Source of Uncertainty in Cash Forecasting

Accurate cash flow forecasting hinges on the forecaster’s ability to reduce the amount if observed error between forecast values and actual values that have occurred. Given the short-run nature of the cash forecast, with most things occurring in the near future, one would tent to think that most financial transaction could be forecast very accurately. This is far from true.

 

In practice few firms, if any are able to forecast their inflows and outflows accurately. Sales forecasts are notoriously unreliable, for actual sales depend in part upon factors that lie outside the control of the firm. Changes in the marketing of competitive products, as well as changes in general economic conditions, can lead to large forecasting errors.

 

We may further note that any errors in sales forecasts have multiple impacts on the firm’s cash flows; they impact on receivable levels (and therefore collections) and also on production expenses (and therefore disbursements).

 

Issues and Approaches to Forecasting -3

We are talking Issues and Approaches to Forecasting. An useful forecasting method is to analyze the historical payment patterns to determine the proportion of credit sales that are collected at various times after the date of sale, and then to use this information (along with the estimates of future sales) to project future receipts. We may, however, adopt a better and a more sophisticated approach.

 

In this, all collection rates are estimated simultaneously by regressing past sales figures against past collections. The estimated coefficients of the sales figures in the regression can be interpreted as the collection proportions, and the standard errors of the estimated regression coefficient as the uncertainty inherent in the estimation of these collection proportions.

 

In a situation where the firm is in multiple business lines, the use of overall payment patterns to forecast receipts will be accurate only when the proportions of total sales made in each business lines are constant. This is an unlikely situation, particularly since the different lines usually have different seasonal variations. In such a multiple situation, the most accurate forecasting result is achieved by forecasting receipts for the different units of the firm individually based on their own receipt patterns, then summing these receipts forecasts to obtain total cash receipts for the firm.

 

Issues and Approaches to Forecasting -2

We are talking Issues and Approaches to Forecasting from last two posts. There are four techniques for forecasting financial variables. Diret Method, Proportion of another Account, Compounded Growth, Multiple Dependencies. We talk on all of the above four techniques for forecasting financial variables.

 

Since cash forecast deal mostly with the near future, many of the items on the cash forecast are usually estimated by some variation of the post method. The bases of these spot estimated are usually the firm’s other financial plans. Remaining estimates are mostly on a ‘proportion of another account’ basis, the account often being particular period’s sales. The other two methods are employed less frequently.  

 

It is a common experience that forecast of disbursements is much easier than receipts, because the cash manager can rely on internal information and knowledge of payment knowledge of firm’s other plans (or budgets) and can make use of the forecasting techniques described above. However, a major challenge for him comes in estimating the receipts from the collection of the firm’s receivables. In this regard, an useful forecasting method is to analyze the historical payment patterns to determine the proportion of credit sales that are collected at various times after the date of sale, and then to use this information (along with the estimates of future sales) to project future receipts.