Question

Briefly outline the problems of using past cash flow data to predict future free cash flows and explain why accrual accounting may provide a better basis for predicting future free cash flow.

Answer tips: Comments on the problems of predicting FCF linked to its role as a distribution measure rather than a performance measure are required here

Answer 1

Cash flow forecasting is an important measure for any business and helps in making sure that enough cash is available when in need. If a business runs out of cash then there is a possibility that the firm may become insolvent. Cash flow is the life blood of an organization. A cash flow forecast may not be 100% accurate and may be problematic.

Problems :

1. Irregularity in estimation

Future cash flows depend on operating cash flows and investment. Return from both depend on state of economy at the time. Thus irregularities occur

2. Historical data may not give true picture of future cash flows.

Historical data represents what happened in past. Cash flows would change with the change in market conditions. Increased foreign competition, new regulations etc all can affect future cash flows whereas historical data doesn't represent it

3. A variety of turning points exist in every business and historical data does not consider these while forecasting future cash flows.

4. Availability of data for long term projections may be difficult.

For newer firms, historical data is either not available or not enough to predict future cash flows accurately.

5. Data may not be available for new product line or category.

Similar to new firms , a new product line lacks availability of historical data thus cannot predict future free cash flows.

6. With passage of time new variables are introduced which definitely affect the cash flows.

7. The users of data may use assumptions which may not be true always.

8. Future payouts and risks may change as per the existing market forces.

Accrual Accounting :

It is an accounting assumption where transactions are recognized when the event occur and not when the cash is received or paid.

Benefits :

1. It is effective for financial management. Companies get clear view of the expected cash flows and is able to meet cash flow requirements by computing cash flow trends on a regular basis.

2. It gives a true picture of available resources so that the company can plan accordingly.

3. Business do not have to wait for cash to be received and the processes don't stop due to it.

4. It gives a more accurate picture of the performance of a business as the revenues and expenses are recorded when they become due.

5. Information about earnings based on accrual accounting provide a better view of ability to generate favorable cash flows.