Cash flow forecasting

Cash flow forecastingis the process of obtaining an estimate of a company's futurecash levels,and itsfinancial positionmore generally.Acash flowforecast is a keyfinancial managementtool, 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,andTreasury management § Cash and Liquidity Management

Cash flow forecasting is an element offinancial management.Maintaining a company's cash flow is a central part of managing the business and the financing of ongoing operations — particularly forstart-upsandsmall enterprises.If the business runs out ofcashand is not able to obtain new finance, it will becomeinsolvent,and eventually declareBankruptcy.

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 incash balancesin 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, seeWorking capital.
• As a discipline offinancial planning— thecash flow forecastis amanagement process,similar to preparing business budgets.
• Externalstakeholders,such as banks, may require a regular forecast if the business has a bank loan.

Corporate finance

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

Cash usually refers to the company's total bank balances, but often what is forecast istreasuryposition which is cash plus short-terminvestmentsminusshort-term debt.Cash flowis the change incashor treasury position from one period to the next period. The cash flow projection is an important input intovaluationof assets,budgetingand determining appropriatecapital structuresinLBOsandleveraged recapitalizations.Depending on the organization, then, this modeling may sit with "FP&A"or withcorporate treasury.

Methods

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

The direct method of cash flowforecastingschedules the company's cash receipts anddisbursements(R&D). Receipts are primarily the collection ofaccounts receivablefrom recent sales, but also include sales of otherassets,proceeds of financing, etc. Disbursements includepayroll,payment ofaccounts payablefrom recent purchases,dividendsandinterestondebt.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 andbalance sheets.

• The adjustednet income(ANI) method starts with operating income (EBITorEBITDA) and adds or subtracts changes in balance sheet accounts such as receivables, payables and inventories to project cash flow.
• Thepro-formabalance sheet (PBS) method directly uses the projected bookcash 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 uponstatistical distributionsand 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 ofsmall 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 aspreadsheet,typically inExcel,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. abridge loanor via increased collections activity. For short term cash flow forecasting there are also a number ofAI drivenlow costsoftware applicationsavailable.

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 matchsales forecastsexactly, 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. usingfinancial accountingas opposed tomanagement accountingstandards - 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