Modeling future financial liquidity
- Treasury position: cash plus short-term investments minus short-term debt;
- Cash flow: change in cash or treasury position from one period to the next period.
Direct method (forecasting horizon of 30 days based on actual as opposed to forecasted data)
- Collection of accounts receivable from recent sales;
- Sales of other assets;
- Proceeds of financing;
- Disbursements (payroll, payment of accounts payable from recent purchases, dividends and interest on debt).
Indirect methods (based on projected income statements & balance sheets for medium to long term forecasting horizon)
- Adjusted net income (ANI) method
- Starts with operating income (EBIT or EBITDA);
- Add or subtract changes in balance sheet accounts such as receivables, payables and inventories to project cash flow.
- Pro-forma balance sheet (PBS) method
- Looks straight at the projected book cash account;
- If all the other balance sheet accounts have been correctly forecast, cash will be correct, too.
- Accrual reversal (ARM) method
- Similar to the ANI method, but instead of using projected balance sheet accounts, large accruals are reversed and cash effects are calculated based upon statistical distributions and algorithms;
- This allows the forecasting period to be weekly or even daily. It also eliminates the cumulative errors inherent in the direct, Direct (receivables and disbursements) method when it is extended beyond the short-term horizon;
- The ARM method allocates both accrual reversals and cash effects to weeks or days. It is more complicated than the ANI or PBS indirect methods;
- The ARM is best suited to the medium-term forecasting horizon.
- Cautions
- Both the ANI and PBS methods are best suited to the medium-term (up to one year) and long-term (multiple years) forecasting horizons. Both are limited to the monthly or quarterly intervals of the financial plan, and need to be adjusted for the difference between accrual-accounting book cash and the often-significantly-different bank balances;
- In the context of entrepreneurs or managers of small and medium enterprises, cash flow forecasting may be somewhat simpler, planning what cash will come into the business or business unit in order to ensure that outgoing can be managed so as to avoid them exceeding cashflow coming in;
- The simplest method is to have a spreadsheet that shows cash coming in from all sources out to at least 90 days, and all cash going out for the same period. This requires that the quantity and timings of receipts of cash from sales are reasonably accurate, which in turn requires judgement honed by experience of the industry concerned, because it is rare for cash receipts to match sales forecasts exactly, and it is also rare for customers all to pay on time. These principles remain constant whether the cash flow forecasting is done on a spreadsheet or on paper or on some other IT system;
- A danger of using too much corporate finance theoretical methods in cash flow forecasting for managing a business is that there can be non cash items in the cashflow as reported under financial accounting standards. This goes to the heart of the difference between financial accounting and management accounting.
