While short-term cash forecasts generally focus on cash management issues, longer-term forecasts (covering periods beyond one year) are designed to address liquidity risk (ie the risk that the organisation has insufficient funds to continue as a going concern).
The key objectives of a long-term cash flow forecast are to:
Once created, a long-term cash flow forecast can be used to:
The forecast will be used by:
In many Western economies, a company may estimate cash flows over a five-year period. But a company may forecast up to 15 years or more for infrastructure finance projects or in countries such as Japan where financial markets are traditionally noticeably less ‘short-term’ in nature.
Coordination across the organisation to create a realistic forecast is key since the firm may have to live with the consequences of any decision for decades
Almost all companies base longer-term forecasts on projected financial statements, known as the pro forma statement method, rather than on forecasts of cash receipts and payments. The main reasons for this are:
There are a variety of ways to generate accounts-based cash flow statements, but one of the most straightforward, and therefore most widely used, is an approach derived from the corporate budgeting and planning system that uses an opening ‘actual’ balance sheet together with a forecast income statement to generate a forecast closing balance sheet and forecast cash flow statement.
Inevitably, the ‘assets’ will not equal the ‘liabilities and equity’ in the forecast closing balance sheet and so ‘cash’ is used as the balancing figure.
If the assets are less than the liabilities, the company is forecasting a cash surplus. If the total assets are greater than the total liabilities, the company is forecasting a cash deficit that will need to be financed.
The forecast should be regularly updated to reflect the latest information while staying aligned to the statements produced by the finance department.
Most organisations will use this process to generate a range of forecasts (as a minimum ‘plan’ plus a downside case), based on a range of scenarios.
Stress testing, where a company will flex the forecast to see how far from forecast it can move before the plan fails (for example, sales fall by 5% resulting in an inability to service debt), is also frequently adopted.
Financial analysis that can be driven from a cash flow forecast derived from prospective financial statements can include:
Long-term forecasts are created to measure the impact on liquidity, capital structure and credit ratings of both ‘business-as-usual’ and/or transformational activity and enable the organisation to identify the size, source (debt or equity) and tenor of any associated funding requirement.
It is important that the treasury team has a strong working relationship with the finance team and local management as well as being fully aware of the strategic thinking of the board when developing long-term plans since, by creating and maintaining a robust long-term cash flow forecast, the organisation can opportunistically access the lending markets and save on finance costs over the long term. The ability to source finance at the ‘right price’ for a project may influence the decision to undertake that project.
Coordination across the organisation to create a realistic forecast is key since the firm may have to live with the consequences of any decision for decades. This means that the finance version of the forecast may need to be adjusted to show a more prudent picture of predicted future cash flows (sales forecasts are invariably highly optimistic) to ensure that any decisions taken are appropriate.
It is important that the cash forecast used by treasury can be reconciled to the forecasts used by the rest of the organisation to ensure that the board is making decisions on one consistent set of numbers. So any adjustment should be shown separately rather than by changing the base figures.
Sarah Boyce is associate director of education at the ACT