Forecasting Cash Flow

What Is Forecasting Cash Flow? 

Forecasting cash flow is about forecasting how much cash will come in and how much will go out over a period of time and when each of those movements will occur. That's different from forecasting income and expenditure. Revenue is recorded when the sale is made; the customer may not pay for 30, 60, or 90 days, and expenditure works the same way in reverse. 

A cash flow forecast follows the actual receipts and payments, so it answers a much more specific and immediate question: will the business have enough cash to meet its bills?

When cash flow is positive, it simply means that more money is entering the business than exiting the business. Negative cash flow, however, means more money is exiting the business than entering the business in a given time frame.

These projections are normally drawn up in accordance with the requirements of a business as well as the applicable factors of the business industry. They are normally forecasted monthly, quarterly, or yearly.

The process of cash flow forecasting entails the estimation of both timing and amounts involved in cash transactions, including sales receipts, payments to suppliers, operating costs, investments in capital, and financing activities.

Cash flow forecasting helps companies understand how money comes in and goes out of their business. This understanding enables them to keep their business liquid to meet expenses on time, repay debts with confidence, invest in business opportunities, and take advantage of opportunities.

Why Cash Flow Forecasting Matters

Cash flow forecasting is significant within financial analysis as it acts as a crucial tool. It facilitates decision-making and assessing firms with ease.

Cash inflows and outflows can be predicted precisely by providing insight in different ways:

• Liquidity management: Forecasts allow companies to be certain they have enough cash in hand for routine operating expenses like wages, rent, utility bills, and payments to suppliers. This helps ensure liquidity and avert crises.
• Strategic planning: Cash flow forecasts give companies information on which to base strategic decisions. They can decide, for instance, whether to invest profit, pay dividends, or direct funds to projects or divisions.
• Risk management: Cash shortages can be anticipated by businesses, and this enables them to take steps ahead of time to counter risks. These actions may also include securing financing alternatives, negotiating longer payment periods with suppliers, or implementing cost-saving measures.
• Investment choices: Cash flow forecasts are employed by companies to ascertain the feasibility and investment return potential when assessing projects, expansions, or acquisitions. Investors and lenders can ask for these forecasts during due diligence.
• Mergers and acquisitions: If a company is near to acquiring or merging with another firm, it will rely on cash flow forecasting to assess the target company's health and compatibility with the existing firm. Cash flow forecasts are heavily relied upon to evaluate the synergies and risk associated with the deal..

Methods of Cash Flow Forecasting

The selection of the method for cash flow forecasting relies on the nature, needs, resources, and priorities of the business. There are trade-offs with each method, and it must align with the organization's priorities and limitations.

Here are three main methods:

Direct method

The direct method consists of forecasting cash flows by directly projecting individual cash payments and receipts. It needs to project in detail all anticipated cash inflows and outflows within a particular period.

This method is considered highly accurate because it provides a granular view of how cash moves in and out of the business.

Indirect method

The indirect method (Accounting Method) relies on existing financial statements, i.e., the income statement and balance sheet. It adjusts accrual-based income and expenses to derive cash flows.

Instead of directly forecasting individual cash transactions, it works backward from net income, considering changes in working capital, which includes current assets and liabilities.

Hybrid Method

The hybrid method approach comprises elements of both the direct and indirect approaches. The objective is to give a more accurate cash flow projection. It can be done by employing the direct approach for some classes of cash flows and the indirect approach for others.

This strategy aims to achieve a balance between precision and convenience.

Considerations when selecting a method

There are some considerations that need to be made before choosing the appropriate method. 

• Nature of the business: A business with a high volume of transactions may benefit more from the direct method, while a business with fewer transactions might find the indirect method sufficient.
• Time constraints: The indirect or hybrid method might be more practical if time is a critical factor.
• Accuracy requirements: Businesses with a high need for precision may lean towards the direct method despite its time-consuming nature.
• Resource availability: The availability of resources, both human and technological, can influence the choice of method.

Forecasted Cash Flows in Valuation Models 

Projected cash flows find a place in several different valuation models, providing valuable information about a company's financial performance.

Within the context of valuation, several models significantly depend on the use of such projections in order to come to a proper understanding of a company's value and its position within the market. 

Consider some of the valuation models that make extensive use of forecasted cash flows:

1. Discounted Cash Flow (DCF) Model
   A DCF values a business on the cash it is expected to generate. You project the free cash flow (usually for 5-10 years), you discount each year's cash flow back to present value, and you add a terminal value to capture all the cash flow beyond the forecast period. 

