Long-Term Cash Flow Forecasts (#328)
/Is it possible to construct a viable long-term cash forecast? Answering this requires some clarification of how a cash forecast should be constructed.
The Receipts and Disbursements Method
A cash forecast has three distinctly different formulations, depending on how far out you want to go into the future. The most predictable cash forecast only goes out about a month, and is based on a detailed accumulation of data from a couple of sources within the company. Most of it comes from the accounts receivable, accounts payable, and payroll records, though some other significant sources are the treasurer, for financing activities, and even the corporate secretary, for scheduled dividend payments. Since this part of the forecast is based on detailed itemizations of cash inflows and outflows, it’s sometimes called the receipts and disbursements method.
The short-term forecast is quite reliable, though even here there can be some uncertainty, since payments from customers don’t always arrive when you expect them. And if those cash inflows are not as predictable as you’d like, then outbound cash payments might be delayed to minimize the risk of running out of cash.
The Medium-Term Cash Forecast
Next, we have the medium-term cash forecast, which begins at the end of the short-term forecast. The components of the medium-term forecast mostly come from formulas, rather than the very specific data inputs used for a short-term forecast. For example, cash outflows related to the cost of goods sold might be based on an estimated percentage of sales, with a time lag based on the average supplier payment terms. Or, the sales forecast can be used to estimate changes in production headcount, which in turn can be used to derive payroll payments. Or, cash receipts from customers are based on a standard time lag between the billing date and the payment date.
The concept of a formula-filled cash forecast that automatically generates cash balance information breaks down in some parts of the forecast. For example, some expenses are based on contracts, such as rent payments, and so are set up with specific cash payouts on specific dates. Or, some expenses are only associated with specific events, like the company Christmas party, and so have to be manually added to the forecast.
And, one of the biggest manual additions is any type of step cost. A step cost is an expense that is constant for a given level of activity, but which takes a large step upward when an activity threshold is crossed. For example, if projected sales surpass a certain point, then the cash forecast has to include additional expenditures to staff up a new production line, or maybe to rent more facility space.
The methods used to construct a medium-term cash forecast are inherently less accurate than the more precise information used to derive a short-term forecast. The problem is that much of the information in the medium-term forecast is derived from the estimated revenue figure, which declines in accuracy just a few months into the future. For that reason, it’s dangerous to develop a cash forecast that extends very far out. And on top of that, there’s an immediate decline in forecasting accuracy as soon as you switch from the short-term forecast to the medium-term forecast.
The Long-Term Cash Forecast
Since I mentioned a medium-term forecast, of course there has to be a long-term forecast, too. This can be used to extend the forecast out for a year or two past the end of the medium-term forecast. The information for the long-term forecast comes from the corporate budget, so it’s only going to be as reliable as the budget – which might not be reliable at all. Long-term cash forecasts are only approximate representations of what will actually happen, so they shouldn’t be used as the basis for any specific management actions. That being said, a long-term forecast can give you a general idea of where your cash balance might be in the future, so it can be a guide for approximately when you might have a cash shortfall, which might require some financing activities.
Whether to Issue a Long-Term Cash Forecast
So, does it make sense to issue a long-term cash forecast? If you do, be sure to point out that the quality of the data declines at specific points – which are one month out, when you switch to the medium-term calculation method, and again further out, when you base the forecast entirely on the budget. If someone insists on a long-term cash forecast, then they have to understand the quality of the information they’re receiving.