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“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”
~Peter Drucker, management consultant, educator, and a leading voice in modern project management theory
No matter what type of business you run, you can’t do it successfully without having a handle on your cash flow.
At least not for very long.
One of the troublesome parts of dealing with balance sheets and working capital is that expenses are unpredictable, especially if your organization is in a growth phase. Your day-to-day expenses don’t occur evenly, and even if they did, bills don’t come in or come due at even increments.
Not to mention, you’re facing the same issue on the other end, with clients that pay with varying degrees of timeliness.
Accounts payable forecasting is the practice of predicting at least one side of that equation: the money you’ll owe in the coming months.
Here’s what you need to know about getting started with forecasting accounts payable.
What are accounts payable?
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Accounts payable (AP) is a term for all the money a company owes to others for goods and services the company has already received. These are debts that must be repaid relatively quickly, usually within 90 days. Bills from vendors, freelancers, and suppliers are all part of AP.
Businesses use AP to understand their expenses (specifically what money is already promised to go out the door) more clearly, enhancing decision-making and financial planning. It’s an oversimplification to say, “you can’t spend money you don’t have.” But at some level, it’s true — spend money you owe vendors on your own office renovation, and you’ll find yourself in an uncomfortable position.
Think of AP like a more complex version of a personal credit card. Each month you receive a statement showing how much you owe and a due date that tells you when to pay to avoid penalties (interest and fees).
With AP, the challenge is that no one else is collecting the “credit card charges” — your business has to do that on its own. As an added layer of complexity, you’ll often have to deal with varying due dates, too.
Just like keeping on top of your credit card payments helps your overall financial health and keeps you from getting into financial hot water, accurately tracking your agency’s AP is essential for managing cash flow, avoiding disruptions, and maintaining vendor relationships.
The basics of forecasting
Accounts payable forecasting is a financial planning process that predicts and plans for near-term expenses. This financial modeling tool measures your current liabilities and paints a part of the picture of your future cash flows.
It’s similar to budgeting for future needs at home. For example, if you know your car needs new tires, you can plan for the expense by making budget adjustments for a couple of months prior. If you wait until you get in an accident because your worn-out tire blows out on the interstate, your expenses will be much higher — and unplanned.
AP forecasting is the business equivalent of planning for that tire replacement (and the rest of your month-to-month and one-time expenses).
To forecast project expenses well, a business needs linear, scheduled, and repeatable processes. Include at least the following steps in your process:
Collect historical data
Most business expenses are cyclical. Even if they don’t come due every month, they aren’t completely random. For example, you might not know exactly when you’ll need to pull in a specialist freelancer, but you already have a pretty good idea that you’ll do so three or four times in the coming year.
If you’re collecting and using historical data, that is.
Some AP forecasting trends might not be front of mind and might not show up in consistent or identical patterns, but they’re still predictable if you look more closely at historical data.
Where do you get this data? If your organization uses accounting software or works with an external accounting partner, that’s a great place to start! If you’re tracking AP and accounts receivable (AR) in another location or document, dive into the data there.
Analyze spending patterns
Take a closer look at your current spending patterns. If you aren’t categorizing expenses, it’s wise to start doing so.
Refer back to that specialist freelancer. Maybe you use quite a few of them for various specialties or verticals, and it’s a little daunting to pull individual invoices and receipts. If you’re categorizing those expenses properly, you’ll be able to quickly isolate all freelancer expenses.
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Take Google Ads as another example. Some businesses buy these for their customers, but it’s not a real “expense” in the sense the customer pays for them as part of their broader contract. Being able to quickly identify all such expenses via categorization helps maintain clear thinking about expenses and income.
Consider external factors
Does the industry you serve experience heavy seasonality? If so, your clients may pay a flat monthly rate while your actual expenses ebb and flow with their seasonality. Market conditions can also factor into cash flow forecasting: inflation, changes in an industry, and so on.
Implement a review process
Don’t assume your AP forecasting process is perfect. (Because it will never be perfect!)
Make sure to create and implement a review process that evaluates your AP forecasting against actual AP. Where it’s not lining up, identify what adjustments you need to make to your formulas.
One more note: A conservative estimate is better than a hopeful one. AP and AR forecasting shouldn’t be what you’re hoping to be paid and what you’re hoping to owe. Instead, use a conservative, realistic estimate of what is most likely to happen.
Accounts payable vs. accounts receivable: What’s the difference?
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Businesses rarely track AP alone. They track it alongside accounts receivable (AR), which is the amount of money that others owe to the company. AP is your outflows, money that will be going out. AR is money that will be coming in (inflow).
