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Understanding Cash Flow Forecasting Methods: Short Term Vs. Long Term

30 November, 2022
5 min read
Valerio Trinchi, Treasury Growth Initiative
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What you'll learn

  • Long-term vs. short-term cash flow forecasting on the basis of techniques, time period, and advantages and disadvantages.
  • Importance of cash flow forecasting and best metrics for forecasting cash flow.
CONTENT
Short Term Forecasting
Long Term Forecasting
Frequently Asked Questions:
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Short Term Forecasting

Short term cash forecasting refers to planning and budgeting cash for a short period. The short period is less than a year, with a span of one to six months.

This includes:

  • Minimizing short-term debt, idle cash, and cash buffers. 
  • Optimizing short-term lending/borrowing decisions.
  • Planning adjustments for seasonal sales fluctuations.

What are the benefits of short term forecasting?

What insights could short term forecasting provide for your organization? 
The benefits are:

  • Reducing working capital costs:  Staying ahead of the curve by effectively managing the working capital by minimizing credit borrowed for funding operating expenses.

  • Short-term cash forecast for working capital management CTA

  • Measuring financial health:  Providing a fair analysis of the financial health of a company by determining the cash deficits or surpluses by tracking the cash flows.
  • Performing scenario analysis to take proactive measures: Stress testing what-if scenarios to proactively avoid scenarios such as bankruptcy and prepare for a recession.

What are the disadvantages of short term forecasting 

The pitfalls of short term forecasting include:

  • High upfront costs: Initial costs of leveraging technology are high, so cash-deficit companies often refrain from doing a regular forecast.
  • The complexity of Accounts Receivable and Accounts Payable:  Accounts receivable and accounts payable are hard to predict long-term because of the sheer volume of invoices, trade cycles, disputes, discounts, etc.
  • Requires accuracy at a granular level: Minor errors in data increase the variance in the forecast. If there are errors in the underlying data, it creates variance in the forecast at a higher level.
  • Delayed decisions due to delayed collaboration: Time required for gathering data from different sources like banks, TMS, etc., and different teams like AR, AP, etc., result in delayed decision-making.

Which technique is used for short term forecasting?

Depending on the budget and complexity of data of a company, and the motive of their cash forecasts, various methods could be used in areas of businesses for their preferred purposes. The typical short term forecasting methods are as follows:

Short-term cash forecasting method

However, these three methods cause multiple challenges for small to medium-sized businesses.

Common short-term forecasting roadblocks CTA

Long Term Forecasting

Long-term forecasting is done for a period ranging from six months to five years

This includes:

  • A bird’s eye view of a firm’s financial needs.
  • Availability of investible surplus in the future. 

What are the benefits of long term forecasting?

Long term forecasting helps in avoiding last-minute hurdles. The advantages are:

  • Multiplying gains by maintaining cash reserves: Planning outlays on capital expenditure projects in advance helps in staying economically secure. Taking action toward FP&A goals increases profitability.
  • Evaluating variances to track performance: Understanding variances in forecasts and digging into the focal point of error to make corrections and mitigate risks.
  • Better asset management: Reviewing the quality, update, or replacement dates of assets lets you save for new acquisitions and find buyers for depreciating assets. 
  • Best practices for long-term cash forecasting CTA

  • Orderly deleveraging and leveraging: Eliminating the need to maintain a higher cash buffer saves interest costs.

What are the disadvantages of long term forecasting?

As the duration of the forecast increases, the accuracy decreases. Here are some disadvantages of long-term forecasting:

  • Siloed data on excel serve as bottlenecks: Data crunching and consolidation into a single master sheet from various excel sheets is labor-intensive and reduces visibility. 
  • Unpredictable nature of the economy: Due to unforeseen economic downturns, there is always a need for more reliability in long-term forecasts.
  • Lack of historical information: This might create havoc for businesses that don’t have sufficient historical data. If the projections fall short, the firm can suffer monetary repercussions.
  • Lack of the right set of technologies: Ideal forecast development boils down to selecting the best-fit forecasting method, but it’s difficult to choose the most suitable technology for your business.

Which technique is used for long term forecasting?

Generally, the adjusted net income method is used for creating long term forecasts. The data required for preparing the adjusted net income forecast is acquired from the corporate budgets. The net income method monitors working capital changes and foretells financial requirements. The major downside to this method is that it does not allow tracing individual cash flows despite it being a great tool in the arsenal for showing the aggregate impact of fund flows.

Frequently Asked Questions:

What is cash flow forecasting? 

Cash Flow Forecasting measures an organization’s future financial position and determines its cash flow position. Cash forecasting is important for making informed decisions for investing and borrowing. It helps in handling a company’s capital structure, financial and interest rate risks, and making adjustments to the budget.

What are the best metrics for forecasting cash flow?

Using data from accounting statements, these metrics should be monitored regularly:

  • Debt-to-equity ratio: Total liabilities / Shareholder’s equity = Debt-to-equity. The debt-to-equity ratio determines a company’s vulnerability to market changes. Liabilities should be less than equity.
  • Days Sales Outstanding (DSO): It’s the average number of days to collect receivables. A shorter DSO ensures better liquidity.
  • Days Payables Outstanding (DPO):  It’s the average number of days to pay the suppliers. DSO should always be shorter than DPO, which ensures enough money in hand to pay bills.
  • Days of Inventory Outstanding (DIO): It’s the rate at which the inventory turns over. A shorter DIO makes a positive impact on working capital.

What are the best practices for cash flow forecasting?

Treasurers should focus on both short term and long term forecasting to offset potential losses. While short-term cash forecasting projects when money is going to hit your bank account, long-term forecasts support plans for expansion and hedge maturities.

Suitable variables must be used for forecasting. Selecting the correlated variables and finding the right model for performing the forecast offers better results. 

Do’s and Don’ts for Short-Term and Long-Term Cash Forecasting CTA

Why is a cash flow forecast important?

Cash flow forecasting is especially important for companies’ growth because it influences strategic financial and investment choices that alter the company’s course and boost earnings. Cash flow forecasting equips a corporation to operate without financial constraints and offers a path toward accomplishing both short-term and long-term corporate goals.

What are the best tools for cash flow forecasting?

Cloud computing is a win-win solution for forecasting since all the data are stored in one place. It eliminates the need for manual data aggregation and consolidation, thus minimizing the scope for errors. 

Statistics of lack of automation tools as a challenge for forecasting

Automation serves as the right hand of the CFO. The presence of RPA, ML, and AI increases the accuracy of the forecasts, hence saving time for value-added activities. Appropriate models provide great assistance when there is a surge in complexity. This increases confidence and makes decision-making and reporting coherent.

Roadmap to get started with cash forecasting CTA

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