Cash flow projection

Cash flow forecasting is the process of obtaining an estimate or forecast of a company's future financial position; the cash flow forecast is typically based on anticipated payments and receivables.
See Financial forecast for general discussion re methodology.

Function

Cash flow forecasting is an important element of financial management generally;
Cash flow is the "life-blood" of all businesses — particularly start-ups and small enterprises — and if the business runs out of cash and is not able to obtain new finance, it will become insolvent. As a result, it is essential that management forecast (predict) cash levels.
How often, will depend on the financial security of the business:
if the business is "struggling", management may assess, if not forecast, cash flow on a daily basis;
if the finances are more stable, then this process may be weekly or monthly.

Key dependencies re the forecast:
* Identify potential shortfalls in cash balances in advance — the cash flow forecast is an "early warning system". This is, by far, the most important reason for a cash flow forecast.
* Make sure that the business can afford to pay suppliers and employees. Suppliers who don't get paid will soon stop supplying the business; it is even worse if employees are not paid on time.
* Spot problems with customer payments—preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note—this is not really a problem for businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale.
* As an important discipline of financial planning — the cash flow forecast is an important management process, similar to preparing business budgets.
* External stakeholders such as banks may require a regular forecast. Certainly, if the business has a bank loan, the bank will want to look at the cash flow forecast at regular intervals.

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.
(See also Owner earnings.)

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.Tony de Caux, "Cash Forecasting", ''Treasurer's Companion'', Association of Corporate Treasurers, 2005

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.Richard Bort, "Medium-Term Funds Flow Forecasting", ''Corporate Cash Management Handbook'', Warren Gorham & Lamont, 1990
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.''Cash Flow Forecasting'', Association for Financial Professionals, 2006

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 need to learn quickly 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 entirely 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.

References

See also

* Cash-flow diagram
* Cash is king
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*Financial forecast
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* Forecast period (finance)
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* Mid-year adjustment
*Owner earnings
*Operating budget
*{{slink, Outline of finance#Financial modeling

Cash flow
Accounting terminology
Working capital management
Forecasting
Corporate finance
Management accounting