 Managers are tempted to focus on earnings

 Earnings can’t be spent

 We must unravel all the effects of accrual
accounting.
 Or we can start with cash flows in the first
place and avoid the confusing effects of
accounting.
 Long range forecasts
 Medium range forecasts
 Daily cash forecasts
 Interest costs and income
 Excess balances
 Administrative costs benefits
 Control
 forecast system costs
 Financial forecasting is the estimation of the
future level of a financial variable, often a
cash flow , asset level or liability level. It is
usually assumed that the relationship
between the financial variable and other
variable is linear.
 There are four common approaches to
forecasting financial variables. But they are all
special cases of general linear model.
 Spot method
 Proportion of another account
 Compounded growth
 Multiple dependencies
 The firms cash disbursements are generally
forecast in a straight forward fashion using
the firms using the firms other plans
and combination of the forecasting methods
described previously.
The biggest challenge for the analysist
comes in estimating the receipt from the
collection of the firms receivables.
 Two major decisions to be made
 Forecasting methodology
 Degree of aggregation
 Turnover method
 Payment pattern method
 The second issue that must be addressed is
the level of aggregation
 The cumulative surpluses and required
borrowings for the firm is the important
result of a cash forecast. This estimate of
available funds for investment and needed
financing enables the firm to plan so as to
obtain the most advantageous borrowing
terms for deficits and achieve the greatest
interest income on surplus.
 Forecasters typically use scheduling for daily
forecasts, especially for short horizons.
 For most companies doing daily forecasting
the immediate days flow are gathered from
balance reporting systems.
 The shorter the horizon the more detail
shown in the cash forecast. Variances are
calculated .
 Some companies find it fruitful to prepare
their cash flow statement with separate
subtotals for operating financing and
investing cash inflows.
 Given to the short run nature of the cash
forecast with most things occurring in the
near future and forecast period being one
year one tends to think that most financial
transactions could be forecasted very
accurately.
 But actually there are numerous sources of
risk.
 Sales uncertainty
 Collection rate uncertainty
 Production cost uncertainty
 Capital outflow uncertainty
 There are two basic approaches in
assessment of risk in cash forecasting
 Sensitivity analysis of the cash forecast
 Simulation analysis of cash forecast
 We can change the input variable and observe
the changes in output variable.
 This kind of analysis provides very useful
information about the amount of possible
surpluses and deficits in various future
periods.
 Even though sensitivity analysis gives useful
information it is generally overall variation
from the means from the monthly cash
deficits and surpluses that concerns the
management the most.
 The information on probability distribution of
surpluses and deficits are necessary .
 To get these methods of simulation analysis
is done.
 First probability distribution for each of the
major uncertain variables are developed.
 Then a large number of trials are run.
 From these trial results frequency
histogrammes of the important outcome
variables would be developed and these
compared to know probability distribution
via goodness of fit method.
 Without some kind of hedge against the
uncertainties of the future cash flows the firm
incurs costs that could be avoided by the use
of a hedging strategy.
 holding a stock of extra cash
 Holding a stock of near cash assets
 Extra borrowing capacities
 Investing temporary surpluses in near cash
assets
 Like the holding of cash balances and near
cash assets, futures and options can hedge
the interest rate risk inherent in the
temporary investment of short term funds
where unexpected future needs for these
funds can cause premature liquidation of the
temporary investments.
 Basics of interest rate future contracts
 Basics of options on interest rate future
contracts.
 Using future and options on future to hedge
the risk in the cash forecast
 Problems in using interest rate options and
futures in hedging