Cash forecast: method and stakes

Cash forecasting is essential in difficult times.

Liquidity remains the ultimate condition for the survival of companies, far ahead of solvency risk (which concerns only a negligible proportion of business failures). A lack of liquidity can occur in the short term, through a lack of forecasting, on elements of working capital requirements, but it can also occur in the long term, through overly heavy investments or made with poor assessments of ancillary working capital requirements. One wrong step and it’s a close call for the company.

Liquidity is a major risk, but it can also be transformed into an opportunity for development, remuneration of shareholders or other stakeholders. Anticipating its cash flows, to stay afloat, or to jump and therefore key for business managers and financial directors. Nevertheless, cash flow forecasts cannot be reduced to that, and their usefulness is much more extensive.

Why make cash flow forecasts ?

Cash flow forecasting is an effective way to hedge and prevent liquidity risk. This liquidity risk can be short term, or medium / long term. In this case this tool is an insurance (to anticipate) for uncertain and complicated futures. These are therefore wave-top projects (investing in a cash forecast project at the bottom of a wave or in difficult times can be counterproductive and inappropriate).

The cash forecast is also a decision tool. In the short term, it allows you to opt for cash investments. In the medium to long term, it is used to guide financing and/or investment projects. Financial flow modelling is used to project, evaluate projects, and to communicate with covenants, shareholders and other stakeholders.

Finally, it can be used as an optimization tool. A cash forecast by currency enables the forecasting of exposure and flows by currency and thus the optimization of currency hedging. It is the input element of a hedge strategy. So reliable, it allows to reduce financial expenses and to have an optimal financial result, but also to communicate on revenues without the uncertainties external to the company such as exchange rates (by hedging exchange rate variations). It is therefore a forecasting tool and a guarantee of stability on elements that are a priori indirectly linked.

What is the time horizon for cash flow forecasts?

We have already mentioned the three horizons of cash flow: short, medium and long term.

Let’s try to define them and see their usefulness for the company.

Short-term planning are done by working mainly on working capital requirements. Heavy investments or financing are known and planned for long term. They are included, but are not the key to these simulations, which revolve around working capital items. It is necessary to plan the due dates and payment dates of trade receivables, suppliers and salaries. The objective in the short term is to look at:

  • if the company can go through a difficult period, or if it must seek to finance its working capital (factoring, loans, etc.),
  • whether the company can engage in cash investment strategies (by investing surplus cash),
  • if currency hedges need to be adjusted,
  • whether investment trade-offs are necessary (when speaking of the short term, one would prefer to speak of postponement rather than re-evaluation of investment opportunities),

In short-term planning, the aim is to avoid bank default, to plan payments/receipts as well as possible, to avoid overdraft. The evaluation grid is therefore one short time period (below one month):

  • in most cases on a weekly basis,
  • per day for the most advanced systems, and simple to plan (on BtoC, with subscription system for example),
  • in thirds of months (10-day increments), to simplify alignment with salary payment dates, and land on the monthly closing date,

Medium / long term planning will revolve around investment and financing projects. Its objective is to evaluate opportunities and make investment choices (trade-offs) for the company. The WCR is modelled (via DSO/DPO/… indicators). Banking positions are only revalued at the end of the cycle. The aim is to generate positive cash flows and no longer to maintain a debit bank position.

Which method should be used ?

When talking about the cash flow statement, two methods are possible:

  • Direct: taking into account the flows that will feed the cash flow,
  • Indirect: cash items (EBITDA or net income) are taken into account from the P&L, then changes in gross operating income, investment and financing are taken into account.

The first is a “banking view” of cash flow. The second has the advantage of linking the company’s performance with cash flows, isolating the contribution of performance to cash flows, and thus better distinguishing the origin of cash inflows or outflows.

Starting from (monthly) financial statements excludes the indirect method for short-term cash flows. Furthermore, short-term cash flows need a precise date (daily, as opposed to accounting data that is captured monthly), for correct evaluations. The direct method, which consists in starting from the transactions and their settlement dates, suits a short term vision but precise in time (daily or weekly). For the WCR, the use of aged balance data (customers and suppliers) allows a precise extrapolation of cash to a horizon of 1DSO/1DPO. Using these indicators to extrapolate payments is strongly discouraged because of the imprecision linked to irregularities in billing dates and amounts (we can make an exception for activities that bill on a fixed date, such as consulting). The direct method is therefore essential on short term horizons, and a finer fineness than the month.

In long-term visions, the indirect vision is more explicit and meaningful, to express the opportunity of an investment or financing project. In the long term, we look at the evolution over the year. The drivers are revenue opportunities / cost reduction, which then generate working capital needs (or DSO / DPO / DIO allow to simulate them in a reliable way). In this case, the indirect method is the only way to combine profitability requirements and the company’s need for liquidity. Furthermore, in the long term (to be able to apply the direct method), a reliable backlog is required.

In a middle-term vision, both visions can exist. The choice is based on the quality of the information available, the cycle times and the complexity of the models.

How to assess the risk / uncertainty ?

Two methods:

  • Scenario methods: a method which allows, by moving variables, to evaluate several scenarios, and to judge the impact and sensitivity of certain parameters on the final result,
  • Monte-Carlo method: risk is integrated and generates the opportunity, applicable if the risk is precisely known (distribution curve), in a stable environment (hypothesis of efficient markets transposed to the micro-economy).

The scenario method is subjective, the parameters change according to what the analyst thinks they are, however it allows to easily limit the pessimistic and optimistic versions. No risk is quantified, but the framing of the values makes it possible to understand the sensitivity of the variables, and the impacts of certain variations.

In the Monte-Carlo method, starting from a known risk, the opportunities and the limits of this one are evaluated. In this case, the knowledge of a risk (objective) allows the opportunity to be qualified. This method, which is known, is applied in the constitution of investment portfolios based on the hypothesis of efficient markets (illusory in times of crisis). Moreover, it works because it relates to a known risk (modelled by a normal law) with good statistical significance (large sample). These two operating criteria are complex to extrapolate to the microeconomic world. When making an investment, each company hopes to distinguish itself and innovate: the risks, costs and benefits for each type of investment are never the same. This method therefore only applies in very specific cases of investments.

The use of statistical models in controlling and corporate finance is complex, and is limited to liquid assets that can be valued in a financial market. We will return to this subject in a future article.

Cash flow forecasting is complex, but is a guarantee of good economic knowledge of its activity. The requirements on this subject depend mainly on the structure of the company’s liabilities (or shareholders’ debt), but should develop. Cash flow forecasts therefore allow for the forecasting and modeling of activities or business groups. Beyond that, they are a lever to reduce risks and financial expenses.

Both methods (direct and indirect) require different sources (and systems). The first must be related to the accounting facts (as recorded in the ERP) and extract either the recurring (salaries, loan repayments, etc.) or the settlement dates (for trade receivables, accounts payable). The indirect method will use modelling to assess working capital requirements (DSO/DPO/DIO). EBIT / EBITDA is extracted from the budgets. Changes in working capital are added to the operational part (by calculation, based on KPIs). Financing / investments are injected to complete the view of direct and indirect methods.

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