Cash Flow Forecasts as Part of Integrated Financial Reporting

A cash flow forecast, in order to be useful as a management and control tool, must be based on real data and actual commitments.  Historical data on which to base a cash flow forecast will be useful, but must be considered in conjunction with information from your business strategy and your budget in order to project a realistic picture of what to expect in terms of future cash flows as you move forward.  And actual commitments, defined in terms of amounts and payment terms, will provide a firm basis on which to project cash flows.

In this sense, a cash flow forecast should be considered an integral part of an overall financial planning and control strategy.  And there should be uniformity between historical financial reports and budgets and forecasts, in terms of format, types of accounts, and the level of detail to be presented.  This way, the different financial presentations will be comparable, and taken together can be used to describe, evaluate and manage the operation using the same terms of reference, within the same parameters.

Cash Flow Activities as Functions of Each Other

A cash flow forecast can be broken down into the same three basic sections as the statement of cash flows, that constitutes one of the basic financial statements:

• cash flows from operating activities,
• cash flows from investing activities,
• cash flows from financing activities.

These three types of cash flow activities are interrelated.  They depend on, and affect each other.  The cash flow forecast should take this into account, and provide a complete picture of where cash will come from and how it will be used for the period being forecast.  The relationships between the different cash flow activities may depend on the nature of the business, the stage of development of the business, and general economic conditions, or conditions within the market or industry in which the business operates.

Ongoing Operations

For example, during a period of relatively normal ongoing operations, the results of the cash flow forecast for operating activities will probably feed the cash flow forecast of investing activities and financing activities.  If a cash flow forecast of operating activities shows cash surpluses during certain periods, these surpluses could be incorporated into a short-term investment plan.  On the contrary, if cash flows from operations are forecast to show a deficit, this information can be used to plan for the necessary financing.

Start-Up

The cause and effect relationship, especially during certain stages of a business, such as during start-up, may be inverted, and the cash flows available for operating and investing activities will depend on the cash flows generated by financing activities.  The amount of financing that can be obtained will determine the capital expenditures that can be made (investing activities) and the amount of working capital that can be used in the business (operating activities).

Growth and Expansion

During a period of growth or expansion, cash flows generated by operations may be used to finance growth, or cash flows from operations may be supplemented by cash flows from financing activities, in order to carry out investing activities, such as making additional capital expenditures to increase production capacity, investing in research and development, launching new lines of products, or starting up or purchasing new lines of business.

Cash Flow Responsibility and Accountability

In a company with separate business units, or different lines of business, that are relatively autonomous in terms of cash management, separate cash flow forecasts may be prepared according to centers of accountability and responsibility.  These different business units may be centralized under a single finance function (in a corporate or home office).  For example, if a particular unit generates a cash surplus, the central finance function may take this surplus and allocate it according to the business needs of the overall company.  On the contrary, if the cash flow forecast of a particular unit shows a cash deficit, the central finance department will know that this unit will require funding.

The general idea is that cash flow forecasts should be prepared where they are meaningful in terms of the information they provide, and where they are useful in terms of the decisions that can be made based on the information the cash flow forecast provides.

Categories and Timing of Cash Flow Items

While the format of a cash flow forecast should be consistent with other financial reports, it must also reflect how cash actually flows.  Sources and uses of cash should be presented in categories that facilitate forecasting and then comparing actual cash flows to forecast cash flows.

The timing of cash receipts and disbursements, and therefore how they are forecast, will depend on the business or activity.  In some cases, there may be a relatively even flow of cash in and out during the period being forecast.  In other cases, cash receipts and disbursements may be concentrated on certain dates within the period.  The nature of your business, your past experience, and any expected future developments should be taken into account in forecasting.

A cash flow forecast is generally done by periods, for example by month.  But it may be useful to set up a cash forecast on a day-by-day basis, as a calendar.  This undoubtedly involves making some assumptions and estimates, but it will define cash flows more precisely; tentatively identifying cash surpluses and deficits that occur during the month, and thus allowing for more targeted cash management actions.  The more refined you can make your forecast, the more it will help you plan and control your finances, maximizing the use of any surplus funds available, and minimizing the costs associated with borrowing to finance operations.

