The broader field of cash flow forecasting is integral to ensuring organizational liquidity. Maintaining cash receipts over a given time frame enables organizations to have cash at hand in a predictable fashion, thus allowing them to reinvest in business operations to avoid the opportunity cost of having unused cash and cash receivables. Forecasting cash inflows and outflows in advance is a primary role of corporate financiers and accountants, and enables efficient use of existing assets to capture maximum competitive value in the marketplace.
The direct method of projecting incoming cash flow is through understanding cash receipts and disbursements of the time period being projected.
With longer term forecasting, it can be useful to consider past averages over time. Larger organizations can look at their average cash receipts over the past few years, and couple that with growth trajectories to project what level of cash inflow is likely over a given time frame.
Why is cash flow forecasting important? If a business runs out of cash and is not able to obtain new financing, it will become insolvent. It is no excuse for management to claim that they didn’t see a cash flow crisis coming. So, in business, "cash is king."
Cash payments describe cash flowing out of a business. These cash payments can result from operating activities, investment activities and financing activities.
|Types of Cash Flow Activities||Examples|
Suppliers for inventory or other supplies
Employees for wages
Government for taxes
Lenders for interest on borrowed money
Purchase of capital assets
Purchase of bonds/notes or shares of other entities
Loans to other entities
Payments of dividends to the company’s own shareholders
Redemption (repurchase) of company’s own shares
Repayment of principal and interest on company’s own bonds or notes
The cash disbursement cycle is important to consider when analyzing cash payments. This is the total time between when an obligation occurs and when the payment clears the bank. A company’s objective regarding the cash disbursement cycle should be to increase the cycle time, or delay making payments until they are due.
A firm may delay payments by:
Financial planning is a critical financial tool for funding profitable operations and dividing existing organizational assets optimally to pursue revenue maximization. The forecast budget will project what cash flows will be needed for each organizational process, and how those cash flows will be utilized over a fixed period of time. If there is a problem with liquidity during an operational period, it can result in huge opportunity costs (i.e., an organization being unable to capture an existing opportunity in the market).
There are a number of ways to approach financial forecasting for a cash budget. A cash budget is all about liquidity, and therefore forecasting what available liquidity will be required over a given period is the primary input for forecasting budgets. There are a number of different approaches, though most of them rely on understanding the inputs required for various business operations.
The inputs include the following cash obligations during regular operations:
EXAMPLEAccounts receivable, short-term financing options, and various other sources of income may directly convert into usable capital. However, budgeting should either build these into the current budget forecast or utilize them during the next calculation of budgetary requirements.
|Types of Cash Forecasting||Description|
|The Direct Method||At its simplest, cash flow forecasting and budgeting can be computed directly based off of fixed information over a short time frame. This works particularly well for consistent businesses that run routine operations with limited risk-taking and diversification in process.|
|The Adjusted Net Income Method (ANI)||The adjusted net income method starts by calculating operating income (EBIT or EBITDA) and adding/subtracting short-term changes in the balance sheet, such as those that occur to inventories, payable, receivables and other short-term. This gives the organization some idea of what short-term cash flows are typically required during an operational period.|
|Pro-forma Balance Sheet Method||Pro-formas are financial statements created in advance as a projection or estimation of what that document will look like after the financial period is finished. By using a pro-forma balance sheet for the upcoming period being budgeted for, the short-term assets and liabilities (if accurately projected) will underline the amount of cash that should be set aside for budgeting purposes.|
|Accrual Reversal Method||A third option for projecting cash budgets is accrual reversal. This process relies on statistical distributions, reversing large accruals, and projecting cash effects via algorithms. This method requires a good deal of data and statistical skill, and is best utilized for mid-term forecasting (unlike the direct method, which is much better for a shorter time frame). The advantage of this method is that it is often accurate to the day or week, enabling high accuracy.|
Source: THIS CONTENT HAS BEEN ADAPTED FROM LUMEN LEARNING'S “Building a Cash Budget” TUTORIAL.