Cash flow modeling is an analytic tool that accountants use to make informed projections about a business's future cash flow. It incorporates various inputs, including historical financial data and differing business scenarios to calculate likely cash flow in the future.
Businesses make projections for a number of things, including cash.
Cash flow is an important metric for cash currency that a business generates during an accounting period. It does not represent profit or loss, the business’s net worth, or its value. Instead, cash flow is a “net quantity.” It accounts for cash coming into the business after subtracting the value of money going out.
Like forecasting for other aspects of the business, projecting cash flow helps managers make informed decisions and develop forward-looking plans. Cash flow is an important metric of a business's liquid assets or liquidity.
Making reasonable projections of how much cash flow a business will generate helps managers make an assessment about future liquidity, which supports the development of sound strategies for investments, purchasing, salaries, and other essential functions of operation.
Cash flow modeling is a tool that managers use to make these projections. Modeling is an analytical process that employs statistical and other data analysis tools to make projections about how the business will perform in the future.
Forecasts can be made about a number of different functions of the business. Cash flow modeling is one such method that specifically analyzes and makes projections about how cash is likely to move into and out of the business in the future.
Cash flow modeling considers the three basic types of cash flow that can be measured for a business:
Operating Activities and Cash Flow Drivers - Accountants identify operating activities and key cash flow drivers by assessing the amount of money a company brings in from its ongoing, regular business activities.
Cash flow from these activities represents the generation of cash from the business's core business behavior.
These might include manufacturing and selling goods or providing a service to customers, depending on the nature of the business.
Investing Cash Flow Forecast - Secondly, accountants make an investing cash flow forecast. All businesses apply cash to long-term goals. These investments come in many forms, also depending on the nature of the business. Investments include stocks or securities, but may also include purchases of equipment, property or facilities. The investment of cash in these assets is intended to bring the business future returns in the form of greater production, growth of the business, and profit from sales.
Financing Cash Flow Forecast - Finally, accountants calculate a financing cash flow forecast. All businesses engage in financing of some sort. Publicly traded companies sell stocks and pay dividends to investors.
They also issue debt in the form of bonds or notes, or take loans from banks, to raise funds. The net proceeds from paying out and receiving these financing instruments is calculated as financing cash flow, and forecasting models will calculate the projected cash flow from these transactions in the future.
Accountants can take several steps to ensure reliable and accurate cash flow modeling:
The first step is to gather the relevant financial data. Income statements, balance sheets, and especially the cash flow statement, will provide the necessary data to input into the cash flow model.
With data in hand, the analysis must identify cash flow categories. As noted earlier, cash flow is typically divided into the three main categories of operating activities, investing activities, and financing activities.
To calculate operating cash flows, analysts sum up all cash flows stemming from the day-to-day operations of the business. These are the core activities of the business, such as sales, production and services, and the calculation considers all revenue and expenses related to these activities.
The second step in the cash flow model is to analyze investing cash flows. This includes the net cash flows related to the acquiring of assets such as property, equipment, and securities. It is calculated as cash inflow from investing (such as the proceeds from the sale of property, equipment or investments) minus cash outflow for the same (i.e., the purchase of property, equipment or investments).
Thirdly, cash flow models assess financing cash flows. This represents the net cash flow from financing activities such as loans, equity financing, and dividends.
Cash flow models must also account for non-cash items. These include such calculations as depreciation and amortization of property and equipment purchased by the business, stock compensation, deferred taxes, and unrealized gains and losses.
With all this information entered, the model can project future cash flows. The model will use the historical data gathered to forecast future cash flows for each of the three categories.
Cash flow forecasting models must also incorporate assumptions and scenarios to account for variability, uncertainty and unplanned events.
After the cash flow forecasts have been made, accountants will prepare model cash flow statements. These statements will incorporate the projected cash flows for each category over the desired time period.
All statements must undergo thorough validation and review to ensure accuracy. Comparing projected cash flows to actual historical data can highlight discrepancies and errors and supports adjustments as necessary.
Accountants must also perform a sensitivity analysis to assess the impact of changes in key variables on cash flow projections. This ensures the accuracy of the projections and the resilience of the models.
To support future modeling and corrections, accountants should also document all assumptions and methodology. Documentation creates transparency in the modeling process and allows for easier reproduction of forecast modeling in future reporting periods.
No model is static. To ensure accuracy and relevance, accountants should regularly update the data. Updating the financial information that is inputted and revising projections based on changing business conditions will ensure that the models generate reliable and accurate forecasts.
