Cash Flow Forecasts Our Company

Cash Flow Forecasts

Our company is going to be preparing cash flow forecasts going forward. These forecasts will be prepared by the finance department with input from managers across the organization. This paper will outline the importance of preparing accurate cash flow statements, the flows that will be considered, the differences between earnings on the income statement and cash flows, and will conclude with an explanation of the uncertainty involved in cash flow forecasts.

A cash flow forecast can be used for a number of different purposes. One reason why cash flow forecasts are valuable is to illustrate the business' underlying strength or weakness in lieu of reliable accounting statements. There are times when accounting profit cannot be trusted - in developing countries for example (DeFond & Hung, 2007). There are also times when significant non-cash transactions skew the statements. For example, a firm can take a large goodwill charge that negates the EBITDA, masking what was otherwise a great year from a financial point-of-view. In these circumstances, cash flow forecasts can help both managers and investors alike understand the firm's performance.

Another reason why cash flow forecasts are important is to ensure that management is aware of its cash flow needs for the coming month/quarter/year. Some automobile firms have gone through periods recently where they were insolvent, so maintaining sufficient cash flow to sustain operations was of major concern to management. At one point, General Motors was actually unable to provide financial forecasts, and this was at a point where the company was cash flow negative (Business Week, 2005). For management to be able to meet all of its financial obligations, the company needs to determine how much cash it will need, and then must figure out where that cash will come from. There is a degree of lead time required for either debt or equity financing, so management will need to know the upcoming cash flow obligations. Indeed, even money held in short-term liquid investments must be converted to cash in order to meet needs at most firms.

The cash flow forecast for my automaker will include all cash flows. The revenue component of cash flows will be incoming cash from sales, rather than sales. The accounts receivable turnover is important to account for, since money earned today may not be paid to the firm for another month or two. With respect to cash outflows, these will include all operating expenses -- wages, benefits, cost of goods sold, selling general and administrative expenses and other cash outflows. These costs include whatever legacy costs the firm is obligated to cover, such as health and pension benefits to retirees. Depreciation and amortization are not cash flows and therefore will not be incorporated into the cash flow forecast.

As well, there are financing and investing flows to consider. Investing flows include cash flows associated with new plants and equipment. While on the income statement, these assets are depreciated over years, they represent an immediate cash outflow. Financial flows include the proceeds from bond and stock issues and dividends paid to shareholders. They also include bond repayments, interest payments, stock repurchases and other similar outflows. In the preparation of a cash flow forecast, all of the firm's expected cash flows need to be considered, not simply the operating flows. This is especially true of an automaker that may have solvency issues. Transfer payments to or from the federal government, where applicable, will also need to be included in the cash flow forecast. Only non-cash expenses should be excluded from the cash flow forecast.

If this is done, then the firm will be able to accurately distinguish between earnings and cash flows. An earning is an accounting measure and is only loosely based in terms of time. In accrual accounting, earnings reflect the firm's economic activity. In order to more accurately reflect the ongoing nature of this activity, expenses are often spread out over the course of their useful lives. This enables the company to better match its inflows and outflows. However, this also means that much of what constitutes earnings is not a direct, immediate cash flow. There are a number of items that will appear on an income statement that are either flows that have already occurred, or are flows that have not yet occurred. However, because the transaction was based in that quarter or year, it appears on the income statement. Earnings, therefore, are intended to reflect the firm's economic activity for the period, not its cash flows.

Cash flow forecasts outline what the firm will have left over after it collects all of its money for the period and pays out all of its expenses (Forsythe, 2006). Because this measures the firm's economic activity, it can be used as an alternative to earnings in evaluating a firm's performance for the period. A cash flow forecast, by contrast, allows management to understand how much cash it will need to operate in the quarter and compare this figure directly with the amount of cash it is expected to receive from all sources. Financing cash flows, for example, are an important element of a cash flow forecast that is not reflected at all in the earnings.

It should be noted, however, that because cash flow forecasts are based on predictions of the future, they are subject to considerable deviation from actual cash flow results. While there are a number of ways to construct a cash flow projection, one common way is to base it on previous results. Even when management accounts for estimated growth rates and the addition or removal of unusual transactions, the forecast may still be subject to deviation because of changes in the prevailing internal environment (cost structure) and external (competitive, economic) environments. The firm is apt to assume that performance for the next period is likely to be similar to performance from a past period, but for any number of different and unforeseeable reasons it may not be.

There are some other reasons as well for deviations between cash flow forecasts and reality. Some managers are optimistic in their cash flow projections, sometimes in order to encourage senior managers to green light a pet project for example (Chen, 2007). There may be shifts in the timing of accounts receivable and payable as well that result in deviations. Unforeseen operating delays or problems -- or successes for that matter -- can also result in deviations from cash flow forecasts.