Sources of Cash

The following are some examples of sources of cash from operating activities, and some considerations to be taken into account in forecasting them:

• Cash sales.  How much of a business’s revenue comes from cash sales will depend on the nature of the business.  Forecasts may be based on historical experience, and by applying the ratio of cash sales to total sales in the past, and applying this ratio to budgeted sales for the period, you can forecast cash sales for the period.  Any changes in terms and conditions of sales would need to be taken into consideration.
• Collections on accounts receivable.  The accounts receivable aging report will provide information on when accounts come due.  Using this data, you can forecast cash flow from collections.  This estimate may need to be adjusted based on historical experience regarding certain customers’ payment records, (some customers may consistently pay either before or after the due date), and it may be necessary to factor in an allowance for doubtful accounts.
• Rent.  If your business involves rent income, you may receive the majority of your cash flow on certain days of the month.
• Progress payments on projects, and contractual payments.  If you have documentation, such as a contract or agreement, that stipulates when payments are to be made, this will be a source of information for forecasting cash receipts.
• You may have cash receipts from installment sales that you can forecast based on a payment schedule included in a sales agreement, or you may receive advance payments on products to be delivered or work to be performed.

Cash receipts from investing activities include dividend and interest payments, and sales or redemptions of short-term or long-term investments in marketable securities, deposits, stocks, bonds, and other instruments.   

Certain financing activities may already be defined at the time of preparing a cash flow forecast.  These cash receipts from financing activities could include the proceeds from a loan that has already been approved, for example.  But you may find that as you do the cash flow forecast, there is a need for additional financing to cover cash deficits in the operation.  The cash flow forecasting exercise in itself may therefore generate items that need to be incorporated into the cash flow forecast as sources of cash from financing activities.  These could include:

• Proceeds from loans.
• Amounts drawn from revolving lines of credit or other facilities.
• Capital contributions made by the owner of a sole proprietor or by partners in a partnership.
• Proceeds from the issuance of bonds or stock, in a corporation.

Uses of Cash

In forecasting the uses of cash in operating activities, it should be kept in mind that cash expenditures will not necessarily be the same as operating expenses for income statement purposes.  By its nature, a cash flow forecast is prepared on a cash basis, so while many cash expenditures also represent operating expenses, there will be some timing differences, such as prepaid expenses and payments of expenses accrued in prior periods.

The following are some examples of the items to be considered in forecasting cash used in operating activities:

• Payroll.  From an income statement perspective, payroll expense is for gross salaries and wages, but from a cash flow standpoint you would have cash disbursements for net salaries and wages, and other cash disbursements for payroll taxes and other amounts withheld.  These disbursements are probably made on different dates.  For example, net paychecks may be paid on the last day of the month, and taxes withheld are paid during the first part of the following month.
• Payments to suppliers and contractors.  Cash disbursements can be forecast based on invoice due dates from an accounts payable maturity report.
• Rent payments are generally made on the same date each month, and this item can be forecast based on lease agreements.
• Payments for service agreements or preventive maintenance agreements can be forecast based on the terms of the agreements.  Other repairs could be forecast based on historical experience, adjusted for additions or reductions in machinery and equipment, for example.  The age, working condition, and general maintenance requirements of machinery and equipment may also be factors in forecasting disbursements for repairs and maintenance.
• Advertising and promotion expenditures may be based on agreements, and can be forecast accordingly.  Expenditures could also be forecast as a function of production or sales, taking into account any additional disbursements associated with plans to launch new products or services.
• Payments for utilities are also generally paid around the same date each month, and can be forecast based on historical experience, changes in the level of activity, rate adjustments, seasonal variations, and growth of your business.
• Tax payments, including federal, state and local income taxes, payroll taxes, excise taxes and others.
• Income taxes can be forecast based on scheduled estimated income tax payments, on their respective due dates, or year end tax payments to be made when an income tax return is filed.  The forecast amount to be paid should be the income tax expense accrued based on actual net income for the year, plus or minus timing and other differences between net income for book and tax purposes, and less estimated income tax payments made during the year, or a credit applied from last year.
• Payroll tax disbursements can be forecast as the amounts withheld from employees’ pay, plus the employer payroll taxes, which can be calculated as a percentage of taxable employee compensation.  The timing of the forecast disbursement depends on the due date for filing payroll tax returns and paying the tax.
• The forecast amounts for disbursements for excise and other taxes should be based on the amounts accrued based on taxable activity for the period, to be disbursed on the respective due dates for the different returns.
• Disbursements for real estate and personal property taxes can be forecast based on historical amounts, taking into account any additions to fixed assets during the period that affect the property’s tax appraisal value, and any additional assessments, for local improvements for example.
• Insurance payments are generally made in advance, and the prepayments can be forecast based on the due dates for the premiums.  If the premiums are payable in installments that are due on certain dates of each month, for example, this should be taken into account for forecasting.
• A certain amount may be forecast to cover other miscellaneous expenditures that are not necessarily expected, but that invariably come up.  This may be forecast as a certain dollar amount or as a percentage of total expenses, based on historical experience and any expected changes in the overall level of operations.

