Cash flow forecasting

Cash flow forecasting is the process of obtaining an estimate of a company's future cash levels, and its financial position more generally. A cash flow forecast is a key financial management tool, both for large corporates, and for smaller entrepreneurial businesses. The forecast is typically based on anticipated payments and receivables. Several forecasting methodologies are available.

Function

See also: Financial forecast, Cash management, and Treasury management § Cash and Liquidity Management

Cash flow forecasting is an element of financial management. Maintaining a company's cash flow is a central part of managing the business and the financing of ongoing operations — particularly for start-ups and small enterprises. If the business runs out of cash and is not able to obtain new finance, it will become insolvent, and eventually declare Bankruptcy.

Cash flow forecasting helps management forecast (predict) cash levels to avoid insolvency. The frequency of forecasting is determined by several factors, such as characteristics of the business, the industry and regulatory requirements. In a stressed situation, where insolvency is near, forecasting may be needed on a daily basis.

Key items and aspects of cash flow forecasting:

• Identify potential shortfalls in cash balances in advance.
• Make sure that the business can afford to pay suppliers and employees - Delayed payments to suppliers and employees can cause a chain effect of decreased sales due to lack of e.g. inventory.
• Spot problems with customer payments—preparing the forecast encourages the business to look at how quickly customers are paying their debts, see Working capital.
• As a discipline of financial planning — the cash flow forecast is a management process, similar to preparing business budgets.
• External stakeholders, such as banks, may require a regular forecast if the business has a bank loan.

Corporate finance

In the context of corporate finance, cash flow forecasting is the modeling of a company or entity's future financial liquidity over a specific timeframe: short term generally relates to working capital management, and longer term to asset and liability management.

Cash usually refers to the company's total bank balances, but often what is forecast is treasury position which is cash plus short-term investments minus short-term debt. Cash flow is the change in cash or treasury position from one period to the next period. The cash flow projection is an important input into valuation of assets, budgeting and determining appropriate capital structures in LBOs and leveraged recapitalizations. Depending on the organization, then, this modeling may sit with "FP&A" or with corporate treasury.

Methods

Cashflows may be forecast directly, as well as by several indirect methods.

The direct method of cash flow forecasting schedules the company's cash receipts and disbursements (R&D). Receipts are primarily the collection of accounts receivable from recent sales, but also include sales of other assets, proceeds of financing, etc. Disbursements include payroll, payment of accounts payable from recent purchases, dividends and interest on debt. This direct R&D method is best suited to the short-term forecasting horizon of 30 days ("or so") because this is the period for which actual, as opposed to projected, data is available.

The three indirect methods are based on the company's projected income statements and balance sheets.

• The adjusted net income (ANI) method starts with operating income (EBIT or EBITDA) and adds or subtracts changes in balance sheet accounts such as receivables, payables and inventories to project cash flow.
• The pro-forma balance sheet (PBS) method directly uses the projected book cash account; if all the other balance sheet accounts have been correctly forecast, cash will be correct, also.
• The accrual reversal method (ARM), is similar to the ANI method. Here, instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily. It also eliminates the cumulative errors inherent in the direct, R&D method when it is extended beyond the short-term horizon. But because the ARM allocates both accrual reversals and cash effects to weeks or days, it is more complicated than the ANI or PBS indirect methods. The ARM is best suited to the medium-term forecasting horizon.

Both the ANI and PBS methods are suited to the medium-term (up to one year) and long-term (multiple years) forecasting horizons. Both are limited to the monthly or quarterly intervals of the financial plan, and need to be adjusted for the difference between accrual-accounting book cash and the often-significantly-different bank balances.

Entrepreneurial

In the context of entrepreneurs or managers of small and medium enterprises, cash flow forecasting may be somewhat simpler, planning what cash will come into the business or business unit in order to ensure that outgoing can be managed so as to avoid them exceeding cashflow coming in. Entrepreneurs will be aware that "Cash is king" and, therefore, invest time and effort in cashflow forecasting.

Methods

A common approach here is to build a spreadsheet, typically in Excel, showing cash coming in from all sources out to at least 90 days, and all cash going out for the same period; any shortfall or mismatch can then be addressed, with e.g. a bridge loan or via increased collections activity. For short term cash flow forecasting there are also a number of AI driven low cost software applications available.

Applying the "spreadsheet approach" requires that the quantity and timings of receipts of cash from sales are reasonably accurate, which in turn requires judgement honed by experience of the industry concerned, because it is rare for cash receipts to match sales forecasts exactly, and it is also rare for customers all to pay on time. (These principles remain constant whether the cash flow forecasting is done on a spreadsheet or on paper or on some other IT system.) Relatedly, it is noted that when using theoretical methods in cash flow forecasting for managing a business - i.e. using financial accounting as opposed to management accounting standards - non-cash items may be included in the cashflow, skewing the result.

One observation, re the commercial tools available is that while these can offer automation and predictive capabilities, there are limitations to their accuracy, especially in areas that involve human behaviour or subjective factors. For instance, predicting when customers will pay their bills accurately can be challenging due to various factors that influence payment behaviour. AI tools heavily rely on historical patterns and predefined rules, which may not always capture the complexities of real-world situations accurately. Moreover, AI tools may lack the flexibility and customization options provided by Excel, as they are typically designed to work within predefined frameworks and may not easily adapt to unique business requirements.

See also

• Cash-flow diagram
• Cash flow at risk
• Cash is king
• Financial analyst § Corporate and other
• Financial forecast
• Financial modeling § Accounting
• Forecast period (finance)
• Valuation using discounted cash flows § Determine cash flow for each forecast period
• Mid-year adjustment
• Owner earnings
• Operating budget
• Outline of finance § Financial modeling