Search This Blog

Tuesday, November 3, 2015

How to Develop a Cash Flow Forecast - Cash Outflows

In yesterday's post I gave some tips on how to formulate estimates of cash inflows, mainly from sales and services rendered. Today, I am going to discuss cash outflows at a general level and will then delve into the different kinds of outflows in more detail.

Generally, there are three main categories of cash outflows:

1.Payments to suppliers, vendors and employees for inventory and expenses.
2. Distributions of profit to owners in the form of dividends or bonuses.
3. Payment of income taxes to the government and other taxes like HST.

Determining each of these items in your cash flow forecast presents different challenges. Some like income taxes and HST cannot be determined with reasonable accuracy until you have either a sales figure or a profit figure. That in turn is complicated by the fact that profit for tax purposes and surplus cash flow for the period are often not the same thing. So in setting up your projections in Excel, it is important to do so in a way that allows you to determine surplus cash flow before income tax, and then adjust it to come up with profit for tax purposes so that income taxes can be calculated and then deducted from surplus cash flow to determine the true surplus for the period.

Distributions from owners is usually factored in last, as it is an arbitrary number. However, care has to be taken to ensure that any bonuses are deducted from profit when determining income tax, as bonuses are deductible from income, whereas dividends are not.

Payments to suppliers, vendors and employees will form the bulk of the cash outflows for your business. Your main challenge is to ensure to ensure that your list of cash outflows is complete. Often you will find that as you are calculating some items, you will think of other expenses that you hadn't thought of before. A good place to start is to make a list of what the fixed expenses of the business are and what the variable expenses are. What are fixed and variable expenses? They are defined below.

Fixed Expenses

Fixed expenses are those expenses that do not vary at all with the volume of business conducted or the number of employees hired. In the short term there are many expenses that are fixed, which vary over the longer term as a business expands, such as:

1. Premises rent
2. Property taxes
3. Most utilities except for electricity and gas
4. Vehicle and equipment lease payments
5. Salaries and benefits

Most of these types of expenses are paid on a periodic basis, such as weekly, monthly, semi-annually, etc. So they often provide the easiest starting point in preparing the outflows section of your cash flow projection, since the amounts are usually known and you can just copy them across the periods of your cash flow spreadsheet (at least within a period where the business is not expanding).

Despite the fact that there are very few truly fixed costs over the longer term, there are a few that are truly fixed such as:

1. Club memberships.
2. Subscription fees for various publications.
3. Insurance expense.
4. Other licences and memberships for a fixed term.
5. Amortization of capital assets.
6. Advertising expenses.

These types of expenses are usually paid annually. Accountants usually amortize them over the full year, expensing a portion of the cost each month, which is fine for determining accounting and profit for income tax. However, from a cash flow perspective, it is important to deduct the outlay in full during the period in which it is actually made. Likewise, amortization, is not usually an expense for tax purposes, nor should it be deducted in determining cash flow. The only deduction that should be made in determining cash flow is the purchase cost of capital assets, when that equipment is actually purchased. If such equipment is leased, then the deduction from cash flow is the actual lease payments made, when they are made.

Variable Expenses

Variable expenses as the name suggests vary in direct proportion with respect to a specific cost driver, such as sales, number of orders processed, number of machine hours of production, number of square feet occupied or number of employees hired. A true variable expense can be scaled back to zero if the business were to cease. Forecasting these accurately therefore requires first that you identify the correct cost driver and then identify what the mathematical relationship is between the driver and the level of expense.

For example EI contributions are a variable expense in which the driver is the total level of salaries paid by your business. Store rent can be a variable expense to the extent that the lease agreement requires a percentage of total sales to be added to the rent payment. Cost of sales is driven purely by sales or number of orders processed. Salaries are determined by number and type of employees hired and so are variable over the longer term, but fixed as long as the number and types of employees remain constant.

So this section of your cash flow projection is much more difficult to complete because there are many interdepencies between the different expenses. This is where being able to program and copy formulas in Excel is so valuable. What you will find is that it is much easier to calculate them if you include line items in your spreadsheet for the actual levels of each related cost driver as well as the actual expenses.

Another complicating factor here is that there are many expenses for tax and accounting purposes that should not be deducted from your operating cash flow in determining surplus cash flow. One of the largest examples is cost of sales. The only time this should be deducted is when your business actually makes an inventory purchase. However, any subsequent sale of that inventory is not deducted from cash flow, since there is no required outlay until it is time to replenish the inventory.

Why is Understanding the Difference So Important?

Understanding the difference between fixed and variable costs is important because it is your level of fixed costs that determines how risky your business is inherently. If your business has a lot of fixed costs, then it will have to make a lot of sales each month just to pay its bills. If sales drop very low or to zero, a business like this will incur a loss. On the other hand, a business that can structure itself in a way that most or all of its costs are variable, will have very little risk and will be ideal for someone trying to build a business on the side.

My business is an example of a business with very little fixed costs. In fact, my only fixed expenses are:

1. My monthly e-bay fees.
2. My monthly bank fees.
3. My monthly alarm fees for my security system
4. My monthly insurance fees.

All of this winds up being about $550-$600 a month, which means that I don't have to sell a lot of stamps to make a profit. If I run out of savings before my sales reach a level sufficient to take a salary then I can always return to work temporarily without having to worry about the business incurring a loss. But if my fixed costs were high, I would not be able to do that and would probably have to concede failure.

Tomorrow's post will look a little more closely at forecasting variable expenses.


  1. Don't forget about financing expenses, such as interest and principal payments. I think you said that your business has 'an investor' that requires these types of payments to be made at some point.

    And these days you have to have a cell phone, and decent internet as costs as well.....

    1. Thanks for mentioning these. My post was intended to distinguish between the different types of expenses and then to give a few examples of each rather than give a complete list all expenses. However it is easy for people to overlook expenses like phone and internet.