While financially healthy companies are focused on things like strategic direction, return on assets and long-term growth, those in or close to financial distress have different concerns. How will the next payroll be made? Which suppliers will have to wait to be paid? Can the factory remain open next week? When a company is financially stable, management is able to take a medium- to long-term view, but those running weaker companies must focus on the near term. One of the most important tools for management that finds itself in this unfortunate situation is the short-term cash forecast.

Usually covering a time period of 60 to 120 days, a short-term cash forecast is based on cash receipts and disbursements. Unlike a GAAP-based statement of cash flows, which starts with net income/loss and then adjusts for non-cash items (such as depreciation and amortization) and non-income statement items (such as capital expenditures, working capital changes and financing), a short-term cash forecast is much more direct, reflecting cash coming in and cash going out. Another difference between shorter-term forecasts and GAAP-based and longer-term forecasts is in the period measured. Longer-term outlooks can be annual, quarterly or perhaps monthly; the shorter ones reflect daily or weekly periods.

Figure 1 shows an example of a short-term cash flow forecast for a two-week period. As can be seen in this simplified example, major categories of receipts and disbursements are classified separately, and the cash balance is rolled forward through the forecast. Using a greater number of line items in the forecast allows different forecasting methodologies to be used for different items and also provides a better basis for tracking variances against forecasts. Companies that are fortunate enough to have in place a revolving credit facility with borrowing availability would incorporate this into the forecast (by rolling availability forward rather than cash balance). Following is a discussion of the more important considerations in forecasting each of the major categories.

Customer Collections

The primary source of cash in any business is collections from the sale of goods or services. This line item also happens to be the most difficult one to predict, as it is not under management's control the way that many disbursements are. Methodologies for forecasting customer receipts vary greatly and are primarily dictated by the nature of the business. Companies with a few large customers, such as aerospace suppliers and large contractors, generally have well-defined payment dates and amounts based on contractual terms. These can be forecast by individual payment, and customer relationship personnel play a large part in deriving these forecasts. However, most companies receive a higher volume of collections, such as retailers that might have hundreds of thousands of daily cash and credit card transactions at dozens of stores, or manufacturers that receive checks in single or multiple lockboxes.

The better methodologies for forecasting collections in "cash businesses" (e.g., restaurants and retailers) are statistical in nature, as the volume of receipts lends itself to such analysis. For example, assume that a retailer collected $1,000 during the third week of November last year. It has 5 percent more stores open this year, and same-store sales have been running down 10 percent. A reasonable forecast for the third week of November this year might be $945 ($1,000 x 105% x 90%).

When using methodologies like this, one must consider calendar differences such as where holidays fall this year compared with the prior year and events in either year that won't likely be repeated, like a major snowstorm, blackout or launch of a hot new product. Daily forecasts can be even trickier, but statistical analysis can help. For example, restaurants will track customer counts by day of the week, so a forecast for a Friday of a particular week will likely be higher than one for a Tuesday of the same week. In many businesses, both "cash"- and "credit"-oriented, Monday is the strongest collection day of the week because it will include cash receipts or check collections from the weekend as well.

Businesses that provide credit terms to their customers can use the benefit of hindsight in preparing their short-term receipts forecasts. For example, if customers pay on average 60 days after sale, November's collections will approximate actual sales in September (after adjustment for returns, discounts and allowances, bad debts, etc.). Of course, the farther out the forecast goes and the shorter the credit terms are, the more difficult this type of methodology becomes. To illustrate this, assume that customers generally make payments within 30 days, and a 90-day forecast is being prepared. Hindsight will help only for the first third of the forecast. Other methods would be required for the latter 60-day period, generally related to sales volume trends.

Other Receipts

Receipts other than customer payments also need to be considered in a cash forecast. These tend to be irregular in timing and amount and relate to items such as tax refunds, insurance settlements and asset sales. Other receipts are best forecast on a specific item-by-item basis.

Cash Disbursements

In certain respects, forecasting cash disbursements is easier than forecasting cash receipts because a company itself controls its payments, whereas it doesn't control its collections. Companies with limited liquidity, however, tend to budget their disbursements on the basis of their receipts (i.e., what goes out must come in first). These companies usually forecast (and actually maintain) a minimum amount of liquidity, and all receipts are used to satisfy outstanding payables. Therefore, accurately forecasting disbursements is possible only when receipts can be forecast accurately.

