Short-Term Financial Management Chapter 12 – Cash Forecasting

Chapter 12 Cash Forecasting Discuss the need for short-term cash forecasts, describe how the process of daily cash forecasting differs from that used in monthly forecasting, and explain the receipts and disbursements, pro forma balance sheet, and distribution methods of cash forecasting.

Chapter 2 Review… In Chapter 2, we said a firm is solvent when its assets exceed its liabilities and liquid when it can pay its bills on time without undue cost. Liquidity includes both flow and stock. If cash from operations (flow) is not sufficient to cover current obligations, the firm needs to draw down other resources (stock). The cash flow cycle refers to the continual flow of resources through the working capital accounts. This results in periods of cash surpluses and deficits.

Cash Forecasting Since cash flows are unsynchronized, uncertain, and uneven, estimating the amounts, timing, and volatility of cash inflows and outflows is critical. Forecasting the cash position is vital. Short- and intermediate-term cash planning is a vital process for planning, monitoring, and controlling firm cash.

Cash Forecasting The objective of Cash Forecasting is to plan ahead for short-term financing needs and opportunities. It enables the accurate planning for: Cash Flows Cash Balances

Cash Forecasting Short-term cash forecasts: Drive short-term investing and borrowing decisions. Selection of investment vehicles and maturities. Selection of loan products (size, terms, and maturities). Drive financial policies, including disbursement policies, credit terms offered, and bank selection.

Forecasting Monthly Cash Flows Typically, a monthly cash budget is prepared for the upcoming year, which includes cash receipts and cash disbursements. It includes all sources and uses of cash, not just cash from operations. During the year: Actual cash is compared to the budget. This can signal issues and prompt corrective action. e.g.: Instruct retail stores to run a store-wide sale. The forecast is updated.

Forecast Parameters The planning process is integrated with overall financial management, and includes: Forecast Horizon and Interval Variable Identification Formulating a Mathematical Model Model Estimation Model Validation

Forecast Parameters Forecast Horizon and Interval The Forecast Horizon refers to how far ahead the cash balance is projected, and usually includes a short-term and longer-term view. e.g.: One-month, three-months, one-year and five-years. The Forecast Interval refers to the units into which the horizons are segmented. e.g.: One-month horizon segmented into days, three-month horizon segmented into weeks, one-year segmented into months; five-year segmented into quarters or years.

Forecast Parameters Identifying the Forecasting Variables Determine what items should be forecasted and how they are to be measured. e.g.: What is ‘cash’ (book bank balance, collected bank balances, accrual-based cash account, include highly-liquid investments, etc.)? Decide what to model based on accuracy and usefulness. e.g.: Inventory purchases, A/R collections, A/P payments, dividends, tax and loan payments, insurance, other operating expenses, etc. It should be properly detailed, but not over-worked or overly aggregated. The accuracy of the work is higher and the work more detailed with shorter horizons (usually +/- 5-10% accuracy is adequate).

Forecast Parameters Formulating a Mathematical Model Model Estimation Select the format and model appropriate for the size and complexity of the firm (see next slide). Model Estimation Integrate data into the model. Model Validation Monitor the existing model to ensure validity and measure variances from established tolerances for error.

Simple Cash Flow Model

Possible Format Receipts & Disbursements Method The line items for Cash Receipts and Disbursements are first determined. The shorter the time horizon, the more detailed the analysis.

Possible Format The Cash Forecast (receipts and disbursements) is crafted from the pro-forma cash flow statements. 97%

Possible Format The timing of receipts and disbursements is then estimated based on historical customer patterns.

Possible Format The starting point is Beginning Cash Balances. Cash Receipts and Disbursements are forecasted…investing and borrowing are NOT yet included. The difference, [Net Monthly] Cash Flow, is added to the Beginning Cash Balance to calculate the Ending Cash Balance.

Possible Format The firm includes some minimum level of cash reserves (target balance) for uncertainties, emergencies, and/or bank compensating balances.

Possible Format Each month is calculated separately. Monthly [Net] Cash Flow represents cash surpluses or shortfalls. If net cash flow for a period is positive, it is invested or used to pay down debt, or both. If net cash flow is negative, any investments would be liquidated and/or additional short-term funds borrowed.

Cash Flow Analysis Example The firm begins the year with $1.5 million in cash and cash- equivalents. After planned activities, it ends January with $2.6 million in cash. The firm has $1.6 million in excess cash to invest in short-term securities after covering the $1.0 million minimum target.

Cash Flow Analysis Example Does not include prior investing/borrowing activities. In February, the firm pays dividends. It not only falls short of the minimum, it actually runs out of cash. After liquidating the investments, the firm still needs to borrow $1.0 million from its bank line of credit. If the investments are not liquidated, the firm would borrow $2.6 million.

Cash Flow Analysis Example In March, net cash is sufficient to pay back the loan, meet the minimum, and invest the surplus ($2.1 million)

Cash Flow Analysis Example It’s possible, depending on interest rates, that the firm might be invested and borrowing simultaneously. Higher yields accompany longer maturities.

Cash Flow Analysis Example The cash forecast allows the firm to pre-arrange a bank line of credit for the largest anticipated shortfall during the forecast horizon. This monthly format does not consider intra-month shortfalls, which is why a daily or weekly analysis is often done for the near- term.

Cash Budgeting The cash budget allows firms to: Arrange adequate short-term financing. Select short-term investment vehicles and the associated investment horizon. It is prepared monthly for the upcoming fiscal year. It is based on planned sales and operating expenses. It is synched with typical billing and payment cycles. It is frequent enough to be adequate, but not so long as to mask imbalances. It includes comparisons to previous years, and once done, is compared to actual results.