Cash flow forecasting can take on critical importance for a firm. Many dot-com start-ups discovered to their dismay that their business venture ended when their cash was unexpectedly used up. Even for firms with substantial cash inflows, a missed cash-flow forecast may mean that money sits idle without earning a return.
A cash budget is a forecast of a firm’s future cash flows arising from collections and disbursements, usually on a monthly basis.
How to Prepare a Cash Flow Forecast
At the core of any good cash flow forecasting system, you will find the cash budget. A cash budget is prepared through a projection of future cash receipts and cash payments of the firm over various periods of time. It reveals the timing and amount of expected cash inflows and outflows over the period studied.
With this information, the financial manager is better prepared to confirm the long-term cash needs of the firm, arrange financing for those needs, and exercise control over the firm’s cash and liquidity.
Although cash budgets can be prepared for virtually any period, monthly projections for a year are most common. This allows analysis of seasonal variations in cash flows. When cash flows are volatile, weekly projections may be necessary.
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Sales Forecast
The key to the accuracy of most cash budgets is the sales forecast. This forecast is often based on an internal analysis, an external one, or both.
With an internal approach, sales representatives are asked to project sales for the forthcoming period. The product sales managers review these estimates and consolidate them into sales projections for product lines.
The projections for the various product lines are then combined into an overall sales forecast for the firm. The main problem with an internal approach is that it can be too narrow. Often, significant trends in the economy and the industry are overlooked.
For this reason, many companies also use an external analysis. With an external approach, economic analysts forecast the economy and industry sales for several years to come. They may use regression analysis to estimate the relationship between industry sales and the economy in general.
After these basic predictions of business conditions and industry sales, the next step is to estimate market share by individual products, likely prevailing prices, and the expected reception of new products.
Usually, these estimates are prepared in conjunction with marketing managers, although the final responsibility rests with the financial forecasting department. From this information, an external sales forecast can be prepared.
When the internal sales forecast differs from the external one, as is likely, compromises should be reached. Past experience can indicate which of the two forecasts is more accurate. Generally, the external forecast should serve as the basis for the final sales forecast, often adjusted by the internal forecast.
A final sales forecast based on both internal and external analyses is usually more accurate than either an internal or external forecast alone.
The ultimate sales forecast should be based on prospective demand, not initially constrained by internal limitations such as production capacity. Decisions to remove these constraints can depend on the forecast. The value of accurate sales forecasts cannot be overestimated, as most other forecasts depend on expected sales.
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Collections and Other Cash Receipts
Once the sales forecast is prepared, the next task is to determine the cash receipts from these sales. For cash sales, cash is received at the time of sale; for credit sales, the receipts come later. The timing depends on billing terms, customer type, and the firm’s credit and collection policies.
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Cash Disbursements
Next comes a forecast of cash disbursements. Based on the sales forecast, management may choose to align production with seasonal demand or maintain a relatively constant rate through a mixed production strategy.
Once the production schedule is established, estimates can be made of the requirements for materials and additional fixed assets.
As with receivables, there is usually a lag between the purchase and payment. If suppliers provide average billing terms of net 30, and the firm pays at the end of this period, there is roughly a one-month lag between purchase and payment.
A schedule of disbursements for purchases and operating expenses can be prepared with this lag in mind. Using a computer-based spreadsheet program, it is straightforward to set up a lagged disbursement schedule.
Wages are assumed to vary with production but not perfectly. Generally, wages are more stable over time than purchases. When production dips slightly, workers are usually not laid off; when production increases, labor becomes more efficient with relatively little increase in total wages. Only after a certain point is overtime or new labor required to meet the production schedule.
Other expenses include general administrative and selling costs, property taxes, interest, utilities, maintenance, and indirect labor and materials. These expenses tend to be reasonably predictable over the short term.
Other Disbursements
In addition to cash operating expenses, capital expenditures, dividends, federal income tax, and any other cash outflows must be accounted for.
Capital expenditures are planned in advance and are usually predictable in the short-term cash budget. As the forecast extends further, these expenditures become less certain.
Dividend payments for most companies are stable and paid on specific dates. Federal income tax is estimated based on projected profits for the period under review. Other cash outflows may include repurchase of common stock or payment of long-term debt.
These are combined with total disbursements for purchases and operating expenses to obtain the schedule of total cash disbursements.
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Net Cash Flow and Cash Balance
Once all foreseeable cash inflows and outflows are accounted for, the cash receipts and disbursement schedules are combined to obtain the net cash inflow or outflow for each month.
The net cash flow is then added to the beginning cash balance in January, and the projected cash position is computed month by month for the period under review.
