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Home > Cash Flow Management Checklists > Preparing a Cash Flow Forecast

Cash Flow Management Checklists

Preparing a Cash Flow Forecast


Checklist Description

This checklist explains how to prepare a cash flow forecast.

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Definition

A cash flow forecast aims to predict a company’s future financial liquidity over a specific period of time, using tried and tested financial models. While cash normally refers to the liquid assets in a company’s bank account, the forecast usually estimates its treasury position, which is cash plus short-term investments minus short-term debt. The cash flow itself refers to the change in the cash or treasury position from one period to the next. The cash flow forecast is an important way to value assets, work out budgets, and determine appropriate capital structures. It will provide a good indicator of a company’s financial health for potential investors.

Several methods are generally used to forecast cash flow—one direct, and three indirect. The direct method is most suitable for short-term forecasts of anywhere from 30 days up to a year, since it is based on actual data from which the projections are extrapolated. The data used are the company’s cash receipts and disbursements (R&D). Receipts primarily include accounts from recent sales, sales of other assets, proceeds of financing, etc. Disbursements include salaries, payments for recent purchases, dividends, and debt servicing. Many of the R&D entries are based on projected future sales.

The other methods all use a company’s projected income statements and balance sheets as their basis. The first method is adjusted net income (ANI), which first examines the operating income (EBIT or EBITDA), then looks at changes on the balance sheet such as receivables, payables, and inventory to forecast cash flow. The pro forma balance sheet (PBS) method looks at the projected book cash account—if the projections for all other balance sheet accounts are correct, then the cash flow will also be correct. Both these methods can be used to make short-term (up to 12 months) and long-term (multiple year) forecasts. Since they use the monthly or quarterly intervals of a company’s financial plan, they must be adjusted to account for the differences between the book cash and the actual bank balance, and these may be significantly different.

The third method uses the accrual reversal method (ARM), which reverses large accruals (revenues and expenses that are recognized when they are earned or incurred, disregarding the actual receipt or dispersal of cash) and calculates the cash effects based on statistical distributions and algorithms. This allows the forecasting period to be weekly or even daily. It can also be used to extend the R&D method beyond the 30-day horizon because it eliminates the inherent cumulative errors. This is the most complicated of all methods and is best suited for medium-term forecasts.

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Advantages

  • Cash flow projections offer a useful indicator of a company’s financial health.

  • Cash flow forecasts enable you to predict the peaks and troughs in your cash balance, helping you to plan borrowings, and they tell you how much surplus cash you may have at a given time. Most banks insists on forecasts before considering a loan.

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Disadvantages

  • A cash flow forecast never tells the whole story about a company’s financial situation and should not be relied on as the sole indicator.

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Action Checklist

  • Be realistic when inputting your estimates. An acceptable method is to combine sales revenues for the same period 12 months earlier with predicted growth.

  • Choose suitable accounting software to help you prepare a cash flow forecast. Check that it will enable you to update your projections if there is any change in market trends or your company’s fortunes. Good software simplifies planning for seasonal peaks and troughs and can also calculate for “what if” scenarios.

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Dos and Don’ts

Do

  • Use the most appropriate method, depending on how long you want your forecasting horizon to be.

  • Remember that a cash flow forecast can only determine the short-term sustainability of a company. The longer the forecast horizon, the higher the chance of an inaccurate projection.

  • Bear in mind that the forecast is dynamic—you will need to adjust it frequently depending on business activity, payment patterns, and supplier demands.

Don’t

  • Don’t rely solely on a cash flow forecast to determine a company’s financial stability—look at the other financial statements and forecasts, such as an income statement and a balance sheet, to see what’s actually going on.

  • Don’t forget to incorporate warning signals into your cash flow forecast. For example, if predicted cash levels come close to your overdraft limits, this should sound an alarm and trigger action to bring cash back to an acceptable level.

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Further reading

Books:

  • Coyle, Brian. Cash Flow Forecasting and Liquidity. London: Global Professional Publishing, 2001.
  • Fight, Andrew. Cash Flow Forecasting. Burlington, MA: Butterworth-Heinemann, 2005.
  • Loscalzo, William. Cash Flow Forecasting: Guide for Accountants and Financial Managers. Maidenhead, UK: McGraw-Hill, 1982.

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