Forecast Cash Flows

What is “Forecast Cash Flows”?

Forecasting cash flows is a component of financial forecasting, which helps to complete the 3-financial statement modeling process. This element includes linking up part of the balance sheet and income statement so that forecasting lines such as interest, cash, and debt are consistent throughout the model. It can be a tricky part of the modeling process but once completed (and checked), it can enable analysts to model forecasts and quantify the ongoing performance as transparently and easily as possible. 

To forecast cash flows for the projected period, for example, from period 1 to period 10, analysts need to first forecast the income statement and the balance sheet based on assumptions. The forecast cash flows will include items from both these statements.  

Steps to Produce Cash Flow Statement

The forecasting process works best when used in a step-by-step sequence. Here is a reminder of the 3-statement financial forecast model as there are certain steps to be followed. 

• Input historical data for the income statement and balance sheet 
• Calculate ratios and statistics 
• Decide on forecast assumptions pertaining to the balance sheet and income statement 
• Build the forecast income statement – except for interest 
• Build the forecast balance sheet – except for cash revolver and debt 
• Build the cash flow statement using the rules of cash into the balance sheet from the cash flow statement 
• Build the debt and interest calculations, plug revolver and long-term debt into the balance sheet 
• Link the interest into the income statement 
• Deal with any circular reference

The key to remember with the cash flow forecasts is that they must represent any movements in the balance sheet over the time period. The cash flow must also reflect any incoming or outgoing payments on the income statement. It essentially links up these two statements and provides analysts with details of where cash is moving throughout the time frame.

This is particularly useful if a company, for example, has a large tranche of debt and it may be planning to make significant interest and capital repayments. It is also useful to see how much cash a company is making each year (or the time period being analyzed), and from what type of activity. These are important as relatively small adjustments in annual forecast debt obligations can have a larger cumulative impact on the company’s overall debt position over the time frame of the model. 

To see where the cash is moving analysts must first categorize the balance sheet line items into operating, investing, and financing flows. Some entries such as PPE, intangibles, and retained earnings will require a BASE analysis as they are “double category” items.  

Using the rules of cash, analysts can then include the change in balance sheet line items into the relevant cash flow category, and do BASE analysis where needed.  After completing this, analysts should reconcile the net cash flow to balance sheet cash (beginning cash +net flow cash = ending cash). Once this is done, there should be a working 3-statement financial forecasting model.

Forecast Cash Flow – Example

Given below is an example of a cash flow statement forecast of Company A – for the projected years 1 to 10. (This is a model which will forecast 10 years of future performance of the company.) Hopefully, this will help demonstrate how the movement in the balance sheet and income statement items (based on forecast assumptions) will impact cash flows and related forecasts for the projected period (period 1 to 10). 

Once the income statement and balance sheet forecasts are completed, we can look to see the movement reflected in the cash flow projections. As usual, analysts must link up year 1 fully before copying the links across the model. This will help avoid any mistakes appearing in the many links and formulas used. 

Looking at it line-by-line we can make sure it is linked to the correct data point: 

Operating Cash Flow

Firstly, net income projections are taken from the income statement (and linked to the appropriate time period). The next item, D&A is a cost in the income statement. As depreciation & amortization is a non-cash item we need to add it back on the cash flow (unlike on the income statement when it was a cost). So it is linked as a positive figure here. It causes the P&PE to go down (as the assets depreciate and are amortized) and cash to go up (as it isn’t considered a cash cost so it increases the net income). 

It’s very important during this process to carefully check which items are cash inflows and outflows as it can distort the model if incorrect.

Financing Cash Flow

Next, we can look at the change in the operating working capital (‘Change in OWC’). There is an inverse relationship here: If inventory has gone up (down), the cash must go down (up). Capex is given on the balance sheet and represents the spending on the infrastructure and services within the business. Capex will increase the PP&E (on the balance sheet as e.g. factories production lines are improved etc) yet cash goes down on the cash flow statement as it is an expenditure. 

Dividends paid will reduce retained earnings (as the payments are made to investors) and therefore the cash will go down. 

Next, with reference to the debt revolver, if it has gone down, then the company has paid off some of its debt. Therefore, the cash goes down (and debt too). When forecasting debt repayments this can be done annually, as well as in lump-sum stages. Company details may show that a tranche of debt is due for repayment in 5 years, and therefore a good model will have this calculated and factored in.

Calculating Net Cash Flow

Net cash flow is the sum of the company’s operating, investing, and financing items for each of the projected years (i.e. operating cash flow + investing cash flow + financing cash flow). But obviously, this is not the only cash in the business. A company typically has cash at the beginning of the year to enable it to operate. We need to add the net cash flow each year to the beginning cash and cash equivalents, to arrive at the ending cash and cash equivalents (at the end of the period). This must be done for each of the projected years.  These figures should equal the cash and cash equivalents in the balance sheet for each of the projected years.

Completing and Checking

Once all the components of the cash flow forecasts are successfully inputted, it is a good time to make sure there aren’t any unwanted circular references in the model. Hopefully, the balance sheet will continue to ‘balance’. If it doesn’t the links will need to be carefully checked until this is resolved. (Tip: this can be due to a wrongly inputted cash inflow or outflow so check which is being used in the formula). 

Conclusion

Finally, the modeler can start to see the full impact of the assumptions and forecasts made earlier across all three financial statements. Tweaks and adjustments can be made to the forecasts to see the potential impact across the financial statements. This is very helpful to see what a small rise in e.g. revenues, or costs, or a debt repayment program can do to the company’s cash flow and profitability. It is also useful to see if a company can afford to fund future plans such as large debt repayment, capex program, or dividend payment. 

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