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Cash Flow Forecasting Best Practices

Can anyone share best practices when coming up with a cash flow forecast model on the indirect method? This is for a large public company with infrastructure around the world. Although we have a robust P&L forecast, there is no current process for forecasting offsetting balance sheet items. We currently have a large cumbersome excel model which first has to tie out to the actual cash flow statement and that is used as a basis for forecasting. We are basically looking to start from scratch and come up with a new way to forecast free cash flows, but are wondering how other companies do this. Any insight would be much appreciated.

Answers

Alan Hart
Title: Consultant
Company: Pacific Shine Group
(Consultant, Pacific Shine Group) |

Forecasting cash flow or more accurately forecasting the company’s Statement of Cash Flows is possible if you are able to accurately forecast your Balance Sheet. The idea is to use a system that automatically generates these two statements from your P&L forecast.

I use a commercially available software solution that provides me with a Balance Sheet and a Statement of Cash Flows for every period of my budget (e.g., month), either using the Direct method or the Indirect Method.

This way I don’t have to worry much about calculating account balances, since the system makes automatic journal entries into these accounts in the right amounts, right periods and into the correct accounts.

Whatever system you choose, make sure it is capable of these automated journal entries, as calculating balance sheet account balances at each budget period end is practically impossible with any level of accuracy and completeness. Also make sure the system allows you to make manual entries into future periods / budget periods, which is useful in forecasting cash needs, borrowings, retirement of existing debt, etc.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

Alan, which system do you use?

Wayne
http://sbaconsulting.com/management.html

Ernie Humphrey CTP
Title: CEO & COO
Company: Treasury Careers
LinkedIn Profile
(CEO & COO, Treasury Careers) |

There are several the Proformative learning platforms which I believe may be helpful to you. https://www.proformative.com/sitesearch?type=Courses&op=Search&keywords=Cash+forecasting

Dan Gollins
Title: Professional Interim
Company: Own interim business
(Professional Interim, Own interim business) |

Hello, I have just signed up and saw this thread.
I am an interim finance professional and have worked on a number of cashflow forecast models across a number of different industries.

These have mainly used Excel, and don't need to be rocket-science complicated. If they are then you lose the ability to understand how the inputs effect the outputs and how to analyse the variance between actual and forecast.

There are packages that maintain double entry integrity, but these can easily be replicated in Excel (see point 5 below).

There are some common threads that are useful:
1). do not try to forecast in detail too far into the future. I work on a four week plus nine. The first four weeks are based on what staff within the business anticipate i.e. collections. The following nine can be driven from historic metrics such as debtor days.
2). every model should have tabs for inputs, outputs, sensitivity analysis and variance analysis.
3). inputs should be driven by metrics such as debtor days.
4). for each metric such as debtor days, there can be a further subgroup metrics based on major customer characteristics i.e. payment profile of public versus private sector customers etc.
5). sensitivity analysis is useful for showing the risk that maybe inherent within the forecast.
6). for absolute clarity (and to tie into a P&L and balance sheet forecast) build the cashflow using "T" accounts. This will ensure that the cashflow forecast doesn't spin off into orbit disconnected from the other forecasts.
7). make it easy to update forecasts with actuals and have a tab that compares the variance. Reasons for variance should be added and reviewed each week to ensure that the assumptions within the forecast are still relevant and reasonable.
8). lock down the template, so that only inputs can be amended and not the model formulas.
Hope this is useful.

Ara Toroyan
Title: Director-Fin. Planning & Procurement
Company: NCCI Holdings, Inc.
(Director-Fin. Planning & Procurement, NCCI Holdings, Inc.) |

Very practical and logical advice. Well done Dan.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

Dan -

Do you have a template you could share?

Kelvin Metcalf
Title: Senior Manager
Company: Joyent
(Senior Manager, Joyent) |

Very nice thread. Anyway I can get more technical information on cash flow forecasting?

Charles Smith
Title: Managing Partner
Company: Pegasus Intellectual Capital Solutions
(Managing Partner, Pegasus Intellectual Capital Solutions) |

There are two levels of detail that you need that require two different models. The longer term model is used for valuation and capital structure. Ours uses the company's historical financials as a basis for setting assumptions. The income statement assumptions are then set for the forecasts and can be modified year-by-year.

