Cash Flow Forecasting Best Practices

There are several the Proformative learning platforms which I believe may be helpful to you. https://www.proformative.com/sitesearch?type=Courses&op=Search&keywords=Cash+forecasting

Very nice thread. Anyway I can get more technical information on cash flow forecasting?

There are two levels of detail that you need that require two different models. The longer term model is used for valuation and capital structure. Ours uses the company's historical financials as a basis for setting assumptions. The income statement assumptions are then set for the forecasts and can be modified year-by-year.

Without a good analysis of former financial performance, you really have no realistic basis for setting assumptions for working capital utilization or performance in a downside scenario for a recession, industry instability or disruption. Unless you are running at least three sets of assumptions (base case, downside case and upside case) you can't determine capital structure or ensure you are avoiding insolvency.

This first model creates the balance sheet and cash flow statements automatically from the income statement forecasts using the balance sheet assumptions calculated in your historical analysis of your financial statements, but with the ability to modify assumptions year-by-year. Working capital utilization and CAPEX are especially vexing, the former impacting both cash flow and valuation powerfully in those companies with high working capital needs (non cash, non-debt current assets minus current liabilities). We have sub-routines that have built in triggers for maximum debt/cap rations, revolver requirements, asset based lending limitations, and other limitations to keep within the real-world. Fast growth and low profitability companies both run into limitations easily.

For payments, we use a 13-week rolling forecast. This model is used used solely for ensuring sufficient liquidity in the near term. These are always used in crisis management situations where cash sufficiency is in question. Many accounting courses teach how to make these. In simplest terms, its about A/R collection and A/P payment. We've done work on the variability of A/R collections and model the effect of changes in collection assumptions on probability of insolvency (inability to pay debts as they come due). As they say, a company only files bankruptcy when they run out of cash, or see that they are going to.

If you have a P&L forecast, and you have a balance sheet forecast, then the cash flow forecast is simply a function of those two statements. It's quite easy to do in a simple Excel spreadsheet.

It sounds like your more pressing issue is the lack of a robust Balance Sheet forecast. Use turnover metrics (DOH, DSO, DPO) to forecast your highest-volume accounts (assuming here that you're a manufacturer), forecast all of your other balances using some logic (historical run rate, known future transactions, etc.), and then cash ends up being a (hopefully reasonable) plug number.

To answer Chris Cahill’s question about the system I use, it is a commercially available software titled Budget Maestro, published by Centage Corporation (www.centage.com). Using this software you prepare your budget in all major areas, such as revenue, cost, OpEx (with a separate personnel module), fixed assets, debt, equity, etc. Since the system mimics your actual GL chart of accounts (and can be actually linked to the actual GL), all budget items, as prepared by all budget participants in all business units cause the software to automatically generate all major financial statements and other user reports.

One reason I like this software is there are no user supplied formulas, functions and links, since all business rules and logic are built in, so you simply cannot break the model. I can also use any number of defined drivers to drive certain areas of the budget. The other reason is I can get an accurate and very complete balance sheet for every period of my budget, because the system automatically makes journal entries driven by the budget itself, in the right GL accounts, in the correct budget period and in the right amounts. The software then uses these balance sheets to generate complete and accurate statements of cash flows (either using the Direct or Indirect method).

I also use the software analytics module that ties my actual accounting numbers to my budgeted numbers in every accounting period, as soon as the actual period is closed. In addition to basic analysis of actuals vs. forecast, I like to use the system to visually forecast key financial ratios and see how they behave throughout the budget year and what changes to the budget must be made in order to achieve a desirable set of ratios.

Another use of the software for me is forecasting compliance with loan covenants throughout the budget period and I can do this visually, knowing that my forecasted balance sheet closely follows my forecasted P&L. There are, of course, many more uses and applications of this system. I hope that helps in answering your question.

The most effective way to forecast cash flow is to develop 2 models: a) a direct, which is based upon actual timing of receipts and disbursements, and b) an indirect, which is driven from the P&L and changes on the balance sheet. Run both for a given time period, and reconcile the large differences.

A few answers have mentioned a balance sheet forecast which would be necessary if you want to produce an indirect cash flow. It sounds like you have a P&L Forecast that is GAAP (or IFRS), but you want some guidance on how to forecast cash.

It is important to keep the balance sheet forecast simple (something that can be explained in 90 seconds to senior management or a board of directors) and ties to the corporate goals.

Depending on your business, there are three basic balance sheet accounts that every leadership team should be looking at: accounts receivable, inventory, and accounts payable. You can extend beyond this once these three accounts are under control and consistently tracking to your forecast.

Let's use AR as an example. Since you already have a P&L forecast, you can also forecast AR as a percentage of sales or receivable days based on your revenue forecast. The metrics you use depends on what is important to the sales leadership. If they set a goal for sales, there must also be a goal for AR. Is it "no more than 25% of sales will be financed each month" or "terms with customers will not exceed 30 days".

Using this process, you can establish goals with the necessary departments for each of the balance sheet accounts. And once you have targets for the balance sheet, you can use the indirect method to forecast cash flow.

It is interesting to see how many people are still trying to implement a spreadsheet approach to cash forecasting or as one member commented a simplified balance sheet. Experience has shown that use of complex spreadsheets to perform complex forecasting of cash account balances or other elements of the balance sheet is inaccurate at best, often resulting in more severe issues that make these forecasts misleading and unreliable.

My approach has always been to put an effort into the traditional budget elements of revenue and expenses and then let technology do the rest. By that I mean implement a solution where the balance sheet and the statement of cash flows are automatically generated from your P&L forecast. This of course, is only possible if the forecasting solution can perform automated journal entries derived from the P&L period activities and other assumptions like customer and supplier payment terms, individually selected for all revenue and expense lines (e.g., Supplier A has 60 day terms vs Supplier B that has 30 day terms, both participate in certain expense budget lines, but each affects the cash balance individually, based on Payment Terms assigned to that expense line).

I’ve been told before that an accurate forecasted balance sheet is not that critical since the P&L forecast is never accurate. It is true that the forecasted balance sheet will always be inaccurate if the forecasted income statement is inaccurate but why not have a system where the balance sheet and statement of cash flows are directly tied into and are perfectly synchronized with the forecasted income statement? You can then focus on the operational plan and P&L forecast and always get a complete set of forecasted financial statements, always synchronized to the forecasted income statement.

The results using this approach are a complete and accurate forecasted balance sheet and statement of cash flows for each period of your budget. You will need to supply the beginning balance sheet account balances (known from your actual accounting system) and make certain manual journal entries into budget period, such as paying down of debt, issuing additional debt, selling assets, etc. These entries and the decisions to make them can be made once you’ve run the forecasted balance sheet and statement of cash flows using the automated forecast of these statements.

In my practice I often into P&L forecasts that are grossly missed only due to the fact that the company did not have the proper financing in place or ability to fund these forecasted activities (e.g., sales of a new product line). An accurate and complete forecasted balance sheet and statement of cash flows can easily show that so the P&L forecast can be adjusted or other financing arrangements can be made ahead of time.

Another benefit to using this approach vs. a rough estimate of just cash balances and maybe other key balance sheet account balances is that you can forecast any set of key financial ratios you use in your finance organization. I like to be able to forecast all financial ratios that are used in the calculation of compliance with loan covenants. This way I can determine how close I am to breaching one or more of these covenants, and I can see that months or even years in advance. This may not be a concern to budget administrators or even mid-level finance managers but is something senior management would love to hear about and insist on implementing in their organizations.