Ever wondered if you could control your SaaS business’ financial future? Do you want to?
What would you do if you could see into the future and predict the amount of money your SaaS can bring in a month later? Or, even a year from now?
As it turns out, an accurate cash flow forecast can do the same for your SaaS business, acting almost as a crystal orb for your business to look into the future of cash flow. In fact, cash flow forecasting can be your prime safety net and steer you away from the path of insolvency.
In this article, we’ll be tackling the fundamentals of cash flow forecasting, why it matters for your SaaS business to have a ready and flexible SaaS cash flow forecast, how you can prepare an effective one for your business, and more! Let’s get right to it!
Cash flow forecasting is pretty different when you compare it with accounting income. Cash flow statements are great for understanding the liquidity and insolvency of businesses, whereas income statement accounting focuses on indicating the profitability of a business for specific financial years.
While cash flow statements follow the cash basis, accounting for income statements involves an accrual basis of accounting. Similarly, the activities that refer to different divisions of the cash flow statement and income statement are different, too.
Cash flow statements account for operating, investing, and financing activities, whereas the income statement accounts for operating and non-operating activities. The latter also includes accounting for depreciation, which the cash flow statement does not.
At its most fundamental level, cash flow forecasting is about how you analyze the historic cash positions of your company. This data can then be used to project how the free cash flow of your SaaS business is supposed to look in a month, a quarter, or even a year from the present moment.
The three components of the cash flow forecasting formula include the following:
To understand this concept better, let's look at a straightforward cash flow forecasting example:
Imagine you manage a SaaS app for social media scheduling. Last month, in free cash flow, it made $10,000. You're growing at a 5% rate over the last quarter with a churn rate of 2%.
With insights into these metrics and your expenses, you can now easily apply the cash flow forecasting method to generate a basic forecast on a rolling 1-year basis or at least for the next quarter. This helps a great deal in future planning for your business.
Here are the top reasons your SaaS business needs a cash flow forecast:
Cash flow forecasting lets you know at which point your cash will end so that you can start focusing on using debt (for example, credit cards) and fundraising. This applies specifically to SaaS startups that have been bootstrapped or depend on venture capitalists. Besides, you could be closing lucrative deals left, right, and center and can still face the cash crunch when it’s time to pay. This shows the importance of mapping out expenses, revenues, and any debt or VC money.
If your SaaS business is not yet cash flow positive, identifying the burn rate and knowing exactly how long the money from investments would last can be crucial. This tells you when you need to become cash flow positive or must raise another round.
If you have never applied the cash flow forecasting method before, chances are you will spot a number of charges that your business can do without.
For example, you may find there are two different businesses that you're paying for essentially doing the same job, or you're still carrying forward a monthly subscription, which your company no longer uses. Laying down the cash flow offers valuable insights about where your cash is going, and making little changes on this front can save you a lot of money in the long haul.
To accurately forecast your SaaS business's cash flow, you must regularly update your investors and lenders. This increases their sense of safety for their investments and loans. This can also improve your scope of negotiation.
While managing burn rate and knowing about your next investment round is already crucial for your SaaS business’ health, showing that you can present a projection of this accurately can make the trust of your investors/lenders go up in your management capabilities. It can further secure future investments for your brand.
Any business’s cash flow can be calculated using direct and indirect methods. These options are acknowledged by Generally Accepted Accounting Principles (GAAP).
The cash flow from financing and investing activities is essentially straightforward across both processes.
This method is all about keeping track of all the cash entering and leaving your business. Naturally, this option would accompany a huge burden of bookkeeping.
This is because now you need two general ledgers: one for recording all of your activities and another for tracking cash transactions. Understandably, this method can be very time-consuming, especially if you compare it with the indirect method. In contrast, the indirect method is a simple one.
When it comes to the indirect approach, this begins with accounting for cash from operational activities. The income statement offers data on net income or loss. Based on this data, the accountant's job is to work backward by removing all expenses and non-cash revenues, along with adding in the entire revenue that has either nor incurred yet or has not been recognized.
