Chapter 14 - Cash Flow Forecasting Flashcards by Matthew Philipps

What is the goal of cash forecasting?

To optimize future cash resources by creating a reasonable snapshot of the projected cash position

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Short-term forecasting uses the XXXXXX method whereas long-term forecasting will use the XXXXXX method

Direct

Indirect (FP&A)

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Uses for Cash Flow Forecasts

(review)

Managing liquidity

Maximizing returns/minimizing interest costs

Controlling financial activities

Meeting strategic objectives

Budgeting capital

Managing currency exposure

Meeting compliance requirements

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Which firm would need to make sure they have a more accurate forecast, a net borrower or one with surplus cash?

Net borrower to ensure they are able to meet payments and comply with covenants

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Describe the importance of each of the issues/opportunities in cash forecasting
* Simplicity
* Collaboration and Communication
* Consistency

Simplicity – the forecast needs to have the appropriate level of detail
Collaboration and Communication – Treasury forecasts rely on input and communication from a variety of other teams
Consistency – the assumptions used, especially by those outside Treasury, should be consistent

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Three factors that influence the type of forecast to create

Purpose
Forecasting horizon
Frequency of updates

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Two Major Categories for Cash-Flow Forecasts

Predictive Forecasts – predict or project what will happen in the future

Analytical Forecasts – simulations, what-if questions

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Time Horizons for Forecasting
* Short-term Forecasting
* Medium-term Forecasting
* Long-term Forecasting

Short-term forecasting – 1 to 90 days
Medium-term forecasting – 3 to 12 months
Long-term forecasting – greater than one year

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Short-Term Forecasting Focuses

Receipts and disbursements

Cash transfers, disbursements

Short-term investing and borrowing decisions

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Medium-Term Forecasting Focuses

Integral part of cash budgeting

Determines the sources and uses of funds (short-term investments or credit line uses)

Serve as benchmark for performance through variance analysis

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Long-Term Forecasting Focuses

Long-term financing

Outlook for strategic planning

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The daily cash position is also known as the

Projected closing cash position statement

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How does the cash forecast process begin?

Identifying the cash flow components

Start broad and then become more specific

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Degree of Certainty for Cash Flows
* Known Cash Flows
* Predictable Cash Flows
* Less Predictable Cash Flows
* Volatile Cash Flows

Known Cash Flows – interest payments, tax payments, etc.

Predictable Cash Flows – cash or credit sales, A/P, payroll, etc.

Less Predictable Cash Flows – new product launch, unexpected repairs, insurance settlement, etc.

Volatile Cash Flows – sales dependent on weather, market variables may influence cash flows such as FX rate changes, interest rate changes, etc.

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Factors to Consider when Identifying and Organizing Cash Forecast Data

(review)

Available information

Assumptions

Desired type of forecast

Source of information

Bank account structure

Reporting requirements

Historical data

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Source Identification for Cash Forecasting is heavily influenced by what?

Degree of centralized reporting for an entity

Focus on as little free-form information as possible

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Steps of Selecting Forecast Method

Establish data relationships
Select a method
Test and validate relationships
Document the process
Using technology

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What is a key item to consider when looking to improve the cash forecast?

The cost benefit analysis of the additional time, investment, etc. and its expected impact on the forecast

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Three Methods for Testing/Validating/Refining Cash Forecasts

In-sample validation
Out-of-sample validation
Ongoing validation

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In-Sample Validation

(Forecasting)

Tested for accuracy using the historical data used to develop it

Typically no data available to compare when a forecast is initially developed

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Out-of-Sample Validation

(Forecasting)

Tested using data that was not used to develop it

Testing the forecast to see if it would be a good predictor for information not included to develop it

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Ongoing Validation

(Forecasting)

Continuing feedback from variance analysis

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A/R Balance Pattern Forecast (Short-Term Forecasting Method)

Specifies the percentage of credit sales during the time period that remain outstanding at the end of the current and subsequent periods

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What is an alternative to using the A/R Balance Pattern Forecast for forecasting?

DSO

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What is a way to further refine the DSO forecasting method?

Calculate actual DSO for significant customers and then use the average DSO for all others

Distribution Forecast (Short-Term Forecasting Method)

Uses historical patterns to allocate proportions of total cash flows over a certain period of time

What is one of the most widely used forecast methods for short-term cash flow forecasting?

The distribution forecast

How are the distribution percentages calculated for purposes of the distribution forecast?

Simple averages and regression analysis

What is a downfall of using simple averages?

There may be more factors at play that will impact the timing of certain cash flows

If simple averages may not be precise enough, what should be considered instead?

A regression analysis

Receipts and Disbursements Forecast & Components (Short-Term Forecasting Method)

**Core of short-term cash-flow forecasting** * Receipts Schedule * Disbursements Schedule * Completed Forecast

Completed Forecast

Utilizes receipts and disbursements schedule to determine minimum balance and corresponding surplus or deficit

The indirect method used for medium and long-term forecasts will require the development of what?