Without a good analysis of former financial performance, you really have no realistic basis for setting assumptions for working capital utilization or performance in a downside scenario for a recession, industry instability or disruption. Unless you are running at least three sets of assumptions (base case, downside case and upside case) you can't determine capital structure or ensure you are avoiding insolvency.

This first model creates the balance sheet and cash flow statements automatically from the income statement forecasts using the balance sheet assumptions calculated in your historical analysis of your financial statements, but with the ability to modify assumptions year-by-year. Working capital utilization and CAPEX are especially vexing, the former impacting both cash flow and valuation powerfully in those companies with high working capital needs (non cash, non-debt current assets minus current liabilities). We have sub-routines that have built in triggers for maximum debt/cap rations, revolver requirements, asset based lending limitations, and other limitations to keep within the real-world. Fast growth and low profitability companies both run into limitations easily.

For payments, we use a 13-week rolling forecast. This model is used used solely for ensuring sufficient liquidity in the near term. These are always used in crisis management situations where cash sufficiency is in question. Many accounting courses teach how to make these. In simplest terms, its about A/R collection and A/P payment. We've done work on the variability of A/R collections and model the effect of changes in collection assumptions on probability of insolvency (inability to pay debts as they come due). As they say, a company only files bankruptcy when they run out of cash, or see that they are going to.

Jeff McGlaughlin
Title: Corporate Controller
Company: Withheld
(Corporate Controller, Withheld) |

If you have a P&L forecast, and you have a balance sheet forecast, then the cash flow forecast is simply a function of those two statements. It's quite easy to do in a simple Excel spreadsheet.

It sounds like your more pressing issue is the lack of a robust Balance Sheet forecast. Use turnover metrics (DOH, DSO, DPO) to forecast your highest-volume accounts (assuming here that you're a manufacturer), forecast all of your other balances using some logic (historical run rate, known future transactions, etc.), and then cash ends up being a (hopefully reasonable) plug number.

Alan Hart
Title: Consultant
Company: Pacific Shine Group
(Consultant, Pacific Shine Group) |

To answer Chris Cahill’s question about the system I use, it is a commercially available software titled Budget Maestro, published by Centage Corporation (www.centage.com). Using this software you prepare your budget in all major areas, such as revenue, cost, OpEx (with a separate personnel module), fixed assets, debt, equity, etc. Since the system mimics your actual GL chart of accounts (and can be actually linked to the actual GL), all budget items, as prepared by all budget participants in all business units cause the software to automatically generate all major financial statements and other user reports.

One reason I like this software is there are no user supplied formulas, functions and links, since all business rules and logic are built in, so you simply cannot break the model. I can also use any number of defined drivers to drive certain areas of the budget. The other reason is I can get an accurate and very complete balance sheet for every period of my budget, because the system automatically makes journal entries driven by the budget itself, in the right GL accounts, in the correct budget period and in the right amounts. The software then uses these balance sheets to generate complete and accurate statements of cash flows (either using the Direct or Indirect method).

I also use the software analytics module that ties my actual accounting numbers to my budgeted numbers in every accounting period, as soon as the actual period is closed. In addition to basic analysis of actuals vs. forecast, I like to use the system to visually forecast key financial ratios and see how they behave throughout the budget year and what changes to the budget must be made in order to achieve a desirable set of ratios.

Another use of the software for me is forecasting compliance with loan covenants throughout the budget period and I can do this visually, knowing that my forecasted balance sheet closely follows my forecasted P&L. There are, of course, many more uses and applications of this system. I hope that helps in answering your question.

Bill Haskins
Title: CFO
Company: Grant Street Group, Inc.
(CFO, Grant Street Group, Inc.) |

The most effective way to forecast cash flow is to develop 2 models: a) a direct, which is based upon actual timing of receipts and disbursements, and b) an indirect, which is driven from the P&L and changes on the balance sheet. Run both for a given time period, and reconcile the large differences.

Jeffrey Eversmann
Title: Managing Partner
Company: Chastain Partners
(Managing Partner, Chastain Partners) |

A few answers have mentioned a balance sheet forecast which would be necessary if you want to produce an indirect cash flow. It sounds like you have a P&L Forecast that is GAAP (or IFRS), but you want some guidance on how to forecast cash.