Cash used in investing activities includes:

• Capital expenditures, such as purchases of land, buildings, machinery and equipment, vehicles, furniture and fixtures, and other fixed assets.  These expenditures could be forecast based on outstanding purchase orders, equipment replacement plans, and on budgeted capital expenditures.
• Purchases of marketable securities, deposits, mutual fund shares, and stocks or bonds in other companies, or interests in partnerships or other companies.  Short-term investments may be a function of the cash flow forecast itself, and normal cash management practices.  More major investments may be forecast based on minutes of meetings of the board of directors or other governing groups.

The following are some examples of cash used in financing activities:

• Loan installment payments.  These could be mortgages, unsecured bank loans or loans from other parties.  Generally the amount of the payment and its due date will be specified in the loan agreement and can be forecast accordingly.
• Dividend payments, in the case of a corporation, are also considered as cash used in financing activities (equity financing).  Dividend payments should be specified in the minutes of meetings of the company’s board of directors.  Purchases of treasury stock (buying back the corporation’s own stock) are also considered a use of cash in financing activities.
• Borrowing that is needed to finance operations may be a function of the cash forecast, in the case of deficits, just as short-term investments are, in the case of surpluses.

Balancing the Cash Flow Forecast

By entering known and expected, or anticipated and estimated cash receipts and disbursements by date, you will be generating a cash flow calendar.  When you can see how you cash balance rises and falls during the forecast period, you will know when to expect cash surpluses and deficits, and you will be in a better position to make decisions regarding cash management.  The idea behind cash management will be to even out cash flows, make the best possible use of existing resources, minimize financing costs, and obtain the best return on cash investments.

Planning for Financing Needs

In this sense, it may be necessary to do a cash flow forecast in two stages.  In reality, no operation can continue for any period of time with a negative cash balance.  So whenever a deficit appears in the cash flow forecast, it will need to be covered, either with an additional investment of funds or by borrowing.

By knowing about the needs for financing ahead of time, different alternatives can be considered and different sources of financing can be compared, thereby obtaining the most advantageous terms.

Planning to Use Surpluses

And on the contrary, a significant cash surplus that builds up over an extended period of time may not necessarily be desirable, depending on the goals and objectives of the operation.   Therefore when a cash surplus occurs, there should be plans as to how to make the most advantageous use of it.

One intended use of cash surpluses generated at certain times during the period may be to fund cash disbursements that are made at other points in the period, or even in subsequent periods.  Cash disbursement are not spread evenly over an operating period.  Some examples of disbursements that need to be taken into consideration for funding purposes and that should be planned for in advance include:

• Insurance premiums that are prepaid for several months
• Deposits for a lease agreement
• Advance payments on contracts
• Estimated income tax payments
• Increased installment payments that can occur with variable rate or interest only mortgage loans
• Scheduled replacement of plant, equipment, vehicles and other assets
• Unexpected disbursements for major repairs
• Debt reductions
• Acquisitions

In some cases, it may be necessary to set aside reserves to cover major expenditures, either expected or unexpected, when they occur.

It may be possible to even out the projected cash flow by borrowing against revolving lines of credit during periods of cash deficits, and repaying the credit during periods of cash surpluses.  Or cash surpluses could be used to purchase short-term investments in marketable securities, which could then be redeemed or sold to provide the necessary funds during periods of cash deficits.

Once there is a reasonable level of assurance that cash requirements are appropriately provided for, surplus cash balances could be destined for investments, and for growth and expansion of the business.