Topic 03_Cash Forecasting of Working Capital Management

Cash Forecasting

1. LOS 3
Cash Forecasting
discussthemethodsforgeneratingthefirm’s
cashforecast
understandwhyweneedtoforecastcashflows
identifythetypesofcashforecasts–short-
termcashforecasting,medium-termcash
forecasting,andlong-termcashforecasting.
discussaboutthemethodsoffinancial
forecasting
forecastcollectionsfromaccountsreceivable

2. Introduction
Thecashforecastisanestimationoftheflowsinandoutofthe
firm’scashamountoveraparticularperiodoftime,usuallya
quarter,month,week,orday.
Thecashforecastisprimarilyintendedtoproduceveryuseful
piecesofinformation:
estimationofthefirm’sborrowingandlendingneeds
uncertaintiesregardingtheseneedsduringvariousfuture
periods
Cashforecastingisextremelyimportanttomostfirms.It
enablesthemtoanticipateperiodsofcashsurplusandcash
deficitswherefinancingwillbeneeded.

3. Why Forecast Cash Flows?
Wherethefirmsdoesnotusecashforecasting,
unanticipatedcashshortagecouldoccur.Duringthese
periods,thefirmwouldhavetoslowdownitscashoutflows,
dipintoreserves,orgetemergencyfinancing.
Atypicalmethodofslowingoutflowsinsuchasituation
wouldbetodelaypaymentstotradesuppliers,whichmight
delaydeliveryofcriticalmaterials,causingexpensive
productiondelays.
Thefirm’sslownessinpaymentmightbecomeknownto
customers,creditors,andshareholders,whowouldquestion
thefirm’sfinancialsoundness.

4. Why Forecast Cash Flows?
Ontheotherhand,wherethefirmhasanunanticipated,
unplannedsurplusofcash,thefirmcannotmakeaninvestment
planthatwillmaximizeinterestincomeonthesurplusfunds.
Withoutacashforecast,thefirmhasnowayofknowinghow
longthesurpluswillpersist.Ifthemoneywouldbeavailable
foronlyafewdays,itwouldbeamistaketoinvestina90-day
instrument.
Ontheotherhand,ifthemoneyisgoingtobeavailableforsix
months,puttingitinarelativelylow-interestbuthighlyliquid
near-cashinstrumentwouldnotproducethehighestinterest
income.

5. Why Forecast Cash Flows?
Thus,weseethatthecashforecastisacriticaltoolforeffective
financingoftemporarycashdeficitsandinvestmentoftemporary
cashsurpluses.
Whilethefirm’scashforecastisimportantdocument,itisnot
generatedordoesitfunctioninisolation.
Thecashforecastisanimportantpartofthefirm’scashcontrol
systemandisoneoftheforecaststhatispartofthefirm’s
financialplanning.
Thefirm’scashcontrolsystemincludesitslockboxes,its
marketablesecuritiesportfolio,itsshort-termborrowing
structure,anditscashmanagementandtransfersystem.

6. Why Forecast Cash Flows?
Companiesthatmakegooduseofcashforecasting,basically
usesitforsome,orall,ofthefollowing:
tosetborrowinglimitsandminimizecostoffunds;
tomaximizeinterestearnings;
forliquiditymanagement;
forforeignexchangeriskmanagement;
forsettingandmonitoringlong-terminvestmentandfunding
strategies;
forfinancialcontrol;
tomonitorandsetstrategicobjectives;
formonitoringvariouslendersandinvestorsratios;
forbudgetingforcapitalexpenditureandprojectappraisal;
asatoolforworkingcapitalmanagement.

7. Types of Cash Forecasts
Thetypesofcashforecastsgeneratedbyfirmscanbe
differentiatedalongtwodimensions:
Thelengthoftheperiods(suchasyearlyflows,quarterly
flows,monthlyflows,orevendailyflows)
Theapproachestocashflows(suchasthereceiptsand
disbursementsapproachandtheadjustednetincome
approach)
Thelengthoftheforecastingperioddependscriticallyonthe
volumeofthefirm’scashinflowsandoutflows.Forexample,if
thefirmissufficientlylargethattheinvestmentofaday’s
surplusisprofitable,itwillprobablypaythefirmtoforecast
onadailybasis.

8. The Receipt and Disbursement
Model

9. The Receipt and Disbursement
Model

10. Adjusted Net Income Aproach

11. Methods of Financial Forecasting
Financialforecastingistheestimationofthefuturelevelofa
financialvariable,oftenacashflow,assetlevel,orliabilitylevel.
Itisusuallyassumedthattherelationshipbetweenthefinancial
variableandothervariablesislinear.Thegenerallinearmodel
canthenbeused:
Yt=a0+a1X1+a2X2+…………+anXn
Here,Ytisthefinancialvariable(Y)tobeforecastinperiodt.
TheX’saretheexplanatoryvariables;theyareassumedtocause
thelevelofYinperiodt.Thea0termrepresentsaconstant
unaffectedbytheX’s.Theotheratermstheestimated
coefficientsoftheexplanatoryXvariables.

