Cash flow forecasting

Cash flow forecasting is the modeling of a company or asset’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 assets, proceeds of financing, etc. Disbursements include, payroll, payment of accounts payable from recent purchases, dividends, debt service, etc. 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. (de Caux, 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 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. 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. (Association for Financial Professionals, 2006)

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 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. (Bort, 1990)

Uses

A cash flow projection is an important input into valuation of assets, budgeting and determining appropriate capital structures in LBOs and leveraged recapitalizations.

References

* “Cash Forecasting”, Tony de Caux, Treasurer’s Companion, Association of Corporate Treasurers, 2005
* “Cash Flow Forecasting”, Association for Financial Professionals, 2006
* “Medium-Term Funds Flow Forecasting”, Corporate Cash Management Handbook, Richard Bort, Warren Gorham & Lamont, 1990