What do we mean by cash forecasting model or cash flow?

The vast majority of the audience will know that cash flow or cash forecasting models is the generic term used to describe the inward and outward movements of an enterprise’s cash resources expressed in terms of actual results or plans (and also refers to budget, and forecasts, over short and long-term periods). It shows the impact of collecting income (including sales, loans, and capital) and paying expenditure (such as salaries, property costs, or raw materials). Most would probably agree with the assertion that the most common reason for business failure is poor cash flow, so in any business, it is vital to understand both the current and expected future cash situation and the drivers that impact upon it.

However, depending on an organization’s stakeholders, the perspective on cash flow may vary significantly.

1. The treasury department may be interested in a daily or weekly cash flow forecast covering a relatively short time frame (e.g. four to 12 weeks), bank account by bank account, both to ensure that sufficient funds are in the appropriate accounts and also for efficient management of any surplus funds.
2. Regulatory authorities are focused on standard reporting to confirm going concerns and benchmarking across businesses (e.g. the ubiquitous “Cash Flow Statement” in published accounts). As well as reviewing the current situation, these may cover long time-frame projected cash flow statements and can be highly prescriptive as in the case of the housing industry or utilities.
3. Investors and financiers require medium to long-term trends and will focus on compliance with any covenants to ensure that risk is managed appropriately within the cash flow budget and regular cash flow reforecast. Typically, these have a time frame of at least the current fiscal year at a monthly level of detail, but frequently multiple years into the future.

What are the drivers of a cash flow forecast or budget?

Cash flow forecasting is the practice of projecting all income (receipts) and expenditure (payments) over a coming period. In some cases, these numbers are fixed and known far into the future, such as contracted sales booked in advance and annually agreed rental costs. But in most cases, these numbers must be estimated. This is where you need the right combination of expertise and modern tools to ensure confidence in the projections, coupled with the appropriate perspective and time frame:

The three categories referred to above tend to feature different approaches and levels of complexity when it comes to building cash forecasting models.

1. Firstly, the short-term treasury model is typically founded on transactional forecasts based on predicted payments and receipts of data held in the core financials (debtors, creditors, payroll, contractual obligations, etc.). These can give a high degree of confidence in the timing of many receipts and payments, which may then be overlaid with other items such as injections of capital or projected sale of assets. Fundamentally this is a relatively simple and accurate model but is supported only as far as the underlying existing data may be relevant, since cash may be collected within the forecast horizon for invoices that have not yet been raised. This is one area where technology will have an impact on cash forecast accuracy in the future: AI will be able to analyze past patterns, identify seasonality and drivers to provide a better quality machine-learning-based output of the unknowns to overlay onto the known or expected. Additionally, it will learn customer paying patterns rather than assuming all customers pay on the due date or an average number of days late, further enhancing cash forecast accuracy in the short term.
    
2. Secondly, the standard reporting model is also a well-understood method of generating indirect cash flow forecasts since it relies on a standard set of mathematical relationships that reconcile the operating result to the cash balance in the balance sheet. This is the classic cash flow statement that is a basic requirement of all businesses that file full accounts. Assuming that there is a valid balance sheet budget or forecast and accompanying income statement with some supporting information about capital movements, the projected cash flow statement may be produced consistently and quickly. This is predicated on having a valid balance sheet budget which may be another topic altogether.
   Although a vital part of any financial reporting, the cash flow statement is often of limited operational use since it does not provide much insight to support driver-based what-if analysis. As stated above, it is a mathematical reconciliation of the net income to the cash balance via the balance sheet, which already represents highly summarised data. Consequently, it does not show, for example, how much cash was collected from debtors or paid to creditors; rather, it shows the net movements of all invoices raised/received and cash received/paid. A significant increase in debtors could be positive news thanks to significant levels of invoicing new business or due to a poor collection record coupled with normal levels of invoicing – or, more likely, some combination of these types of factors. Consider the combination of these simple examples across all the working capital lines and multiple divisions, product lines, etc., and it’s easy to appreciate how difficult it can be to get much insight from a standard projected cash flow statement. However, this is not to say that it does not have real value in organizations where business is very similar year-on-year subject to relatively predictable variations where its simplicity can be a real asset.
    
3. Investors and financiers have very exacting demands for understanding the impact that market forces and management decisions have on cash. This brings us finally to what is probably the most demanding, complex, sophisticated, and arguably most useful form of cash forecasting model - the driver based or direct method. This is the type of cash forecasting model most often used and built by experienced, senior finance professionals typically using undocumented spreadsheets which are dependent on one person’s ownership – and this is often a single point of failure.
   
   The direct, driver-based method aims to model the generation of cash payments and receipts based on the income statement and capital expenditure projections of the business (line by line as appropriate). Drivers such as debtor days, creditor days, or local sales tax rates, may be flexed by territory, division, or line of business to gain insight as to the availability of cash for investments or requirements to postpone expenditure.
   
   Version management means that stress tests may be conducted to understand sensitivities with visibility of which areas of business require the most focus. Using these methods, operational management gains visibility of the effects of decisions and performance on cash as well as the bottom line. The balance sheet budgets and forecasts may be built up from projecting the cash effect of operations rather than the cash flow deriving from the balance sheet (but the standard cash flow statement will still be produced as a by-product).

How will cash flow be addressed in the future?

Technology is the enabler in delivering seamless cash flow forecasts and cash flow budgets that will feature:

• Effortless integrations between transactional and planning applications to facilitate near real-time updates such that forecasts are always based on the best quality data
• Secure, standard, trusted cash forecasting models for short, medium, and long-term projections in a single environment
• AI and machine learning will be able to identify and use previously unseen relationships across large data sets to produce automated benchmark cash flow forecasts and budgets
• Multiple what-if scenarios allowing flexing of key drivers to understand the risks and sensitivities

This will deliver better insight to the drivers of cash and could devolve the ownership and understanding of cash implications on business decisions from the center of the organization to other teams.

No plan exactly predicts reality, but the more we plan, the better we can respond to reality. The best cashflow forecasting models will give a strong indication of the direction of travel and highlight pinch points to allow corrective action to be taken in a timely, dynamic manner.