12. Methods of Financial Forecasting
Itisunderstoodthatanyforecastmadeinthiswayissubjectto
somepredictionerrorbecauseofuncertaintyaboutboththe
futurelevelsoftheX’sanduncertaintyabouttheexact
relationshipbetweentheexplanatoryvariables(theX’s)andthe
outcomevariable(theY).
Therearefourcommonapproachestoforecastingfinancial
variables,buttheyareallspecialcasesofthegenerallinear
model.
SpotMethod
ProportionofAnotherAccount
CompoundedGrowth
MultipleDependencies

13. Methods of Financial Forecasting
SpotMethod
Hereitisassumedthatthevariabletobeforecastis
independentofallothervariables,oralternatively,is
predetermined.Thevariableisforecastbyusingitsexpected
orpredeterminedlevel.
Allotherexplanatoryvariablesarepresumedtobeirrelevant
andtheformulausedis:Yt=a0,wherea0istheexpectedor
predeterminedlevelofYt.

14. Methods of Financial Forecasting
ProportionofAnotherAccount
Thistechniqueisusedtoprojectfinancialvariablesthatare
expectedtovarydirectlywiththelevelofanothervariable.
Theformulausedis:Yt=a1X1,whereX1istheothervariable
towhichYisrelatedanda1istheconstantofproportionality
betweenthetwo.
Thismethodiswidelyusedwhenthereisacasuallinkfrom
theexplanatoryvariabletothevariabletobeforecast.

15. Methods of Financial Forecasting
CompoundedGrowth
Thismethodisusedwhenaparticularfinancialvariableis
expectedtogrowatasteadygrowthrateovertime.
Theformulaisjustliketheformulaofproportionofanother
accountmethod,buttheexplanatoryvariableX1istheprior
period’slevelofY,anda1isoneplustheexpectedgrowth
rate:Yt=(1+g)Yt-1,wheregistheperiod’sgrowthrate.

16. Methods of Financial Forecasting
MultipleDependencies
Herethevariableisthoughttobedependonmorethan
onefactor;notjustsalesorsomeothervariablebuta
combinationofseveralvariables.
Thegenerallinearmodelisused,andthestatistical
techniqueoflinearregressionisoftenemployedwith
historicdatatoestimatewhichexplanatoryvariablesare
significantindeterminingYtandtoestimatethe
coefficientsofthesevariables.

17. Methods of Financial Forecasting
Indecidingwhichofthesemethodstousetoforecasta
particularvariable,aprimaryconsiderationisthetermofthe
forecast:howfarintothefutureareweprojecting?
Intheshort-run,mostthingsarepredeterminedor
preplanned;verylittlecanbechanged.Inthelong-run,
almosteverythingisvariable.
Sincecashforecastsdealmostlywiththenearfuture,many
oftheitemsonthecashforecastareestimatedbysome
variationofthespotmethod.Remainingestimatesaremostly
ona“proportionofanotheraccount”basis;theothertwo
methodsareemployedlessfrequently.

18. Forecasting Collection from A/R
Toestimatethereceiptsfromthecollectionofthefirm’s
receivablesisamajorchallengefortheanalysts.
Therearetwomajordecisionstobemade:
theforecastingmethodologytobeused(suchasturnover
methodandpaymentpatternsmethod)and
thedegreeofaggressionoftheforecastacrossthefirm’s
linesofbusiness.

19. A/R Forecasting Methodology
Theturnovermethodisavariationofthepercentofsales
methodinwhichitisassumedthatreceivableswillallbe
collectedbasedontheaverageturnoverofthereceivablesof
thefirm.
Theproblemwiththissystemisthatitdoesnotdoavery
goodjobofcapturingtheactualprocessofreceivables
collection,andthereforeitdoesnotproduceaccurate
forecastsexceptinspecialcases.
Abetterreceiptforecastingmethodisthepaymentpattern
approach.Inthismethod,theanalystdetermines(using
historicaldata)theproportionofcustomersthatpayat
varioustimesafterthedateofsaleandfromthisinformation
projectsfuturereceipts.

20. Degree of A/R Forecasting
Aggression
Thesecondissuethatmustbeaddressedinforecasting
receivablescollectionsisthelevelofaggressionofthese
forecastsacrosslinesofbusinessformultibusinessfirms.
Inasituationwherethefirmisinmultiplebusinesslines,the
useofoverallpaymentpatternstoforecastsreceiptswillbe
accurateonlywhentheproportionsoftotalsalesmadein
eachbusinesslineareconstant–anunlikelysituation,
particularlysincethedifferentlinesusuallyhavedifferent
situationvariations.
Insuchmultiplesituation,themostaccurateforecasting
resultisachievedbyforecastingreceiptsforthedifferent
unitsofthefirmindividuallybasedontheirownreceipt
patterns,thensummingthesereceiptstoobtaintotalcash
receiptsforthefirm.

21. A/R Forecasting