When you’re running a business, it’s easy to think your idea is great and your business is healthy. While optimism is important and you should stay positive, being realistic about your finances can keep your business afloat. More specifically, knowing exactly how much money you have coming in and out of your business is important.

How important? Considering 29% of small businesses close because of Cash Flow problems, it’s pretty darn important. But fear not. You can run a cash flow projection, also known as a cash flow forecast, to determine how much money you have and how much you could have in the future.

What is a cash flow projection?

Cash flow is how much actual money you have coming into your business, as well as leaving it. A cash flow projection is an estimation of your cash flow over a set period. Most businesses stick to a period of 12 months, tracking their cash flow for a full year.

There’s a difference between cash flow and the value of your business. Many business owners make the mistake of gauging their business’s health by looking at their business value, which can include assets, intellectual property and so on. While these elements are important for attracting investors or selling your business, they’re drastically different from cash flow.

Cash flow is the money you have going in and out of your business, meaning it’s on-hand and available in the short-term. By knowing what your cash flow is, you know how much you’ll have on-hand in the event of an emergency. If your business location is flooded and needs repairs, your assets or total business value won’t help you, but your cash flow and money on-hand will.

The perks of cash flow projections

Cash flow projections come with a lot of perks beyond knowing how much you can spend on coffee and donuts for your team. Here’s a look at a few other business benefits.

Understand where your money is

As a small business owner, cash on hand never lasts too long. Bills have to be paid and the unexpected often comes up just in time to derail your plans. But, with regular cash flow projections, you can have a better idea of where your money is actually going.

Budgets help you stay on course, but cash flow projections and cash flow statements show you where your money is going. Understanding where you’re spending your money is important because it can help you avoid falling into the red. Staying out of the red often means avoiding closure, and your company will be more attractive to investors when they see your financial foundation is sound.

Chart your business’s future

Nobody can predict the future, but with a cash flow projection, you can come fairly close by seeing where your business is month-to-month and where it will be down the road. If you run a cash flow projection and see that your company will likely continue to be stable for the foreseeable future, you can more accurately determine how hiring an employee or expanding your business would impact your finances.

Get ahead of problems

Much like a budget, cash flow projections allow you to see glaring issues with your finances. For example, if you see that you’re regularly getting customer payments after their due date and it’s resulting in a deficit at the end of each month, it might be time to require all payment up front or start enforcing late fees.

These kinds of problems, while not always immediately noticeable, can spell financial disaster if you suddenly need money but find it’s tied up in delinquent accounts.

Avoid total collapse

It happens — businesses run out of money and are forced to shut their doors. A cash flow projection can’t prevent this entirely, but it can at least help you be aware of whether or not your business is heading in that direction.

When you have an idea of how much money your business has coming in and out, you can better prepare for the worst. This includes things like market shifts, competition or disasters. That’s assuming you set some money aside each month in an emergency fund (which you should absolutely be doing).

Performing cash flow forecasting in 4 steps

It’s clear that to pave the way for financial success in your small business, you need to stay on top of your cash flow. You’ll know where your business could be heading, you’ll make better business decisions, and you’ll potentially avoid collapse. Now, it’s time to do a cash flow projection. Follow these four steps to project your cash flow for the next year.

1. Estimate your sales

To predict the amount of cash that will come into your business next year on a month-by-month basis, you’ll first need to take a look at your actual results for the past few years. The past is the best indicator of the future, so you should use historical numbers as a starting point. But to ensure accuracy, you’ll need to take some changes into consideration.

For instance, if a competitor is moving into your territory, and you fear they may take some of your market share, you might want to decrease your forecasts. On the other hand, if you added a new product or plan to run a major marketing campaign, you’ll want to account for it by increasing your sales estimates.

If you own a new business and don’t yet have a sales history, you will have to use your industry research and make an educated guess. The key is to make a reasonable estimate based on your research and logic, and not be overly optimistic.

Don’t just make a yearly estimate. Estimate sales for each month of the next year.

2. Calculate when you will be paid based on the terms you offer

If you operate a retail store or a website that takes instant payment from customers, you are probably paid at the point of sale and can skip this step. However, if you extend credit to your customers, you will have to wait to see the cash from those sales.

In these instances, it’s important for you to estimate when you will actually receive cash from your sales to more accurately predict your cash flow.

For example, if you sell to other businesses and offer 30-day terms, you should use your current days sales outstanding (DSO) figure — the average number of days it takes to receive payment from customers — to predict when you’ll be paid. Incorporate that lag time into your estimates.

To calculate your DSO, use the following formula:

(Monthly accounts receivable ÷ total sales) × days in the month = DSO

3. Estimate your fixed and variable expenses

Next, you’ll need to estimate both your fixed and variable expenses on a month-to-month basis. Your fixed expenses are those that don’t change — such as rent, employee salaries, insurance, and marketing expenses.

Variable expenses tend to fluctuate with your sales. For example, your shipping costs are variable because they will change depending on how many products you sell and ship. Your packaging, raw materials, commission, and labor costs may also go up and down depending on your sales volume.

Just as you did for sales, you will need to estimate your fixed and variable expenses for each month of the next year. If you have an accounts payable department or someone in charge of accounts payable, they’re a great resource here. They can help you go through your sales records and estimate what your next year could look like.

If you don’t have an accountant or someone who can help you with this process, you can tackle it yourself. Start a spreadsheet with columns for fixed costs and variable costs, and start tallying them up. Your variable costs will likely be a little trickier, so take your time and breakdown the parts costs, labor costs, etc. for your products. If you’ve calculated your breakeven point, you can pull most of this info from there as well.

4. Put it all together

Now that you’ve calculated all the numbers you need, it’s time to put them together to get an idea of how much cash your business will take in next year.

Begin with the cash balance from last month’s operations, and then add this month’s projected receipts to it after accounting for your DSO. Next subtract your projected expenses, and you have this month’s projected cash flow. Carry over that balance to the next month, and repeat the steps above. Do this for the next 12 months. The formula for this goes as follows:

(Last month’s cash balance + current month’s projected receipts) – Projected expenses = current month’s projected cash flow

While the calculation is an easy one, there are a lot of moving parts to it, so it helps to use a cash flow template. And to rein in that unbounded entrepreneurial optimism, some experts recommend that you create a best-case and worst-case scenario to get the most realistic projection of cash flow. Your actual cash flow will likely be somewhere in the middle.

Projecting greatness

Cash flow projection is fairly straightforward but incredibly useful. It can be a bit sobering to see your actual cash flow, but this information will only help you make better-informed decisions and grow your business in a responsible way.

Over time you’ll become a total pro at cash flow projections. You may even grow to enjoy them. Make cash flow forecasting a part of your business routine, and do them at least once a year to stay on top of any changes. You’ll wind up more in tune with your business, confident in where you’re going, and most of all, set up to succeed.