Cash Flow Forecasting!
Get an overall picture of incoming and outgoing cash flows.
Cash flow forecasting is vital for every business. With the help of the cash flow forecast, an organization gets an overall picture of incoming and outgoing cash flows and the advantage is to know when the expenses must be covered and there is no need for unexpected borrowing to cover the cash needs. If the cash flow forecast has been created weakly the company may face great financial losses and lose its business opportunities.
THE EFFECT OF CASH FLOW FORECASTS ON ACCRUAL QUALITY AND BENCHMARK BEATING.
Purpose-Driven Solutions.
We posit that cash flow forecasts increase the transparency of accrual manipulations used to manage earnings. As the transparency of opportunistic earnings management increases, so does the likelihood of restatements and regulatory interventions, which in turn, increases the expected costs to the firm and to managers of engaging in opportunistic earnings management. As the expected costs of engaging in earnings management through accrual manipulations increase, managements’ incentives to do so are expected to decrease. Thus, we posit that by increasing the transparency of accrual manipulations, analysts’ provision of cash flow forecasts serves as an effective earnings management constraint that increases the quality of reported accruals. We also predict that by reducing accrual manipulations, the provision of cash flow forecasts will reduce the likelihood that firms will meet or beat earnings targets. In addition, we hypothesize that when firms’ ability to manage earnings through accruals is constrained they are likely to shift to other mechanisms in an effort to achieve earnings benchmarks.
The Effect Of Cash Flow Forecasts.
An accurate cash flow forecast helps companies predict future cash positions, avoid crippling cash shortages, and earn returns on any cash surpluses they may have in the most efficient manner possible.
When analysts provide forecasts of both earnings and operating cash flow, they also implicitly provide a forecast of total operating accruals. Thus, cash flow forecasts enable parties external to the firm to more readily decompose an earnings surprise into the portion attributable to unexpected cash flows and a portion attributable to abnormal accruals.
It can predict the impact of different decisions, like hiring a new employee or changing the business location, on the company’s financial cash health.
WHY CASH FLOW FORECASTING IS IMPORTANT FOR ANY BUSINESS?
Cash flow forecasting is important because if a business runs out of cash and cannot obtain new finance, it will become insolvent. Cash flow is the lifeblood of all businesses—particularly start-ups and small enterprises. As a result, it is essential that management forecast (predict) what will happen to cash flow to make sure the business has sufficient funds to survive. How often, management should forecast cash flow is dependent on the financial security of the business. If the business is struggling or is keeping a watchful eye on its finances, the business owner should be forecasting and revising his or her cash flow daily; however, if the finances of the business are more stable and ‘safe,’ then forecasting and revising cash flow weekly or monthly is enough.
Here are the key reasons why a cash flow forecast is so important:
- Identify potential shortfalls in cash balances in advance—think of the cash flow forecast as an “early warning system.” This is, by far, the most important reason for a cash flow forecast.
- Make sure that the business can afford to pay suppliers and employees. Suppliers who don’t get paid will soon stop supplying the business; it is even worse if employees are not paid on time.
- Spot problems with customer payments—preparing the forecast encourages the business to look at how quickly customers are paying their debts. Note—this is not really a problem for businesses (like retailers) that take most of their sales in cash/credit cards at the point of sale.
- As an important financial planning discipline, the cash flow forecast is an important management process, similar to preparing business budgets.
- External stakeholders such as banks may require a regular forecast. Certainly, if the business has a bank loan, the bank will want to look at the cash flow forecast at regular intervals.
THE DIRECT METHOD OF CASH FLOW FORECASTING!
The direct method of cash flow forecasting schedules the company’s cash receipts and disbursements (R&D). Receipts primarily collect accounts receivable from recent sales and include sales of other assets, financing proceeds, etc. Disbursements include payroll, payment of accounts payable from recent purchases, dividends, and interest on the debt. This direct R&D method is best suited to the short-term forecasting horizon of 30 days or so because this is the period for which actual data is available instead of projected.
The three indirect methods are based on the company’s projected income statements and balance sheets.
- The adjusted net income (ANI) method starts with operating income (EBIT or EBITDA). It adds or subtracts changes in balance sheet accounts such as receivables, payables, and inventories to project cash flow.
- The 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.
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 financial plan’s monthly or quarterly intervals and need to be adjusted for the difference between accrual-accounting book cash and the often significantly different bank balances.
- The third indirect approach is the accrual reversal method (ARM), which is 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, R&D method when it is extended beyond the short-term horizon. But because the ARM 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.
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