The indirect method can arguably add more ease to calculating your SaaS business cash flow, which is precisely why many small businesses prefer this indirect method. Moreover, with this first option, you have your accountant record their assumptions into a spreadsheet to check how far their assumptions affect the cash flow projection. The following is an example of a SaaS cash flow template that the accountant can use.
Figure 1: Example of Cash Flow Forecast Template
(Source: Driveninsights.com)
A cash flow statement can complement the financial statement of your SaaS business like nothing else. Intrinsically, cash flow statements share a close connection with the income statement and the balance sheet.
In fact, if you simply have your income statement and balance sheet laid down in front of you, you can generate the cash flow statement by using only these two. The statements can perfectly outline the cash entering and leaving the business across a specific period.
The key elements of the cash flow statements are the money coming from operating activities, financing activities, and investing activities. The illustration below is an example of an annual cash flow statement of Amazon.
Figure 2: Amazon’s Consolidated Cash Flow Statement for 2011-2013
(Source: Annualreports.com)
Putting SaaS financial modeling first in the initial stages can nudge accurate revenue forecasts in the right direction and lay down the important KPIs you should be keeping track of.
A simple SaaS financial model also works to clarify your SaaS firm's financial viability, offer a sandbox to assess strategies' impact on your business's profitability, provide a comprehensive idea of cash flow, and closely monitor your unit economics. The basic components of the simple SaaS financial model are the following:
A. Profit & Loss Statement: This report summarizes the balance sheet and the cash flow of your SaaS business for a given period and analyses your firm's financial health.
B. Revenue Models: This report helps in tracking your revenue. It includes both Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR). Some of the key elements present in this report are New MRR, Downgrade MRR, Expansion MRR, and Churn MRR. The revenue your business has at the month-end, and the percentage of logo churn can be found prominently here.
C. Unit Economics: This is all about how a business expresses its revenues and costs on a per-unit basis. With this, the profitability of your SaaS business can be calculated at the unit level, making unit economics fundamental for achieving profitability and growth.
There are at least 3 advantages that your SaaS business can profit from if you're taking your cash flow forecast seriously, those being:
By definition, startups funded by VCs tend to operate with limited resources. This also includes a looming deadline by when these businesses will eventually run out of cash. If you choose to bootstrap, you also face an equally time-constrained position. This makes it important for SaaS businesses to track their monthly expenses so as to have a clear picture of how the runway appears and what the burn rate is.
Your business should be aware of the good, the bad, and the ugly for risk-ready cash flow planning. This is precisely the aim of stimulating different scenarios that may be less rosy to prepare your SaaS business better for the future.
It's a healthy exercise to lay down all your expenses on a spreadsheet. Spot the spendings that don't make much sense or are redundant. This can make cost-saving opportunities come to the surface and be visible for you to capitalize on.
Before you begin calculating your cash flow forecast, you need to know a few avoidable factors that can negatively impact it. Some of those have been discussed below:
Inaccurate data can cause the most common cases of inaccurate cash flow forecasts. This can be an alarming issue and frequently results from human errors, along with mistakes in formatting the data, missing details, and erroneous spreadsheet formulas.
Teams are generally faced with two options: 'sandbagging' a little to make sure they are exceeding leadership expectations or motivating themselves to meet higher stretching goals. You should account for these human influences when it comes to calculating SaaS cash flow forecasts.
For any financial plan, accounting for increasing headcount is critical. However, you cannot ignore other costs that accompany business growth. These can include plan expansion in SaaS tools including Slack, Google Apps, and Zendesk, bonuses and salary raises for employees, along with potentially major growth costs such as increasing advertising budget, office migration or expansion, etc.
“The fact is that one of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality.” – Chris Chocola, American businessman, lawyer, and former politician.
Often, in the pursuit of day-to-day client servicing, branding, profitability, and overall high-voltage growth, entrepreneurs tend to overlook the “little details” concerning cash flow – a habit that can jolt them into cruel reality, if and when their business faces an unexpected slump.
Old-fashioned as it may be, cash flow forecasting for your SaaS business is imperative as it lets you know where you’re coming from, where you’re standing today, and what you’ll need to get to where you’re planning to be.
We hope this article has helped you understand the fundamentals of cash flow forecasting and has prepared you sufficiently well to take on this much-needed challenge!