Cash flow projections

Learning outcome statements

The learning outcome statements relevant for this section are:

1. identify the factors required to prepare medium- and long-term cash forecasts
2. use financial projections to determine required outside financing and dividend policy

Factors required to prepare medium- and long-term cash forecasts

Unlike short-term cash budgets, these medium- and long-term forecasts look further ahead to assess a company’s cash position over multiple quarters or years, providing strategic guidance to meet financial goals.

Accurate cash flow forecasting for medium- and long-term periods requires integrating several key factors:

1. Revenue projections

Cash inflows begin with expected revenue, which is based on sales forecasts and anticipated growth. This data often comes from the sales budget and includes assumptions about market conditions, customer demand, and price levels.

2. Cost projections

Cash outflows are projected by estimating both fixed and variable costs. Projections of costs related to production, selling, administration, and capital investments are necessary to calculate accurate cash requirements over time.

3. Accounts receivable and payable policies

The timing of cash receipts and payments depends on credit terms with customers and suppliers. Effective cash flow forecasting considers these policies and their impact on cash availability, especially if accounts receivable collection periods or accounts payable payment terms vary.

4. Capital expenditures and asset replacement

Planned investments in assets (e.g., equipment, infrastructure) impact cash flow significantly. Future capital expenditure needs and asset replacement schedules should be forecasted to ensure alignment with cash resources.

5. Debt and equity financing

Debt repayments, interest, and financing costs need to be accounted for in cash flow projections. Additionally, cash inflows from new equity or debt financing affect available resources, and the ability to access financing will influence long-term cash flow planning.

6. Dividend policy

For companies issuing dividends, projections include anticipated dividend payments based on the company’s policy. This impacts available cash for reinvestment and strategic needs, influencing the balance between shareholder payouts and reinvestment in growth.

By incorporating these elements, companies can create more comprehensive forecasts that accurately reflect cash availability and requirements over medium- to long-term periods.

Using financial projections to determine required outside financing and dividend policy

Before looking to outside sources, organizations often aim to fund their operations and growth internally. Internal financing sources, such as cash generated from sales, retained earnings, and improved efficiency in managing working capital, are typically the first options for meeting funding needs. Relying on internal sources can help a company minimize debt, reduce interest costs, and maintain greater operational independence.

However, when internal financing is insufficient for strategic initiatives, financial projections play a critical role in determining the need for external financing and shaping dividend policy. Projected cash flows, anticipated revenue streams, and forecasted expenses are analyzed to assess whether the organization can cover its financial obligations and pursue growth opportunities without external funding.

Financial projections help companies:

• Determine outside financing needs: cash flow projections reveal potential shortfalls where cash inflows are insufficient to cover outflows, highlighting the need for outside financing. Companies can explore options such as debt financing, equity issuance, or other capital sources. These forecasts also enable companies to time financing requirements strategically, securing capital in advance to prevent liquidity issues.
• Evaluate dividend policy: cash flow projections help management balance shareholder distributions with reinvestment needs. For companies with positive cash flow projections, dividends may be increased without compromising strategic objectives. Alternatively, if cash flow is forecasted to be tight, management may choose to reduce or pause dividend payments, prioritizing internal reinvestment or debt reduction.

Several methods can help organizations translate financial projections into financing and dividend decisions:

1. Forecasted (pro forma) financial statement method: project the balance sheet forward - the gap between projected assets and projected liabilities plus equity is the required external financing.
2. Percentage-of-sales method: estimate the financing gap directly from the expected change in sales (see the example below).
3. Cash flow projection method: project cash inflows and outflows period by period to pinpoint the size and timing of any shortfall.
4. Sensitivity analysis and scenario analysis: test how the financing need changes under different assumptions.
5. Regression analysis: use historical relationships between sales and other accounts to project future financing needs.

Example: Required outside financing

Achievable Corp. expects sales to rise from $1,000,000 to $1,200,000 next year. Assets that vary directly with sales (cash, receivables, and inventory) are currently 60% of sales, and spontaneous liabilities (accounts payable and accruals) are 15% of sales. The company’s profit margin is 5% of sales, and it plans to pay out 40% of net income as dividends.

The percentage-of-sales method estimates the additional funds needed (AFN) as:

$$AFN=\left(\frac{A}{S}\right)\Delta S-\left(\frac{L}{S}\right)\Delta S-M\times S_1\times (1-d)$$

Here, $A/S$ and $L/S$ are assets and spontaneous liabilities as a percent of sales, $\Delta S$ is the change in sales, $M$ is the profit margin, $S_1$ is projected sales, and $d$ is the dividend payout ratio.

• Change in sales: $\Delta S=\$1,200,000-\$1,000,000=\$200,000$
• Increase in assets needed: $0.60\times \$200,000=\$120,000$
• Increase in spontaneous liabilities: $0.15\times \$200,000=\$30,000$
• Retained earnings added to equity: $0.05\times \$1,200,000\times (1-0.40)=\$36,000$

$$AFN=\$120,000-\$30,000-\$36,000=\$54,000$$

Answer: Achievable Corp. needs $54,000 in outside financing to support the projected sales growth.

Example: Dividend policy and outside financing

If Achievable Corp. instead pays no dividends ($d=0$), retained earnings rise to $0.05\times \$1,200,000\times 1=\$60,000$, so $AFN=\$120,000-\$30,000-\$60,000=\$30,000$.

Answer: Cutting the payout ratio to zero lowers required outside financing from $54,000 to $30,000 - a higher payout ratio leaves less cash retained, increasing the need for outside financing, while a lower payout ratio reduces it.

Watch out: only items that move automatically with sales get scaled - current assets, fixed assets (only at full capacity), and spontaneous liabilities like payables and accruals. Notes payable, long-term debt, and common stock don’t scale automatically with sales. Retained earnings and spontaneous liabilities both reduce the required outside financing, so omitting either one overstates the financing gap.