Pro forma financial statements

What is a common method that is used to construct pro-forma financial statements?

Percentage-of-sales method

Percentage-of-Sales Method

Projecting the income statement as a percentage of sales

Three Steps in Percentage-of-Sales Method

* Forecast the income statement and balance sheet * Calculate the projected ending cash balance * Compare the projected ending cash balance with the firm’s target cash balance and adjust the pro forma statement to show the source of funding for a cash shortfall or surplus

Sources-and-Uses-of-Cash Technique

Explains all differences in the balance sheet as a source or use of cash

Which forecast tenors can benefit from a statistical method of forecasting?

All of them

Time Series Forecasting

A serial chain of values for some variable using historical values Contains: * Trend * Seasonal pattern * Cyclical pattern * Random movement

Seasonal vs. Cyclical Patterns

Seasonal = within the year Cyclical = outside of the year

Simple Moving Average

Rolling average of past values Lag a trend Will tend to dampen or smoothing seasonality or other irregular events

If you have a larger number of data points for use in a moving average, what does this do to the trend and the seasonal impact?

It creates a larger margin for missing the trend Seasonality dampening is worsened

Smoothing Constant

Alpha symbol Weight assigned to most recent actual as opposed to the forecast

Exponential smoothing is developed using in-sample or out-of-sample forecasting approaches?

In-sample

If trends do exist in the data, will setting the alpha value closer or farther away from 1 result in a faster identification of the trend?

Setting the value closer to 1 because it puts a stronger weighting on actuals

Correlation

Degree of association between two variables

Regression Analysis

Statistical method that can be used to assess the impact of an independent variable on a dependent variable Analysis will then indicate how strong of a correlation there is between the two values

Intercept Point for Regression Analysis’ Forecast Equation represents what? What about the slope?

* Impact to cash when sales are $0 * $X in sales leads to a $X increase in cash

Exponential Smoothing | (Forecasting)

Produces a forecasted cash value based on the most recent actual value, most recent forecasted value, and a number between zero and one

Is correlation associated with exponential smoothing or regression analysis?

Regression analysis

Explain each of the following best practices when forecasting: * Use of appropriate detail * Disclose assumptions * Use the appropriate platform * Invest the appropriate amount of resources * Perform variance analysis * Cooperate and communicate * Ensure the forecast is usable

Use appropriate detail – forecast for appropriate currencies, accounts, etc. Disclose assumptions – keep record of all assumptions Use the appropriate platform – more predictable cash flows and forecasts require less effort and system involvement Invest the appropriate amount of resources – 5-minute daily forecast that is 90% accurate is sufficient for most Perform variance analysis – review both variances and incorporate feedback in future iterations Cooperate and communicate – clear expectations and common technology should be utilized Ensure the forecast is usable – must provide meaningful data and be able to be produced timely

Which items on the balance sheet can be projected as a percentage of sales?

Inventory A/R A/P

When creating an exponential smoothing forecast from a moving average forecast, make sure to cutoff actual data when?

Before the current period In other words, don’t include the current period’s actual when estimating that period’s forecast

What is the most important forecasting best practice?

Use appropriate detail

The appropriate amount of resources corresponds to what when it comes to covenant requirements?

If the margin is tight for going out of compliance, more emphasis on accuracy should be invested.

RPA | (Forecasting)

Robotic Process Automation

Collation and driving efficiency for forecasting is something that can be handled by what?

RPA

If a treasury department has access to a sophisticated forecasting system, should it be deployed?

Not always Cost-benefit analysis should be incorporated

What are the 5 steps a treasury professional should take when building a cash flow forecast?

1. Establish assumptions, including by leveraging historical information, if available 2. Estimate future cash inflows and outflows 3. Generate a pro forma cash position 4. Identify how to finance cash deficits or invest cash surpluses. The shortfall or surplus is measured relative to the predetermined, minimum desired target cash balance 5. Review the forecast against actual results, and revise the forecasting process as necessary

What is an advantage of using a regression analysis in a distribution forecast?

It can accurately predict changes in trend

Can regression analysis predict changes in trend?

Yes

Which two things need to be established at the start of a cash forecasting effort?

Clear expectations and common terminology

Which cash forecast tenor is an integral part of cash budgeting?

The medium-term forecast

When using a regression analysis, it will consider the historical relationship between sales and what?

Cash flows

Which is the bigger downfall for using a simple average forecasting method: not taking factors like holidays into account or always lagging any trend?

Holidays – the problem with taking a simple average is that actual payment posting dates may be influenced by more factors than the number of days after issuance

Simple Moving Average vs. Simple Average | (which one is statistical?)

Simple moving average is considered a statistical method of forecasting as it includes a rolling average

What is the most important motive for cash flow forecasting?

Managing liquidity