Question

4. Provide the first 5 steps in the McKinney method when building a cash forecasting model. Be brief.

5. Provide 3 reasons companies began in 2005 to hold more cash than before.

Answer 1

Running out of cash is not only a sign of poor planning, but it's also one of the biggest reasons that businesses fail. Forecasting your company's cash flow can be tricky because of the many variables that determine how much cash you will need for operations versus the amount available.

Cash Flows from Financing Activities

After forecasting investing activities, we will now learn how to calculate cash flows from financing activities. Most financing activity items are calculated by simply comparing the forecast year with the prior year. In our model, we included dividends in our financing activity. In practice, some organizations include dividend cash flows in operating activities. The choice should reflect how dividends are reported in financial statements.

Forecasting Free Cash Flow

Free cash flow to the firm (aka Unlevered Free Cash Flow) forecast is the preferred approach when valuing equities using discounted cash flows. Free cash flows to the firm can be defined by the following formula:

FCFF = EBIT*(1- Tax %) + Depreciation or Amortization-Net Capital Expenditure- Increasing Working Capital

FCF to the firm is Earnings Before Interests and Taxes (EBIT), times one minus the tax rate, where the tax rate is expressed as a percent or decimal. Since depreciation and amortization are non-cash expenses, they are added back. Net capital expenditures and increases in net working capital are then deducted. Note that decreases in working capital will be added to the equation.

Forecasting Free Cash Flow to Equity

Although FCF to the firm is the preferred approach to equity valuation, it is not the only FCF calculation used. There is another FCF variant that is used called FCF to equity.

Free cash flows to equity are used to determine how much cash is available to equity investors after paying off debt interest and satisfying sustainable obligations. In simple terms, FCF to equity is cash flow from operations, minus capital expenditures, plus net debt issued.

Keys to Accurate Cash Flow Forecasting

1. Establish Lines of Communication

The consequences of an inaccurate forecast can be severe. A company might borrow more than it needs to meet conditions that don't materialize. On the other hand, it could leave funds unnecessarily idle. The best way to avoid any type of liquidity crisis within your organization is to train top management on the importance of forecasting, as well as the mechanics of the process.

As with just about any other successful process within a company, communication is one of the keys to accurate cash flow forecasting. An effective forecast requires input from a variety of individuals throughout your organization who can provide important figures and valuable insights that will increase understanding of what drives the numbers.

1. Don’t Confuse Cash Flow with Revenue

Both revenue and cash flow are used as indicators to help investors or analysts evaluate the financial health of a company, but revenue provides a measure of effectiveness in sales and marketing, whereas cash flow is more of a liquidity or money management indicator.

Cash flow includes operational sales revenues and monetary sources beyond merely sales revenues. Companies often generate or obtain cash in a variety of ways that lie outside the conduct of their main business.

The critical importance of cash flow lies in the ability for a company to remain functional; it must always have sufficient cash to meet short-term financial obligations.

While sales revenue is only a measurement of a one-way inflow of money and no other type of transaction, cash flow is a measurement of cash that comes into a company in the form of sales as well as other methods. Therefore, unlike revenue, cash flow has the possibility of being a negative number or value.

1. Identify Your Inflows and Outflows

For any CFO, much of this is elementary, but your cash flow forecast should be a detailed look at your company's cash position relative to its inflows and outflows. To start, how much money will you be bringing in over the period in question and from what sources? This isn't a measure of your company's capacity to produce products or services, but rather what will be collected in payment for goods and services.

Historical sales data is a good place to start, but this must take into account macroeconomic factors such as consumer confidence levels and even small business confidence if you rely on B2B sales. Obviously, sales won't always be consistent, so those communication channels you developed will give you valuable insight into other factors and business drivers that could impact these numbers.

Have any of the terms or relationships with vendors changed that could affect the speed or amount that you are paid for products or services? Your systems should be able to identify patterns in debtor remittance that allow for more accurate forecasting. Have you had recent price changes that will adjust your figures?

Your company may have a new product release scheduled which will affect sales or it could have had a product recall which is going to throw a wrench into your forecast figures. Consider what just happened with Ford Motor Company. Recalling 350,000 current year trucks and SUVs will not only affect future sales figures but expenses as well.

When you forecast your outflows, you'll need to include both fixed and variable costs while making a distinction between the two. Obviously, your business will have some type of overhead which includes the salaries, rent, and utilities that you pay. While some of these expenses may increase in times of high volume business, you should be able to predict them will a fair amount of accuracy.

