Cash flow forecasting
Encyclopedia
Cash flow forecasting or cash flow management is a key aspect of financial management
of a business, planning its future cash requirements to avoid a crisis of liquidity.
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. 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.
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 asset
s, proceeds of financing, etc. Disbursements include payroll
, payment of accounts payable
from recent purchases, dividend
s 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 sheet
s.
Both the ANI and PBS methods are best 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.
Uses
A cash flow projection is an important input into valuation
of assets, budgeting and determining appropriate capital structure
s in LBOs
and leveraged recapitalization
s.
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 need to learn fast that "Cash is king
" and therefore they must become good at cashflow forecasting.
Methods
The simplest method is to have a spreadsheet that shows cash coming in from all sources out to at least 90 days, and all cash going out for the same period. This 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.
A danger of using too much corporate finance theoretical methods in cash flow forecasting for managing a business is that there can be non cash items in the cashflow as reported under financial accounting standards. This goes to the heart of the difference between financial accounting and management accounting
.
Uses
The point of making the forecast of incoming cash is to manage the outflow of cash so that the business remains solvent. The section of the spreadsheet that shows cash out is thus the basis for what-if modeling, for instance, "what if we pay our suppliers 30 days later?"
Financial management
Financial management may refer to:* Managerial finance, a branch of finance that concerns itself with the managerial significance of finance techniques....
of a business, planning its future cash requirements to avoid a crisis of liquidity.
Corporate finance
DefinitionIn the context of corporate finance
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, cash flow forecasting is the modeling of a company or entity’s future financial liquidity over a specific timeframe. Cash usually refers to the company’s total bank balances, but often what is forecast is treasury
Treasury management
Treasury management includes management of an enterprise's holdings, with the ultimate goal of maximizing the firm's liquidity and mitigating its operational, financial and reputational risk. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding...
position which is cash plus short-term investments minus short-term debt
Money market
The money market is a component of the financial markets for assets involved in short-term borrowing and lending with original maturities of one year or shorter time frames. Trading in the money markets involves Treasury bills, commercial paper, bankers' acceptances, certificates of deposit,...
. Cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
is the change in cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
or treasury position from one period to the next.
Methods
The direct method of cash flow forecasting
Forecasting
Forecasting is the process of making statements about events whose actual outcomes have not yet been observed. A commonplace example might be estimation for some variable of interest at some specified future date. Prediction is a similar, but more general term...
schedules the company’s cash receipts and disbursements
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
(R&D). Receipts are primarily the collection of accounts receivable
Accounts receivable
Accounts receivable also known as Debtors, is money owed to a business by its clients and shown on its Balance Sheet as an asset...
from recent sales, but also include sales of other asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s, proceeds of financing, etc. Disbursements include payroll
Payroll
In a company, payroll is the sum of all financial records of salaries for an employee, wages, bonuses and deductions. In accounting, payroll refers to the amount paid to employees for services they provided during a certain period of time. Payroll plays a major role in a company for several reasons...
, payment of accounts payable
Accounts payable
Accounts payable is a file or account sub-ledger that records amounts that a person or company owes to suppliers, but has not paid yet , sometimes referred as trade payables. When an invoice is received, it is added to the file, and then removed when it is paid...
from recent purchases, dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
on debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
. 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 sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
s.
- The adjusted net incomeNet incomeNet income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
(ANI) method starts with operating income (EBITEarnings before interest and taxesIn accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses...
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 looks straight at the projected book cash account; if all the other balance sheet accounts have been correctly forecast, cash will be correct, too.
Both the ANI and PBS methods are best suited to the medium-term (up to one year) and long-term (multiple years) forecasting horizons
Planning horizon
The planning horizon is the amount of time an organization will look into the future when preparing a strategic plan. Many commercial companies use a five-year planning horizon, but other organizations such as the Forestry Commission in the UK have to use a much longer planning horizon to form...
. 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.
- The third indirect approach is the accrual reversal method (ARM), which is similar to the ANI method. But instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributionsProbability distributionIn probability theory, a probability mass, probability density, or probability distribution is a function that describes the probability of a random variable taking certain values....
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.
Uses
A cash flow projection is an important input into valuation
Valuation (finance)
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets or on liabilities...
of assets, budgeting and determining appropriate capital structure
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
s in LBOs
Leveraged buyout
A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...
and leveraged recapitalization
Leveraged recapitalization
In corporate finance, a leveraged recapitalization is a change of the capital structure of a company, a substitution of equity for debt —e.g. by issuing bonds to raise money, and using that money to buy the company's stock or to pay dividends...
s.
Entrepreneurial
DefinitionIn 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 need to learn fast that "Cash is king
Cash is king
"Cash is king" is an expression sometimes used in analyzing businesses or investment portfolios. It may refer to the importance of cash flow in the overall fiscal health of a business...
" and therefore they must become good at cashflow forecasting.
Methods
The simplest method is to have a spreadsheet that shows cash coming in from all sources out to at least 90 days, and all cash going out for the same period. This 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.
A danger of using too much corporate finance theoretical methods in cash flow forecasting for managing a business is that there can be non cash items in the cashflow as reported under financial accounting standards. This goes to the heart of the difference between financial accounting and management accounting
Management accounting
Management accounting or managerial accounting is concerned with the provisions and use of accounting information to managers within organizations, to provide them with the basis to make informed business decisions that will allow them to be better equipped in their management and control...
.
Uses
The point of making the forecast of incoming cash is to manage the outflow of cash so that the business remains solvent. The section of the spreadsheet that shows cash out is thus the basis for what-if modeling, for instance, "what if we pay our suppliers 30 days later?"