Cash flow forecasting


A cash budget is arrived at through a projection of future cash receipts and cash disbursements of the firm over various intervals 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 able to determine the future cash needs of the firm, plan for the financing of these needs, and exercise control over the cash and liquidity of the firm. Though cash budgets may be prepared for almost any interval of time, monthly projections for a year are most common. This enables analysis of seasonal variations in cash flows. When cash flows are volatile, however, weekly projections may be necessary.

Sales Forecast:

The key to the accuracy of most cash budget is the sales forecast. This forecast can be 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 screen these estimates and consolidate them into sales estimates for product lines. The estimates for the various product lines are then combined into an overall sales estimate for the firm.

The basic problem with an internal approach is that it can be too myopic. Often, significant trends in the economy and in the industry are overlooked.

For this reason, many companies use an external analysis as well. With an external approach, economic analysts make forecasts of the economy and of industry sales for several years to come. They may use regression analysis to estimate the association 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, prices that are likely to prevail and the expected reception of new products. Usually, these estimates are made in conjunction with marketing managers, even though the ultimate responsibility should lie with the economic forecasting department. From this information, an external sales forecast can be prepared.

When the internal sales forecast differs from the external one, as it is likely to do, a compromise must be reached. Past experience will show which of the two forecasts is likely to be more accurate. In general, the external forecast should serve as a foundation for the final sales forecast, often modified by the internal forecast.

A final sales forecast based on both internal and external analyses is usually more accurate than either an internal or an external forecast by itself. The final sales forecast should be based on prospective demand, not modified initially by internal constraints, such as physical capacity. The decision to remove these constraints will depend on the forecast. The value of accurate sales forecasts cannot be overestimated because most of the other forecasts, in some measure, are based on expected sales.

Collections and Other Cash Receipts

The sales forecast out of the way, the next job is to determine the cash receipts from these sales. For cash sales, cash is received at the time of the sale; for credit sales, the receipts come later. How much later depends on the billing terms, the type of customer, and the credit and collection policies of the firm. Pacific Jams Company offers terms of “net 30,� meaning that payment is due within 30 days after the invoice date. Also assume that in the company’s experience, an average of 90% of receivables are collected one month from the date of sale and the remaining 10% are collected two months from sale date if no bad-debt losses occur. Moreover, on the average, 10% of total sales are cash sales.

Let us take for example January total sales to be $250,000, of which $25,000 are cash sales. Of the $225,000 in credit sales, 90 percent, or $202,500, is expected to be collected in February, and the remaining 10 percent, or $22,500, is expected to be collected in March. Similarly, collections in other months are estimated according to the same percentages. The firm should be ready, however to change its assumptions with respect to collections when there is an underlying shift in the payment habits of its customers.

Cash receipts my rise from the sale of assets, as well as from product sales. If Pacific Jams intends to sell $40,000 of fixed assets in February, total cash receipts that month would be $294,000. For the most part, the sale of assets is planned in advance and easily predicted for purposes of cash budgeting. In addition, cash receipts may arise from external financing as well as investment income.

From the above example, it is easy to see the effect of a variation in sales on the magnitude and timing of cash receipts, all other things held constant. For most firms, there is a degree of correlation between sales and collection experience. In times of recession and sales decline, the average collection period is likely to lengthen, and bad-debt losses are likely to increase. Thus, the collection experience of a firm may reinforce a decline in sales, magnifying the downward impact on total sales receipts.