.
Accounts Receivable (Customers/Debtors) and Accounts Payable (Suppliers/Creditors) working capital needs
- If you send out invoices to customers and there’s delays in receiving payment from them you can more quickly than you might expect go broke waiting to be paid, all while in supposedly positive growth mode. Operationally you want to have active, tight escalation processes in place to collect what you’re owed and in your forecasts you want to allow for the difference between (invoiced) revenue and when you receive the cash - you’ll sometimes hear this referred to as debtor days.
- On the flip-side, while we have more automatic real-time credit card payments than ever, there are still potentially delays in paying our suppliers
The net “working capital” needs of these can lead to quite a dramatic difference between supposedly profitable business and their cash position
- If you’ve got any form of interest bearing (startup, shareholder, bank etc) loans - even ATO payment plans then you’ll be making regular cash payments of both interest and principal that need to be allowed for cash-wise.
- Revenue Recognition. Many of our clients are in the good position of receiving pre-payments such as annual contracts (sometimes referred to as “bookings”). While this is good cash-wise it is not correct accounting-wise to refer to this in totality as revenue. Strictly, you need to recognise 1/12th of the cash received as revenue over 12 months. This is not just accountant-speak either. Your investors and banks will expect this difference to be shown in any forecasts
- Prepayments and deposits (which is kind of the flip-side of revenue recognition) where you’re pre-paying suppliers and landlords for subscriptions, insurance, rent etc.
- While it tends not to be a big point (except when you’re growing your team fast) another example is buying cash assets, with a monthly P&L depreciation impact.
We have a saying at Standard Ledger:
If you don’t understand (from your P&L) where your cash is going, the answer is on your Balance Sheet.
If it seems like we’ve spent more time on this Balance Sheet section than on the P&L is because accounting for the timing of things (on the Balance Sheet) in a forecast can quickly (as you can see) get complicated with lots of things to keep track of … in future, in a 3-way forecast. We work with clients to work through each of these as build our financial models and then keep an eye on the cash forecasts to make sure we’ve got the timing right.
Cashflow Statement - understanding the nature of your cash inflows and outflows
The Cashflow Statement is used to show the underlying cash nature of your cash inflows an outflows.
For completeness as it’s the “third way” and even though it’s typically not used / referred to much until you’re (much) larger, a cashflow statement is essentially a re-statement of your P&L and (movements in) your Balance Sheet to show the nature of your cash inflows and outflows, typically broken into operating, finance and investing activities.
While we derive and include the Cashflow Statement as part of our 3-way financial model forecasts, investors and banks are usually more concerned that you’ve correctly allowed for and forecast the P&L and Balance Sheet so that there can be confidence in the cash forecast.