Positive cash flow indicates that a company's liquid assets are increasing,

enabling it to settle debts, reinvest in its business, return money to

shareholders, pay expenses and provide a buffer against future financial
challenges. Companies with strong financial flexibility can take advantage of
profitable investments. They also fare better in downturns, by avoiding the
costs of financial distress.

Even profitable companies can fail if operating activities do not generate

enough cash to stay liquid. This can happen if profits are tied up in accounts
receivable and inventory, or if a company spends too much on capital
expenditure. Investors and creditors, therefore, want to know if the company
has enough cash and cash-equivalents to settle short-term liabilities. To see if
a company can meet its current liabilities with the cash it generates from
operations, analysts look at debt service coverage ratios.

But liquidity only tells us so much. A company might have lots of cash
because it is mortgaging its future growth potential by selling off its long-term
assets or taking on unsustainable levels of debt.

Free Cash Flow

To understand the true profitability of the business, analysts look at free cash
flow(FCF). It is a really useful measure of financial performance – that tells a
better story than net income — because it shows what money the company
has leftover to expand the business or return to shareholders, after paying
dividends, buying back stock or paying off debt.

Free cash flow = operating cash flow - capital expenditures - dividends

(though some companies don’t because dividends are viewed as
discretionary).

For a measure of the gross free cash flow generated by a firm, use unlevered
free cash flow. This is a company's cash flow before taking interest payments
into account and shows how much cash is available to the firm before taking
financial obligations into account. The difference between levered
and unlevered free cash flow shows if the business is overextended or
operating with a healthy amount of debt.

What is a Cash Flow Forecast?

Components of a Cash Flow Forecast
In its simplest form, a cash flow forecast will show you where your cash balances will
be at certain points in the future. This helps highlight when and where funding needs
arise and allows you to take advantage of times when excess liquidity is available. A
more comprehensive cash flow forecast will show you where your cash is right now,
where it’ll be in the future and what will happen along the way (e.g. classified cash
receipts and payments). Typically a cash forecast will contain some or all of the
following components:

• Opening Balance for the period;

• Receipts – broken down by cash flow item/ classification;
• Total Receipts;
• Payments – again broken down by cash flow item;
• Total Payments;
• Net Movement – either by individual cash flow item or at a minimum total net
movement.
• Closing balance for the period.

Broadly speaking, most cash forecasts will be structured as shown below. The image
below shows a cross section of 13 week cash flow forecast:

The cash flow items that make up the receipt and payment elements are unique to a
company’s forecasting needs. For example some companies would track high level
Accounts Payable / Accounts Receivable cash flows and other companies would
break the cash flows down to the level of individual customers and suppliers.

Actual Cash Flow Data

As well as capturing forecasted positions, cash flow forecasts often also capture
actual cash flows in the same model or template. In the example above left of the red
line indicates that the cash flows are actuals. The benefits of capturing actuals in a
cash forecasting process are:

1. It ensures that the projected cash flows are starting from the actual cash flow
position.

2. Historic cash flow data provides a good basis for making future projections.

3. Capturing actual cash flows means that you can compare what was forecasted to
what was actually received allowing you to analyse the accuracy of the previous
forecasts.

Types of Cash Flow Forecasts

When setting up a cash flow forecast the first decision that needs to be made is how
far into the future the forecast will look. This will be determined by business needs
and the availability of information within your organisation. Generally there is a trade-
off between availability of information and forecast duration. The longer the forecast
the less detailed the forecast is likely to be.

• Short term forecasts are used to manage the day-to-day cash needs of a business.
Typically they look a couple of weeks into the future and contain a daily breakdown
of cash payments and receipts. A daily forecasting process would often include a
degree of automation capturing cash flows from bank accounts and ERP systems.

• Medium term forecasts such as rolling 13 week cash flow forecasts are extremely
useful from a liquidity planning perspective. The 13 week period is important as it
gives a quarterly view for each submission.
• Longer term forecasts such as a 12 month forecast is often the starting point for a
budgeting process and is an important tool for assessing the cash required for longer
term growth strategies and capital projects. The benefits of a long term forecast need
to be balanced against the dependability of forecasts over a long period of time.

• Mixed period forecasts involve a combination of time periods. For example, a

forecast spanning six weeks in total could contain two weeks of a daily cash flows
and four weeks of weekly cash flows. This approach ensures detailed visibility where
it matters most. An example of a mixed period cash forecast is shown below. This
example covers a period of four months where cash flows are captured weekly in the
first two months and monthly thereafter.

In most companies forecasts are collected on a weekly or monthly basis from

business units. Forecasts can either be rolling or fixed term. A rolling cash flow
forecast extends with each new submission and a fixed term forecast counts down to
an end point such as quarter or year-end.

Summary
In summary, cash flow forecasts are the main tool used by companies for forward
liquidity planning. Their format and duration vary depending on the exact nature of
each businesses requirements. Finance teams structure their cash forecasts
depending on what makes sense for them and what is important for the Treasurer,
CFO and ultimately the CEO. A robust and accurate cash flow forecasting process,
where accountability is built in, is an indicator of strong fiscal discipline in a company.