Cash flow forecasts show the money that goes into and out of a business. This is normally done on a weekly or monthly basis. The length of the forecast depends on a business’ complexity. But, typically, it shows the situation 6-12 months into the future.

Scenario planning shows the impact different outcomes are likely to have on finances. For example, you might want to see what difference investing in your sales team makes.

Creating financial models can seem like a big step. But if you already have a cash flow forecast, it’s likely you'll have done some scenario planning before. For example, you might have added to the staff costs line in your cash flow forecast to see the impact of a new employee.

Scenario planning allows you to understand the implications of different decisions. That makes it a useful tool to mitigate risks and figure out what direction to go in. You can then get to grips with uncertain situations.

Understand the impact of decisions

There are lots of times when business owners need to decide what strategy to take. Perhaps you’re considering launching a new product or shutting down an office. You can use assumptions to show what these scenarios look like.

There will always be uncertainty. But understanding the likely implications of decisions allows you to plan effectively.

Plan for funding needs

Scenario planning shows a company's funding requirements in different situations. This highlights whether more working capital is needed. That capital could either cover day-to-day expenses or invest.

That could be in the form of short-term financing like an overdraft or a loan for a particular project. The point is you can plan for this in advance, rather than being caught out.

Long-term planning

It’s important to understand what resources are needed to achieve company goals. Growth normally incurs upfront costs, like investing in R&D or training employees,

You can check targets by testing how different scenarios might play out for your cash flow. Can you be more ambitious or do you need to cut back?

Launching new products

Developing a new product or service creates opportunities. But it also has financial implications and it can be hard to figure out how to go about it effectively.

You might need to invest in manufacturing capacity or assign a marketing budget. Scenario planning allows you to adjust the assumptions in your cash flow forecast. That will show you the likely impact.

Making a business case for investment

Investors, whether private individuals or financial organisations, provide capital to grow businesses. Investors want to know you have a rigorous strategy, that you’ve planned what you’re going to do with the money.

Integrating scenario planning into your cash flow forecasting provides you with important information. You can use this information to make the case for investing in your business.

It will show your assumptions, what the money's for and how that impacts your income.

This guide assumes you already have a cash flow forecast. If you don’t, the British Business Bank has a guide to cash flow that can help you get started.

To plan a scenario, you need to be able to easily change different inputs. You might want to adjust a copy of the sheet or build a model that compares different scenarios.

These forecasts are normally built in Excel. There are also tools that plug into your accounting software.

The key is to balance accuracy and complexity. You need to gain an accurate understanding of what a scenario looks like. However, the model needs to be simple enough for you to use.

Step one: Understanding what assumptions you need to adjust

The first step is understanding what metrics drive your business.

Most businesses will need to adjust common factors like sales, staff costs and the cost of goods sold.

Individual businesses have different levers or metrics that impact cash flow. For example, a subscription company might track customer churn. An ecommerce store might track average order size.

If you have identified particular drivers, build them into your cash flow forecasting. It will mean you can create more accurate scenarios.

Step two: Duplicate your cash flow forecast

One way to get started with scenario planning is to copy your existing cash flow forecast. That means copying the spreadsheet and giving it a new name, such as “Cash flow forecast – Impact of sales hire”.

That gives you the freedom to make changes without worrying about resetting them. You can also save this version to show to team members or advisers when you’re discussing a strategy.

This approach works well for one-off decisions you want to sense check. For example, investing in new premises, hiring team members or launching a product.

The only drawback is that the rest of the assumptions won’t stay up to date.

Step three: Making your cash flow forecast more flexible

The next step is building flexibility into your main cash flow forecast.

For example, you might add extra lines to the income part of your forecast. This will allow you to add assumptions about the amount of new business you’re going to win.

Using software to test different scenarios

Accounting software connects to a company's bank feeds to track spending. When that information has been tagged, reports can be generated automatically.

It’s common for accounting software to allow cash flow forecasting plugins. This additional functionality makes it easy to build new scenarios.

The decision of whether to use software or a spreadsheet to do your cash flow analysis is up to you. It depends in part on what you’re most comfortable using.

Step four: Developing more complex models

Creating a bespoke scenario model commonly includes adding an input table. In the table, you can adjust metrics such as average basket size that update the rest of the forecast.

It may also allow you to monitor more than one scenario simultaneously.

Talk to your accountant or financial adviser if you need to build something more complex. It may be the case that they can create something you can use on a regular basis.

Finally, the cash flow forecast should plug into your other financial reports. That includes your profit and loss statements and balance sheet. So, you can see the impact different scenarios have on the whole business, rather than just your cash flow.

Businesses that manage stock may also connect forecasts to Enterprise Resource Planning software. This is important because the amount of stock you have directly impacts the cash you need.

Again, as your business becomes more complex, it’s worth seeking advice. Your accountant should be able to talk through what scenario planning can help.

Scenario planning equips business owners to make effective decisions. You're often weighing up different strategies or considering the impact of external events. It’s helpful to know the implications on cash flow.

Setting up a model might take some time. But it can be used again and again and make your decision making process much more robust.

The key is to integrate the tool into your planning process. Perhaps you tie scenario planning to monthly or quarterly meetings or planning sessions. That way, you get into the habit of checking the impact of decisions or events. This should allow you to become more effective in your role.

What to do next?

We have a wide range of content dedicated to helping you solve crucial business challenges, but here are some suggestions:

• A story – We’re having to ask customers for a forecast to understand their needs
• A guide – How to keep your cash flow forecast up to date
• A template – Using scenario planning to inform your decisions