There is no way to overemphasize the importance of cash flow forecasting in corporate finance. When executed well, a cash flow analysis will accurately predict your company's financial liquidity over the next three, six, or even twelve months. Peaks and valleys won't catch you off guard, you'll be in a better position to budget your funds, and you'll have a good idea of whether or not your projected income will cover your costs. In essence, forecasting your cash flow is the best way to gauge your company's financial health and to diagnose any potential ailments in the coming quarters.
While "cash" typically refers only to liquid assets, a cash flow forecast deals with overall treasury management, in particular, the subtraction of short-term debts from a combination of your liquid assets and short-term investments.
There are several methods of cash flow forecasting: direct and indirect. Examine each of them to determine the best fit for your company.
Direct cash flow forecasting
The direct method-also known as the Receipts and Disbursements method-is based on actual data which is comprised of receipts (sales to customers, sales of assets, etc.) and disbursements (accounts payable, payroll/labor, etc.). Because it's based on tangible numbers, the direct method cash flow forecasting method is most fitting for shorter-term forecasts, one week to one financial quarter. (And, in rare cases, up to one year.) For most companies, the direct method is the best option for internal evaluation.
Indirect cash flow forecasting
Of the indirect methods, the most common is the Adjusted Net Income (ANI). Often used for annual reports, the ANI method begins with a company's net income and then adds or subtracts non-cash income or expenses. These might include owner's salary and personal expenses, amortization, depreciation, and anticipated one-time expenses. After the additions and subtractions, the resultant number is your net cash projection from all operating activities.
The Pro Forma Balance Sheet method is another indirect cash flow forecasting tool. It differs from a traditional balance sheet only in that it predicts how your company will manage its assets in the coming quarters. In essence, a Pro Forma Balance Sheet will predict your company's financial future based on your current balance sheet. This method is a simple equation: projected total assets will equal projected liabilities plus projected equity. Both the Adjusted Net Income and Pro Forma Balance Sheet methods are most useful for middle-term projections, from 6-12 months to several years.
The final indirect cash flow forecasting method is the Accrual Reversal method, which incorporates elements of the direct (R&D) and the ANI methods. This method uses algorithms and statistical distribution models, rather than a projected balance sheet, to reverse large accruals. The Accrual Reversal method is best for medium-term forecasting. It's also the most complicated of these four methods, so tread lightly.
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