Finally, accountants should review and refine their model. Periodically reviewing and refining the cash flow model will ensure that it remains accurate and relevant to the business's financial needs and objectives.
Cash flow modeling should not be confused with a cash flow statement model. While the two are similar in that they both examine cash flow, they are distinct in their goals and their methods.
Cash flow model, or cash flow statement, is one of many financial statements produced by a business. The cash flow statement measures the net flow of cash into and out of the business for a particular reporting period. The information that is gathered to create the cash flow statement is historical. It is for a preceding accounting period, either monthly, quarterly or yearly. It follows a structured format and is used for financial reporting and compliance.
On the other hand, cash flow modeling is a forward-looking analysis. It is used to calculate a projection of cash in the future. It employs different assumptions and scenarios to project different outcomes, and it is used in decision-making, strategic planning and assessing the value of the business.
How a business employs a cash flow model will determine its results.
Effective implementation will lead to models that provide relevant information for the business.
Analysts should first choose the right model for the business. This will depend on several factors, including the nature of the business, its goals and objectives, timelines and complexity. A more complex business may require a more detailed modeling approach.
There are also various ways to calculate cash flow, including direct, indirect, and discounted cash flow methods. Which of these methods i incorporated into the model will depend on the nature of the business and the factors that affect its cash flow.
Effective data collection and analysis is also essential to effective cash flow modeling. Choosing the appropriate parameters for historical data and performing the right analysis will lead to more accurate projections.
Identifying the drivers that affect cash flow in the business will also help determine which data should be gathered. There are also various methods of statistical analysis that can be employed. Choosing the right method will improve the accuracy of the model.
No model is perfect and continuous monitoring and adjustment ensures that models are up-to-date, accurate and reliable. Analysts should consistently update historical data, revisit and correct assumptions if necessary, and be prepared to add new information to the model to make sure it is accurate and reflective of changing circumstances.
Cash flow modeling has its challenges, and accountants should be prepared to address those challenges to ensure that their models are effective.
Depending on the nature of the business, models should account for seasonal variations. Weather, industry cycles and consumer spending patterns can all impact cash flow.
Businesses should also attempt to plan for unexpected expenses, such as equipment malfunctions, damage from extreme weather events, legal disputes, fines and penalties, and changes in consumer behavior. Incorporating these scenarios into the cash flow modeling will result in more reliable projections.
Businesses must also manage debt and interest payments on loans, bonds, lines of credit and other forms of financial obligation. These payments impact cash flow and forecasting models must include these payments to be entirely accurate. Payment schedules and changing interest rates, for example, can impact cash flow in the future.
Like so many processes in business accounting, digital automation is having an impact on cash flow modeling. Managers are increasingly turning to automation, like Blackline's Accounts receivable automation, because of the many advantages it gives them.
Digital automation can eliminate much of the tedious and time-consuming, manual gathering and inputting data, leading to a more accurate, streamlined and efficient process. Digital applications can process complex scenarios with less effort than manual approaches.
Automation also leads to more timely entry of data, allowing for real-time modeling that is efficient and accurate. Finally, automated cash flow modeling is more easily integrated with other systems and can be easily scaled as the business expands, making its accounting practices and projections more versatility and adaptable to changing circumstances.
It is important that cash flow models remain accurate. How often they are updated will depend on a number of factors, including the duration of cycles impacting the business, market conditions, regulatory requirements, consolidations, acquisitions and the introduction of new products to the market. Typically, businesses update their models monthly, quarterly or annually, depending on the totality of these conditions.
Cash flow modeling, like all sorts of forecasting, cannot predict every crisis that may occur. By considering different scenarios, providing leaders with an opportunity to examine the health of the business, and informing good decision-making, it can help the business better prepare for these types of occurrences.
Cash flow modeling and traditional budgeting have similarities, but they are significantly different in their approach and their objectives.
Traditional budgeting is a more broadly focused exercise. It looks at income and expenses and is aimed at minimizing costs and maximizing profits over a set period of time, usually one year. The budget is a static document that does not change until the next budget is produced.
In contrast, cash flow modeling is specifically focused on making projections for a specific aspect of a business's finances -- cash flow – at a point in the future. Its aim is to identify the key drivers of cash flow and to project how they will perform depending on various factors. It is a dynamic analysis that is often changed and updated to reflect changing circumstances and information.