Both of these elements (among many others, like current assets, liabilities, and liquidity) will be included in an organization’s financial statements. Keep the two terms straight by remembering this:
P/Pay/Payable = Bills to pay
R/Receive/Receivable = Money you’ll receive
Let’s examine these concepts in more detail.
Accounts payable
Accounts payable refers to any outstanding bills for goods or services already delivered that will be due in the near term. It’s money you’ve already committed to spend, which is why businesses use accounts payable as they forecast resource costs.
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Accounts receivable
Accounts receivable refers to any outstanding source of income for goods or services you’ve already delivered to others (such as invoices that you’ve sent to clients for completed work, but that clients haven’t paid yet). It’s money your customers or clients have already committed to pay you, but hasn’t hit your bank account yet.
Accounts payable formulas
There are already several established accounts payable formulas out there. Businesses use one or more of them to forecast AP. Which one is right for you depends on the types of clients you serve and the specifics of your financial situation.
Historical trend analysis
The formula for historical trend analysis looks like this:
Current amount - base/previous amount = change in amount
To turn that into a percentage, divide the answer by the base year/previous amount.
Using this formula, you can track changes over time, either by percentage or in real numbers. You might use this to compare AP and AR over time to project future trajectory or identify past seasonality.
Regression analysis
Regression analysis compares a dependent variable and an independent one and can be used in AP forecasting to identify what a specific change is likely to do to another aspect of the business.
A simple linear regression looks like this:
Y = a + bX + ϵ
And a typical regression analysis extends out to this:
Y = a + bX1 + cX2 + dX3 + ϵ
(Courtesy of the Corporate Finance Institute)
Cash conversion cycles (CCC)
CCC is calculated by adding days inventory outstanding (DIO) and days sales outstanding (DSO), then subtracting days payable outstanding (DPO). In a formula:
CCC = DIO + DSO - DPO
This formula measures how long it takes for goods (or services) to turn into income, minus how long it takes you to pay your AP. A low figure is usually considered healthy, and if your CCC score starts to rise, it’s wise to investigate why.
Of course, it requires knowing how to calculate the average number of days in your DPO, DSO, and DIO metrics. Here’s a detailed guide.
Simple moving average
The formula for simple moving average (SMA) looks like this:
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This formula averages every instance of a figure over a fixed set of periods, such as a 50-day moving average, showing what the average price is during that stretch. It’s useful for comparing volatile figures over time, such as if your AP or payment patterns are spiky, you could measure this element in a three- or four-month rolling average.
Vendor payment policies (2/10 and Net 30)
2/10 Net 30 is a popular policy where payers get a 2% discount if they pay an invoice within 10 days but otherwise have up to 30 days to pay without penalty. Here’s the formula for the 2/10 part of the policy:
x - .02x = y
Where x is the agreed-upon price and y is the discounted price for early payment (within 10 days).
Best practices for accurate forecasting
Accounts payable forecasting isn’t easy, and it will never be precise. But when you follow best practices for accurate forecasting, you’ll have a much easier time with resource management and understanding your cash flow.
1. Mine historical data
Your historical data should be a gold mine for forecasting, especially once you have data both on what happened (actual) and on your forecasts for that period. (This is one reason to start forecasting today, not next quarter!)
Look back at periods with sudden expenses. How well did you forecast them? Did your model withstand the spike, or did it punch right through your predictions?
Where you see large variances, look for the “why,” which will often point to what you need to change for next time.
2. Identify patterns
Many unexpected or sudden expenses don’t actually need to be unexpected or sudden.
They’re things that you can plan for. You might not know when you’ll need a new laptop, but you know it will happen sometime between now and the turn of the decade.
Look at those “sudden” expenses in your historical data and see how many of them were predictable or falling into a pattern. Then, incorporate those elements into your forecasting.
3. Understand the ramifications
Not all late payment penalties are the same. But some will cost you financially. Others will cost you reputationally. As you continue honing your forecasting, start identifying these elements as well, especially if money is tight. Should you need to delay on a line item in your AP, it’s advantageous to know which one will have the least amount of impact (whether financial, relational, or both).
Get a stronger, more robust financial forecast for your business with Teamwork.com
Consistently predicting your business expenses accurately is liberating for businesses: you can operate confidently and spend less time worrying about cash flow, freeing you up to focus on your business’s unique selling proposition and delighting your clients.
Teamwork.com is the ideal platform to run every aspect of client work. With budgeting and forecasting tools, you’ll be able to plan and budget for projects with ease and clarity.
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