Cash flow forecasting involves the creation of a detailed listing of when cash receipts and cash expenditures should occur in the future. This information is needed to make fundraising and investment decisions. The cash flow forecast can be divided into two parts: near-term cash flows that are highly predictable (typically covering a one-month period) and medium-term cash flows that are largely based on revenues that have not yet occurred and supplier invoices that have not yet arrived. The first part of the forecast can be quite accurate, while the second part yields increasingly tenuous results after not much more than a month has passed. It is also possible to create a long-term cash forecast that is essentially a modified version of the company budget, though its utility is relatively low. In particular, there is an immediate decline in accuracy as soon as the medium-term forecast replaces the short-term forecast, since less reliable information is used in the medium-term forecast.
The short-term cash forecast is based on a detailed accumulation of information from a variety of sources within the company. The bulk of this information comes from the accounts receivable, accounts payable, and payroll records, though other significant sources are the treasurer (for financing activities), the CFO (for acquisitions information) and even the corporate secretary (for scheduled dividend payments). Since this forecast is based on detailed itemizations of cash inflows and outflows, it is sometimes called the receipts and disbursements method.
The medium-term cash forecast extends from the end of the short-term forecast through whatever time period is needed to develop investment and funding strategies. Typically, this means that the medium-term forecast begins one month into the future.
The components of the medium-term forecast are largely comprised of formulas, rather than the specific data inputs used for a short-term forecast. For example, if the sales manager were to contribute estimated revenue figures for each forecasting period, then the model could derive the following additional information:
- Cash paid for cost of goods sold items. Can be estimated as a percentage of sales, with a time lag based on the average supplier payment terms.
- Cash paid for payroll. Sales activity can be used to estimate changes in production headcount, which in turn can be used to derive payroll payments.
- Cash receipts from customers. A standard time lag between the billing date and payment date can be incorporated into the estimation of when cash will be received from customers.