The Cash-Flow Forecast

It is extremely important that cash receipts and payments are effectively planned and anticipated.

This has not been done in nearly all businesses that fail.

A good manager will plan that sufficient resources are available but that not too many resources are tied up.

This can be done in isolation but it is better done as part of the overall budgeting process.



Cash-Flow Forecast will yield many benefits

The preparation of a detailed Cash-Flow Forecast will yield many benefits.

Calculating and writing down the figures may suggest ideas as to how they can be improved.

For example,

• the figures for cash payments from trade debtors will be based on the estimate of the average number of days' credit that will be taken.
• This will pose the question of whether or not payments can be sped up.

Are the Cash-Flow Forecast results acceptable?

When the Cash-Flow Forecast is finished it will be necessary to consider if the results are acceptable.

• Even if resources are available the results might not be satisfactory, and improvements will have to be worked out.
• If sufficient resources are not available, either changes must be made or extra resources arranged.  Perhaps, an additional bank overdraft can be negotiated.

Either way, a well-planned document will help managers to take action in good time.


Best illustrated in a table format

The principles of a Cash-Flow Forecast are best illustrated with an example in a table format.

Variations in the layout are possible but a constant feature should be the running cash or overdraft balance.

Do not overlook contingencies and do not overlook the possibility of a peak figure within a period.

Free Cash Flow (FCF) = EBITDA - Capex

The net Free Cash Flow is free cash flow less interest and other financing costs and taxes.

In this approach, FCF is defined as EBITDA (earnings before depreciation, interest and taxes) less capital expenditures.

Capital expenditure encompass all capital spending, whether for maintenance or expansion and no changes in working capital are considered.

Information obtained through analysis of cash flow statement.

Through analysis of individual cashflows, investors and creditors can examine the following characteristics of a business:

1.  Whether financing is internally or externally generated.
2.  Whether the firm is able to cover all debt obligations.
3.  Whether the firm is able to afford expansion.
4.  Whether the firm is able to pay dividends.
5.  Whether the firm has financial flexibility.

Cash Flow Computation

Cash Flow Computation
The total cash flow for a period can be computed as:


Income from Operations (*see below)
+ Depreciation
- Taxes
- Capital Spending
- Increase in Working Capital
------------------------------
Total (Free) Cash Flow


Explanation:

Income from operations equals revenue minus costs and expenses and is the major source of cash.  

However, two adjustments must be made to get to actual cash inflow:

• Income from operations is before taxes are deducted, so taxes need to be subtracted here to get a corrected cash flow,
• Also, depreciation charges are included in income from operations but do not lower cash in the period, so depreciation is added back to get a corrected cash flow.

Finally, only changes (up or down) to the components of working capital (inventory, receivables, payables, etc.) in the period are part of computing cash flow.  If working capital has increased, cash is required this will need to be subtracted from total cash flow.

(Additional note:  The total cash flows used in an NPV (net present value) analysis should come from well-prepared proforma financial statements developed for the project.  The total project cash flows for a period can be computed as above.)

----

Income Statement

for the period x through y

Net Sales

- Cost of Goods Sold

-------------------------

Gross Profit

Sales & Marketing

Research & Development

General & Administrative

--------------------------

Operating Expenses

Gross Profit

- Operating Expenses

-------------------------

Income from Operations*

+ Net Interest income

- Income taxes

-------------------------

Net Income

How much should you pay for a business? Valuing a company (6)

Cash flows

When considering purchasing a company, another way to value the business is to examine what cash it will generate over a period of time.

• This can be in straight cash terms not taking into account inflation, price erosion etc. 
• You may also wish to apply discounted cash flow principles to arrive at a net present value (NPV) for the company, or 
• even an internal rate of return (IRR) on the purchase.
• 
  

Perhaps the most useful way to value it is to estimate the economic benefits that the business will generate in the next few years and then apply the NPV process to them. All valuations based on forecast figures are essentially educated guesses, but this analysis is likely to pinpoint the best opportunity for creating value, if the forecasts turn into reality.

Also read:

Valuing a company (1)

Valuing a company using Asset Value (2)

Valuing a company using Multipliers (3)

Valuing a company using Market Capitalisation (4)

Valuing a company using Non-Financial Measures & Balanced Scoreboard (5)

Valuing a company using Cash Flows (6)