Chapter Ten

Cash Flow Forecasting

FORECASTING OF CASH FLOWS is one of the most underrated yet critical aspects of a company’s operations, and the Treasurer is the vortex of the entire process.

FORECASTING IN THE CONTEXT OF LIQUIDITY MANAGEMENT

The goal of the cash flow forecasting (referred to in this chapter as forecasting) exercise is primarily to increase visibility of the cash and liquidity position of the firm by determining the timing, amount, currency, and location of cash inflows and outflows in advance.

The eventual objective is to determine funding requirements and liquidity usage and planning to ensure minimal borrowings and maximum utilisation of the firm’s cash. This would reduce cost of capital and hence expenses and would increase returns on excess cash.

Strong forecasting also enables a robust risk management process. The core aspect of management of a firm’s risk is to manage its future or expected cash flows and balance sheet positions, which is effectively the forecasted financial value of the firm.

Figure 10.1 depicts the basic forecasting process and its role in liquidity management. The inputs and influencers in the forecasting process are derived from various entities around the world, including business units, procurement units, finance, manufacturing, human resources, and the like. It is very important to keep the teamwork going and to ensure seamless cooperation across these functions.

FIGURE 10.1 Basic Forecasting Process

Figure 10.2 shows the typical inputs and influencers into the forecasting process.

FIGURE 10.2 Typical Inputs and Influencers in the Forecasting Process

Various methods are used in forecasting, which are discussed later in the chapter.

Measurement of forecasting accuracy is a critical aspect (see the next note). Feedback of accuracy is passed on for business units to track to keep improving on quality of inputs.

Finally, decisions are made on the basis of these forecasts—decisions concerning liquidity, financing, investment, and risk management. Firm valuation using the discounted cash flow method also uses cash flows, and capital and corporate action decisions are taken using these critical numbers.

The following note depicts a common scenario in companies, and a possible solution.

Process Changes to Increase Forecast Accuracy

Several process improvements can increase the visibility of cash flows and hence contribute to more accurate firm financial results. These include:

• Invoicing as per schedule. Invoicing delays can cause incremental delays and unpredictability in client cash flows. Being in control and invoicing at a set time can significantly improve certainty of due dates and hence incoming flows.
• Payment as per schedule. Paying as per due date or netting cycle date increases the visibility of firm’s cash outflows.
• Attractive on-time payment terms. Treasury can work with sales to try to incentivise customers to pay on time or at an earlier prespecified date (see the section on the financial supply chain in Chapter 14).
• Efficient collection process. A collections team that is in control of its receivables management and works to receive expected cash flows on due dates coordinated with Treasury, especially for materially large inflows, adds tremendous value to the firm.
• Early-warning mechanisms. Events that could cause disruptions to the payment environment, such as liquidity situations, cross-border or credit events, supply chain disruptions, or payment disruptions, are best prepared for in advance. In some cases, events are triggered at too short a notice and unexpectedly. In many cases, however, early-warning signs can be felt through strong sensors on the ground. Treasury needs the complete buy-in of the teams on the ground to support it by warning of situations that are getting worse. In this manner, should the event occur, Treasury should have had sufficient time to prepare for the exigency.

FORECASTING METHODS

There are several methods for cash flow forecasting, some of which are mentioned here, along with the fundamental philosophy behind the method. Actual implementations vary depending on the firm’s actual needs. Figure 10.3 shows the two classical types of forecasting, direct and indirect.

FIGURE 10.3 Classical Types of Forecasting

Direct methods build a bottoms-up approach to forecasting and are more likely to be used for short-term horizons. These methods are used more to generate definitive and tangible cash flows rather than to predict the future.

Indirect methods use a top-down approach that rationalises cash flows from medium- to long-term projections and arrives at estimated cash flows.

Receipts and Disbursement Method

The receipts and disbursement (R&D) method remains, across its various forms, one of the most commonly used methods for forecasting short-term cash flows. This is not as much a predictive technique but an information-gathering process of actual expected flows on which there is maximum visibility—in a sense, this is the determination of actual expected cash flow (see Figure 10.4). In effect, the R&D method seeks to schedule the receipts and disbursements of the company’s cash by time period.

FIGURE 10.4 R&D Method

This is further illustrated in the following example.

Distribution Method

Distribution method is often used for cheque clearing estimation, based on earlier statistically analysed distribution of the number of days it typically takes to clear cheques. Hence, a day-wise assessment of cheque clearances may be made, for example:

To augment the above expected value, weekly patterns may be added depending on payee tendency to bank instruments around weekdays.

In addition, statistically backed-up month-end additions may be used based on number of days to go for month-end, since payees tend to bank cheques closer to the end of the month in some markets. Other factors such as seasonality, payroll dates and capital expenditures can also be factored in.

Adjusted Net Income Method

The adjusted net income (ANI) method uses an indirect but simple technique, starting with earnings before interest, taxes, depreciation, and amortisation (EBITDA), and gradually reducing or adding on forecasted changes to balance sheet items, such as inventory, accounts receivable, accounts payable, assets, and others. It is a good top-down method. When used scientifically, it is a reasonably good estimate for medium- to long-term cash flow forecasting.

Accrual Reversal Method

The accrual reversal method (ARM) works similar to the ANI method—starting with the EBITDA and working the forecast down by adding or removing expected changes to the balance sheet, expected accruals are reversed and expected cash increases are removed. The difference from the ANI is that with the ARM, statistical, rather than user-defined, estimates are used. The ARM is one of the more complex methods used, but if backed up by strong regression and analytics, it can be a useful tool.

Pro Forma Balance Sheet Method

A simpler method used for medium-term forecasting, the pro forma balance sheet (PBS) method uses the pro forma balance sheet of the company with projected financials. The method assumes sanctity and integrity of all non-cash items on the balance sheet, and hence takes the cash element to be correct based on the estimation of all other inputs being verified and accurate. (Though differences between the cash projections and actual bank balances need to be accounted for.)

Figure 10.5 shows a list of different time horizons and methods that can be used.

FIGURE 10.5 Snapshot of Methods of Forecasting Across Time Horizons

SUMMARY

Efficient forecasting of cash flows remains one of the determinants of a company’s well-oiled financial machinery, since the accuracy and timeliness of the forecasting process determines visibility and hence ability to better manage the company’s cash flows, borrowings, investments, and balance sheet. This chapter explored the context and processes for forecasting and evaluated some methods of forecasting cash flows.