Payroll

Payroll is generally one of the easiest types of disbursements to forecast and one of the most important types to make timely. Its predictability comes from the fact that it is on a fixed schedule and is determined by formula based on salary/wage rates and headcount. Its importance is obvious: Few non-owner employees would tolerate the extension of credit to their employers, even for a single day. All short-term forecasts will include a separate line item for payroll and related expenses (FICA matching, insurance and other benefits).

"Fixed Charges"

Fixed charges include regularly scheduled repeating payments. The most common examples are rent, lease payments, and principal/interest on debt obligations. Like payroll, these are relatively easy to forecast due to their "fixed" nature. It is also important that these be paid timely, because of the potential ramifications of being late (eviction, foreclosure, default, etc.), although with certain of these items there is somewhat more leeway than with payroll.

Accounts Payable

Most other payments can be classified in the general category of accounts payable. These will typically include payments for goods and services related to costs of the product produced, selling, general and administrative (SG&A) expenses, and capital expenditures. Forecasting accounts payable disbursements is more difficult than forecasting the more regular payroll and fixed-charge payments, and several methods can be employed in doing so.

Companies with tight liquidity are often behind in their payments to suppliers, so all funds remaining after forecasting payroll and fixed-charge payments are allocated to accounts payable. Projecting on the basis of "funds left over" produces an accurate, but not particularly meaningful, forecast. Such forecasts are accurate with respect to cash balances, because the balances are typically shown at or near zero‹and the actual balances tend to be in this same range. However, forecasting on this basis does not show the true liquidity picture, since the accounts-payable balance and aging could change because the payments made are not correlated to the actual payments due. Although the cash balance might stay relatively stable (close to zero), a growing payable balance or deteriorating aging would signal weakening liquidity. Forecasting the accounts payable balance and incorporating the information into the short-term cash forecast as a memo item is one way to manage this issue when preparing a forecast. However, forecasting the accounts payable balance tends to be a difficult task, because increases in the balances are related to production levels, material costs, timing of bills received and other factors that are sometimes hard to predict.

An alternative approach to forecasting accounts-payable disbursements is to reflect the payments when due (or at the latest point to which they can be reasonably extended). Two benefits of using this approach are that (1) it requires a detailed review and analysis of outstanding payables and (2) the cash balance is not pegged at zero, so it reflects true liquidity (or deficit when the balance goes below zero). Much like the example above, where cash receipts come within 30 days and a forecast extends out 90 days, this methodology becomes more difficult when making longer-term forecasts. The exact payables due in the 60- to 90-day timeframe may not be known to a company when it is preparing the forecast, so it must incorporate a methodology related to activity level.

In preparing or analyzing a cash forecast, it is important to remember the distinction between "book" balances and "bank" balances. When a check is written, the "book" cash balance goes down immediately, but the "bank" cash balance is not reduced until the check clears the issuing bank. Most companies, particularly those with limited liquidity, are more concerned with bank balances and manage their cash accordingly to get the benefit of the outstanding check "float." As can be seen in Figure 1, check clearings are kept separate from wire transfers, and checks issued are shown as a memo item. When this is done, the bank balance gets tracked rather than the book balance. Wire transfers reduce the balance immediately, while checks issued are reflected as "checks cleared" and reduce the balance several days later. A good forecast will make this distinction. However, for conservatism (or simplicity), some forecasts are kept on a "book" basis with respect to disbursements. Similar consideration must be given to cash receipts, as checks received do not usually turn into available funds for several days.

Summary

As with any type of financial projection, the more detailed the analysis, the better. More meaningful and accurate forecasts tend to be "bottom up" and based on actual payments and receipts due, whenever possible, and they show a larger number of distinct line items. Where estimates need to be made, they should be done on the basis of a statistical method, generally involving historical analysis, modified for current conditions. And the distinction between "bank" and "book" balances must always be considered.

When prepared well, the short-term cash forecast can be one of the most useful tools for financial management of a company in distress. It can also be a valuable source of information to lenders and others who are evaluating such companies. Users of cash forecasts should give due consideration to all of the factors discussed above to assess the quality of a particular forecast before relying on it to make important decisions.