   The terminal value will invariably be the dominant component of the total, and that's why small changes to the long-term growth assumption can have such a large impact on the final result.

   The cash flow you're forecasting determines the discount rate. If you're forecasting unlevered free cash flow (the cash available to all capital providers prior to interest) then you discount at the WACC, and you get enterprise value. 
   If you're forecasting levered free cash flow (the cash available to equity holders after interest and debt service), then you discount at the cost of equity, and you get equity value directly.

   Unlevered free cash flow = EBIT × (1 − tax rate) + depreciation and amortization − capital expenditures − increase in net working capital

2. Comparable Company Analysis (CCA)
   Comparable company analysis (often referred to as trading comps) values a company by reference to how the market prices other publicly traded companies. You calculate valuation multiples for a peer group (e.g., EV/EBITDA, P/E) and apply those to the target's own numbers.

   Forecasting comes in via forward multiples. The analysts will typically use next year's projected EBITDA or earnings (EV/NTM EBITDA, for instance) as the basis of their comparison, as that's the way the market prices companies (on where they're going). The comps themselves won't use a cash flow forecast; they're only as good as the forecasted numbers that you put into the multiple.

3. Comparable Transaction Analysis (CTA)
   Precedent transaction analysis (also known as transaction comps) involves looking at what buyers have actually paid to acquire similar companies. You gather the multiples from those transactions (e.g., enterprise value divided by the target's LTM EBITDA) and then apply those to the company you're valuing.

   The precedents will usually produce a higher multiple than the trading comps as they include the premium that the buyers are paying to take control. Forecasts are of less relevance in this instance as the majority of the precedent multiples are LTM-based.

4. Leveraged Buyout Model (LBO) 
   The LBO model focuses on estimating returns for investors by projecting the future cash flows of an acquired company. This estimation is crucial in assessing the target company's ability to repay debt taken on during the acquisition. 

The LBO model often incorporates assumptions about improving operating costs synergies, and revenue growth to enhance projections of cash flow.

How to Create a Cash Flow Forecast

To create an accurate Cash Flow Forecast for a business, we can follow the following steps: 

• Step 1: Set the Purpose and Horizon: Decide what the forecast is for before you start to build it. A liquidity forecast for the next quarter will be a weekly forecast and will be built on the direct method. A forecast for a budget or a valuation will be a monthly or annual forecast and will be built on the indirect method. The purpose will also tell you how much detail you need. A 13-week forecast will list individual customers and suppliers, whereas a five-year forecast will be built from totals and ratios.
• Step 2: Start From Today's Cash and Historical Data: Start with the actual opening cash balance in the bank accounts (not an estimate). Then go back and pull 12 to 24 months of historical financial statements to look for patterns. Look at the seasonal peaks, the actual time it takes customers to pay, the time it takes the company to pay its suppliers, and any one-off items that you would expect to be a one-off.
• Step 3: Forecast Cash Receipts: Start with a sales forecast based on history, the sales pipeline, pricing, and market conditions, and then convert that to cash. If your customers are on 45-day terms, then March sales will show up as April and May cash receipts. Your historical DSO is the usual point of departure for when you collect. Build in seasonality there rather than as a separate step and add in any other inflows (interest income, proceeds from the sale of assets, etc.).
• Step 4: Forecast Operating Payments: List all payments to suppliers, payroll, rent, utilities, marketing, and all other operating costs. Split the fixed costs from the variable costs (the ones which vary with sales). Timing is as important as the amount. Your payments to suppliers will be according to your payment terms (your DPO). Payroll will be according to your pay calendar, and some costs (e.g., insurance, annual bonuses) will come in lumps.
• Step 5: Add Investing and Financing Flows: These are the items most commonly omitted, and they are generally the big ones. Capital expenditure, interest and principal on debt, tax payments, dividends and any planned borrowing or equity raises would all be included. The cash flows are grouped in the way the cash flow statement groups them (operating, investing and financing), which makes the forecast much easier to check against the actual reported results at a later date.
• Step 6: Calculate Closing Cash and Compare It With the Minimum: For each period, opening cash plus receipts less payments equals closing cash, which is then the opening balance for the next period. Compare that against the minimum cash balance the business needs to run safely. Any period that falls below that line is a funding gap that you need to make up, via either drawing down on a credit line, delaying a purchase, or chasing your receivables.
• Step 7: Run Scenarios and Track Actuals: Build at least a base case and a downside case (e.g., a 15% fall in sales or a major customer paying 30 days late) and check that the company can still make up the gap. Once the forecast is live you then compare it to actuals on a periodic basis and look at the large variances. A lot of companies will run it as a rolling forecast, simply adding on a new week or month as each one closes. Spreadsheet models are used by most companies, and as volumes increase, treasury software can be used to automate the data collection.