It is important to keep the balance sheet forecast simple (something that can be explained in 90 seconds to senior management or a board of directors) and ties to the corporate goals.

Depending on your business, there are three basic balance sheet accounts that every leadership team should be looking at: accounts receivable, inventory, and accounts payable. You can extend beyond this once these three accounts are under control and consistently tracking to your forecast.

Let's use AR as an example. Since you already have a P&L forecast, you can also forecast AR as a percentage of sales or receivable days based on your revenue forecast. The metrics you use depends on what is important to the sales leadership. If they set a goal for sales, there must also be a goal for AR. Is it "no more than 25% of sales will be financed each month" or "terms with customers will not exceed 30 days".

Using this process, you can establish goals with the necessary departments for each of the balance sheet accounts. And once you have targets for the balance sheet, you can use the indirect method to forecast cash flow.

Alan Hart
Title: Consultant
Company: Pacific Shine Group
(Consultant, Pacific Shine Group) |

It is interesting to see how many people are still trying to implement a spreadsheet approach to cash forecasting or as one member commented a simplified balance sheet. Experience has shown that use of complex spreadsheets to perform complex forecasting of cash account balances or other elements of the balance sheet is inaccurate at best, often resulting in more severe issues that make these forecasts misleading and unreliable.

My approach has always been to put an effort into the traditional budget elements of revenue and expenses and then let technology do the rest. By that I mean implement a solution where the balance sheet and the statement of cash flows are automatically generated from your P&L forecast. This of course, is only possible if the forecasting solution can perform automated journal entries derived from the P&L period activities and other assumptions like customer and supplier payment terms, individually selected for all revenue and expense lines (e.g., Supplier A has 60 day terms vs Supplier B that has 30 day terms, both participate in certain expense budget lines, but each affects the cash balance individually, based on Payment Terms assigned to that expense line).

I’ve been told before that an accurate forecasted balance sheet is not that critical since the P&L forecast is never accurate. It is true that the forecasted balance sheet will always be inaccurate if the forecasted income statement is inaccurate but why not have a system where the balance sheet and statement of cash flows are directly tied into and are perfectly synchronized with the forecasted income statement? You can then focus on the operational plan and P&L forecast and always get a complete set of forecasted financial statements, always synchronized to the forecasted income statement.

The results using this approach are a complete and accurate forecasted balance sheet and statement of cash flows for each period of your budget. You will need to supply the beginning balance sheet account balances (known from your actual accounting system) and make certain manual journal entries into budget period, such as paying down of debt, issuing additional debt, selling assets, etc. These entries and the decisions to make them can be made once you’ve run the forecasted balance sheet and statement of cash flows using the automated forecast of these statements.

In my practice I often into P&L forecasts that are grossly missed only due to the fact that the company did not have the proper financing in place or ability to fund these forecasted activities (e.g., sales of a new product line). An accurate and complete forecasted balance sheet and statement of cash flows can easily show that so the P&L forecast can be adjusted or other financing arrangements can be made ahead of time.

Another benefit to using this approach vs. a rough estimate of just cash balances and maybe other key balance sheet account balances is that you can forecast any set of key financial ratios you use in your finance organization. I like to be able to forecast all financial ratios that are used in the calculation of compliance with loan covenants. This way I can determine how close I am to breaching one or more of these covenants, and I can see that months or even years in advance. This may not be a concern to budget administrators or even mid-level finance managers but is something senior management would love to hear about and insist on implementing in their organizations.

Jaime Campbell
Title: Chief Financial Officer
Company: Tier One Services, LLC
(Chief Financial Officer, Tier One Services, LLC) |

A simple approach of Days in A/R, Days In A/P, and Inventory Turnover Days - when these three metrics are entered as assumptions - can provide a quick set of 3 lines for the (Increase) decrease in Accounts Receivable line item and related line items on the forecasted indirect Statement of Cash Flows.

If you need to segment these, you can, but that's what I use for forecasted financial statements for small businesses.

For the other assets and liabilities, I do a calcuation based on the changes in the Balance Sheet.

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