Variable expenses will change along with your production and sales volume. This includes your cost of goods sold (COGS) as well as recurring variable expenses such as quarterly taxes, seasonal inventory, and months with an extra pay period.

The timing of these payments is critical for an accurate forecast. Let's assume that your COGS is 60% and you plan to generate $100,000 in sales during the first quarter. You would need $60,000 worth of goods in inventory to cover those sales, but not all of that cash may be needed upfront. You will have to pay for labor immediately, but raw materials may be on credit terms of 90 days or more.

Your company should also accurately forecast for any one-time expenses that it foresees. These might include equipment purchases, employee training programs, and annual bonus payments. If in doubt about a potential expense, it's best to put it into your forecast as a safety measure.

1. Create Several Scenarios

When you produce a cash flow forecast, it may be helpful to create several different scenarios. Let's assume that you work in an industry where a potential tariff could undermine your future business. It hasn't happened yet, but it would be helpful to know what your cash situation is going to be should this occur.

1. Publish, Monitor, and Adjust Results

No cash flow forecast should be set in stone, since there may be customers who fail to pay, sales that don't materialize, or unexpected expenses that show up on your doorstep. Once you publish a forecast, continue to monitor results in real time as much as possible. Doing this will allow you to identify opportunities to improve your process and may permit you to take advantage of a better cash position on occasion.

Since few companies will hit their forecast on the mark, the measure of cash flow accuracy is one of degrees. As a company, decide what sort of variance is acceptable and aim to reach that goal. For example, you may be comfortable with a 5% variance overall but have different targets for certain categories.

Most organizations don't have the financial strength to survive even a short-term cash flow crisis, so having accurate forecasts on hand is essential. When you have these working reports available, you and your management team can monitor your company's results and make adjustments to your plan as needed. Large and complex organizations should prepare a monthly forecast that extends a minimum of six months and preferably out to a year.

Provide 3 reasons companies began in 2005 to hold more cash than before.

To the first point, corporate leaders are worried they will not be able to find credit when needed. Keeping a large amount of cash on hand alleviates the need to secure a loan, but also restricts the credit markets and reduces borrowing opportunities for other firms. Thus, hoarding cash is a vicious cycle that tamps down economic activity.

The second motive for hoarding is simple: corporations do not want to pay repatriation taxes. From the Fed’s analysis:

Many countries, including the U.S., tax their citizens based on their worldwide income. In particular, taxes due to the U.S. government from corporations operating abroad are determined by the difference between the taxes already paid abroad and the taxes that U.S. tax rates would imply. Importantly, such taxation only takes place when earnings are repatriated. Therefore, firms may have incentives to keep foreign earnings abroad.

Corporations argue this is a good reason for a “repatriation holiday” – a corporate giveaway that would allow corporations to bring cash back to the U.S. tax free. Why do firms with billions in the bank need another tax break, you ask? Their lobbyists argue it will spur investment and hiring in the U.S., despite evidence showing otherwise.

Take the repatriation holiday of 2005, when the Bush Administration offered a corporate tax holiday that was promised to spur U.S. hiring and investment. It offered corporations – at least, those with great accountants and sophisticated tax shelters – the chance to bring income back to the U.S. nearly tax free. Eight hundred companies took advantage of the legislation, to the tune of $312 billion total.

However, the promised hiring and investment never materialized. In a report on the results, the National Bureau of Economic Research reported that nearly 92 cents of every dollar went to shareholders in the form of dividends and buybacks – and not to hiring, purchasing or reinvestment.

In fact, many of the corporations that brought back billions in tax-free profits, “laid off domestic workers, closed plants and shifted even more of their profits and resources abroad in hopes of cashing in on the next repatriation holiday” – which generated even more offshore profits:

• “Merck brought back $15.9 billion in October 2005. The next month, it unveiled a restructuring plan to cut 7,000 jobs. Over the next three years, about half those cuts were made in the United States, where the company’s employment fell to 28,800 jobs, from 31,500.” – NYT

• “Hewlett-Packard repatriated money, $14.5 billion, and soon after it announced it was eliminating jobs, 14,000.” – NYT

Corporations already pay painfully low federal tax rates. According to a recent report from Citizens for Tax Justice, 9 out of 10 Fortune 500 companies surveyed paid a lower federal tax rate than the average American family.

The Fed report authors conclude that modifying U.S. tax policy may play a part in helping overcome the slow recovery from the Great Recession, although they don’t make specific recommendation. In any case, let’s just hope it doesn’t include another corporate tax cut.