Sales are an important indicator of success in your business. However, there are even more important numbers that you need to know to understand if your business is going to be successful or not — profits and cash.

To figure out your future profits and how much cash you’ll have in the bank in the coming months, you’ll need to create a Profit & Loss forecast and a Cash Flow forecast. These two forecasts work together to help predict the future health of your business. 

What is profit?

Profit is what’s left over after you subtract your business expenses from your total revenue in a given month.

Your profit shows how generally healthy your business is. After all, a successful business needs its sales to be greater than its expenses in the long run. So typically, you’re looking at your profit and loss statement, to get a full picture of your income and expenses.

But there are a few important things you need to remember when you’re forecasting your profit:

1. Every dollar you spend isn’t an expense

For example, if you run a bike shop you might invest in purchasing a large number of bikes as inventory for the Spring season. But, you can only expense this inventory as you make sales. So, if you buy 20 bikes at the beginning of the season and then only sell 5 bikes in a month, you can only count the cost of those 5 bikes in your expenses.

2. Non-monetary expenses can impact your profits

When most people think about profit, they are thinking about “Operating Profit” which is your revenue minus your expenses but does not include interest payments, taxes, or depreciation. Depreciation is a non-monetary expense that can reduce your profitability — for example, the declining value of a building your business owns.

3. Some expenses get spread out over time

Slightly similar to inventory expenses, some business expenses are spread out over time. For example, you might pay up-front for an annual license for business software, such as a CRM system or accounting system. But, because of accounting rules, you’ll only include one month’s worth of that expense in your profit calculation in any given month.

4. Taxes and interest payments count, too

After you calculate your Operating Profit, you’ll subtract any tax payments and interest payments you are making on business loans. This is because taxes are calculated on Operating Profit and you’ll then subtract that number to get your Net Profit.

What is a cash flow forecast?

Unlike a Profit & Loss forecast, your Cash Flow forecast measures how much actual cash is moving into and out of your business. Your cash flow forecast predicts how much cash you will receive each month and how much cash you will spend each month to predict how much money you’ll have in the bank at the end of every month.

This is a crucial distinction because profits and cash are very different. We have an entire guide on this topic, but here’s a quick explainer: 

As we saw with the profit forecast, not all spending can be counted in your expenses. Take the inventory example above. Your business will spend cash buying bikes for the spring season, but you can only count that inventory as an expense as you sell those bikes. However, your cash flow forecast does track this spending. When you buy inventory, that shows up immediately in your cash flow forecast to show the cash that you spent on inventory.

Your cash flow forecast will also take into account that not all sales equal immediate money in your bank account. For example, if you make a sale and send an invoice to a customer, it may take that customer 30 or even 60 days to pay you. So, the sale will count immediately in your profit forecast, but won’t count in your cash flow until you actually receive the payment from your customer.

Is a profit forecast more important than a cash flow forecast?

In short, a profit & loss forecast is not more or less important than a cash flow forecast. These two forecasts work together to give you a complete understanding of your business. They tell you very different but complementary pieces of information that tell you how your business is working. 

Your profit & loss forecast will tell you if you are building a sustainable business over the long term. Even if your business starts out being unprofitable, your forecast will show how you will become profitable — by increasing your revenue over time, decreasing your expenses over time, or some combination of the two.

Meanwhile, your cash flow forecast will show you how much cash you should have in the bank to fund your sales and expenses over time. The forecast will predict the times where you may be low on cash, even though your business is profitable. This can happen because of large purchases of inventory and other large investments in equipment that you can’t expense entirely up-front. Cash crunches can also happen if customers don’t pay you right away. 

Having these two forecasts will help you build a healthy and sustainable business in the long run.

How do you create and review a profit & loss forecast and cash flow forecast?

Two methods of cash flow forecasting

For cash flow forecasting you have two different methods to work from, known as the direct and indirect methods. The direct method is simply subtracting the amount of cash you plan on spending in a month from the amount of cash you plan on receiving. This gives you your net cash flow which you then add to your current cash reserve to determine your projected forecast.

The indirect method on the other hand has you start with your projected net income (profits) and add back any items that affect profitability but not your cash position (such as depreciation). You can read a full detailed guide on how to build either type of forecast here.

Profit & loss forecasting

You’ll want to start your Profit & Loss forecast by looking at your sales and revenue forecast. You simply predict how many units you’re going to sell this month, figure out the average price for each unit and multiply these two numbers. This will provide you with your projected revenue.

From there you can determine what your expected expenses will be, and subtract that from your sales numbers. Typically, you can pull your expense numbers based on the previous months accounting data.

Forecasting tools can simplify this process

You can build either of these forecasts in Excel. It will require you to manually update, pull in your accounting information and build out equations to accurately calculate your projections. A broken link, missing parenthesis, or incorrectly inputted data can quickly disrupt these sheets so you’ll need to carefully build these out.

If you use a sales forecasting tool like LivePlan, you can greatly simplify the process of creating these forecasts. If you use a tool like LivePlan, you can greatly simplify the process of creating these forecasts. Simply create a revenue forecast and an expense budget and the software will do the rest. It will automatically figure out your inventory purchases and when customers will typically pay you.

Using software for forecasting has big advantages because it makes it easy to explore different scenarios. Seeing what impact customer payments will have on your cash flow is as simple as moving a slider. No complex calculations required.

The other key benefit is integration with your accounting software. Once you connect to QuickBooks or Xero, a cash flow forecasting tool like LivePlan can instantly compare your forecasts to your actual results to see if you’re on track to meet your goals.

Both forecasts are only useful if you revisit them regularly

The most important aspect of forecasting is not which financial statement is more vital to your business, but that you need to review them both regularly. Forecasting is only beneficial if they’re base numbers are accurate. If you leave them alone and don’t regularly sync them up to actual results, they’ll quickly divert from reality.

As a rule of thumb, it’s useful to check and update both your profit and cash flow forecasts at least once a month. If you have a tool that allows you to easily adapt and update them, it may be worth updating them more often. 

Building these key forecasts can seem intimidating at first, but they are well worth the initial investment to help you build a business that will outperform your expectations.