With these steps, you can create a comprehensive and accurate cash flow projection that may serve as a useful tool for valuation, financial planning, and decision-making.

Forecasting Cash Flow Example

Take a small wholesaler with $50k in the bank. Sales are $90k in Dec, $100k in Jan, $120k in Feb and $150k in Mar. Customers pay 30 days after sale and goods cost 50% of sales (so $45k in Dec, $50k in Jan, $60k in Feb and $75k in Mar). Suppliers are paid 30 days after the sale. Payroll and rent are $40k per month. The company is going to buy $30k of equipment in Feb and repay $10k of a loan in Mar. It needs to have at least $40k in the bank to run.

On paper, the business is doing very well. PBT (profit before depreciation, interest, and tax) is $10k in January, $20k in February, and $35k in March for a total of $65k for the quarter. Cash, on the other hand, is $5k at the start of the quarter, and in February it falls below the $40k minimum. 

Growth is the reason for the cash flow issues, as they are paying for the sales each month before the customers actually pay them. The forecast picks up the gap a month in advance, so there is time to either push the equipment purchase to April, draw on the credit line, or offer customers a discount for early payment.

Challenges and Disadvantages of Cash Flow Forecasting

Acknowledging the challenges and disadvantages associated with this financial analysis tool is important despite the fact that cash flow forecasting provides valuable insights and benefits:

1. Dependency on Accurate Estimates
   It is dependent on accurate estimates of all cash inflows and outflows. Inaccuracies in such estimates can translate into false forecasts, resulting in inefficiencies in the forecasting process.
2. Time-Consuming Nature
   The direct method can be time-consuming because of meticulous projections of all expected cash movements, as it is known for its detailed accuracy. This time investment may pose challenges, especially for businesses with limited resources or those operating in dynamic environments.
3. Assumptions and Reliability
   The indirect approach, although faster to apply, is based on assumptions regarding the relationship between cash flows and accruals. Being dependent on these assumptions can introduce some uncertainty, possibly at the expense of granularity and accuracy for speed.
4. Dynamic Business Environments
   Businesses operate in dynamic environments where unforeseen events and changes in market conditions can impact cash flows. Forecasting might struggle to account for these unpredictable factors, leading to disparities between projected and actual cash flows.
5. Resource Intensiveness
   No matter the approach, developing a cash flow forecast takes lots of time and effort. Small businesses may see the process as time-consuming, straining limited resources that might be used on other significant activities.
6. Risk of Overlooking Non-Operating Items
   Non-operating items can significantly impact cash flows. There are chances of ignoring these items in the forecasting process, leading to an incomplete or inaccurate illustration of the cash position.
7. Dependency on External Factors
   Economic and industry trends, being external determinants of cash flows, can be difficult to predict. Trends in the overall economy or industry can have a cascading impact on cash flows, introducing uncertainty into the forecasting process.
8. Constant Need for Updates
   Cash flow forecasts are living models that need updates and rewriting on a regular basis. Failure to update the forecast can result in stagnant data, which reduces the effectiveness and applicability of the forecasting model.
9. Limited Predictive Power in Unprecedented Situations
   In extraordinary circumstances or times of economic downturn, past data and trends will not necessarily be sufficient to inform cash flow projections. The weakness of forecasting models is revealed when confronted with unusual circumstances that break from previous trends.

Conclusion

The contribution of cash flow forecasting should be worth as much to an investor, business owner, creditor, or analyst. With this knowledge, you can navigate the landscape easily and make the right choices.

One of the firm's determinants of financial stability is Effective cash flow forecasting, since it plays a significant role in key areas such as liquidity management, strategic planning, and risk avoidance. Subject to the characteristics and preferences of the firm, the decision on whether to use an indirect or hybrid method is within.

Although valuation models such as Discounted Cash Flow (DCF), Leveraged Buyout (LBO), and others use forecasted cash flows for purposes of evaluation, it is necessary to recognize the difficulties involved in such a practice.

Notwithstanding these difficulties, periodic updating of forecasts, embracing technological developments, and using a method to counter possible deficiencies are essential to make cash flow forecasts valid and useful instruments for negotiating the financial scenario.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Financial Forecasting
• Forecasting Finance (Equity, Debt, Interest)
• Forecasting Methods
• Monthly Cash Flow Forecast Model
• Stress Test – Financial Modeling