Future cash flow
| Future cash flow |
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| See also |
Future cash flow is a projection of an organization's expected future cash receipts and payments, based on current and anticipated financial conditions. It is an important component of financial planning and is typically used to determine how much working capital is available to the business. Managers use future cash flow to plan for upcoming expenses, to assess potential investments and to identify potential cash flow shortages. It can also be used to compare and analyze the performance of different investments over time.
Example of future cash flow
- Future cash flow can be used to assess potential investments. For example, if an organization is considering investing in a new business venture, it can use future cash flow projections to determine whether the expected cash inflows from the venture will be greater than the cash outflows required for the investment. In this way, future cash flow can help organizations evaluate the potential return on investment and decide whether to proceed with the venture.
- Future cash flow can also be used to plan for upcoming expenses. For example, if an organization is expecting to make a large purchase in the near future, it can use future cash flow projections to estimate how much cash it needs to set aside to cover the expense. This will help the organization ensure that it has the necessary funds available when the purchase is due.
- Future cash flow can also be used to identify potential cash flow shortages. For example, if an organization's cash flow projections indicate that there will be a shortfall in cash in the near future, the organization can take steps to address the issue, such as by increasing prices, reducing costs, or seeking additional financing.
Formula of future cash flow
Future cash flow can be calculated using the following formula:
$$CF_t = CF_{t-1} + ΔCF_t$$
Where:
$$CF_t$$ = Future cash flow at time period t
$$CF_{t-1}$$ = Previous period's cash flow
$$ΔCF_t$$ = Change in cash flow from period t-1 to period t
In this formula, the future cash flow is dependent on the previous period's cash flow and the change in cash flow from the previous period to the current period. Thus, to calculate the future cash flow, we need to calculate the change in cash flow. This can be done using the following formula:
$$ΔCF_t = (Revenue_t – Expense_t) – (Revenue_{t-1} – Expense_{t-1})$$
Where:
$$Revenue_t$$ = Revenue at time period t
$$Expense_t$$ = Expense at time period t
In this formula, the change in cash flow is determined by subtracting the total expenses from the total revenues in both the current and previous period. This number is then added to the previous period's cash flow to determine the future period's cash flow.
To summarize, the formula for future cash flow is:
$$CF_t = CF_{t-1} + (Revenue_t – Expense_t) – (Revenue_{t-1} – Expense_{t-1})$$
When to use future cash flow
Future cash flow is an important tool for financial planning and can be used in a variety of situations. It can be used to:
- Estimate the amount of working capital available to the organization. This is important for budgeting and forecasting in order to ensure that the business is not running low on cash.
- Assess potential investments by forecasting the future cash flows of a potential project and determining whether it is worth pursuing.
- Identify potential cash flow shortages by monitoring current and anticipated cash receipts and payments.
- Compare the performance of different investments over time by projecting future cash flows and determining the return on investment.
- Plan for upcoming expenses by forecasting cash receipts and payments and allocating funds accordingly.
Types of future cash flow
Future cash flow can take many forms, depending on the needs of the organization. The most common types of future cash flow include:
- Operating cash flow: This is the cash generated from the regular operations of the business. It includes cash received from customers for goods or services and cash paid out for expenses such as payroll, inventory, rent, and utilities.
- Investing cash flow: This is the cash generated from investing activities, such as the purchase or sale of investments.
- Financing cash flow: This is the cash generated from activities such as issuing or repurchasing debt and equity, or taking out or repaying loans.
- Discretionary cash flow: This is the cash generated from non-operating activities such as dividends, share buybacks, or special one-time payments.
By understanding and forecasting each of these types of future cash flow, businesses can better plan for their future financial needs and investments.
Advantages of future cash flow
Future cash flow is an important tool for financial planning, allowing managers to assess the performance of investments over time, plan for upcoming expenses and identify potential cash flow shortages. There are many advantages to using future cash flow to make financial decisions, including:
- Improved decision-making: Future cash flow provides managers with valuable insights into the financial health of the organization, enabling them to make better-informed decisions.
- Reduced risk: By understanding the cash flow of the organization, managers can identify potential cash flow shortages before they occur and take action to mitigate risk.
- Increased efficiency: By using future cash flow to accurately plan and budget, organizations can maximize their resources and increase efficiency.
- Improved forecasting: With a detailed view of projected cash flow, organizations can more accurately forecast future performance.
- Increased capital: By assessing potential investments, managers can identify opportunities to increase capital and increase the value of the organization.
Limitations of future cash flow
Future cash flow can be a valuable tool for financial planning, but it also has some limitations. These limitations include:
- Uncertainty: Future cash flow projections are based on assumptions, which can be inaccurate due to changes in the economy, customer demand, and other external factors.
- Over- or Under-Estimation: The assumptions used in future cash flow projections can lead to over- or under-estimating the amount of cash that will be available in the future.
- Limited Information: Future cash flow projections can be limited by the information available at the time of the projection.
- Inability to Plan for Unexpected Costs: Unexpected costs, such as repairs or legal costs, cannot be accurately planned for in advance.
- Data Integrity: Poor data quality can lead to inaccurate projections.
- Difficulty of Forecasting: Future cash flow projections can be difficult to make accurately, especially when there is a lack of reliable data.
In addition to future cash flow, other approaches to financial planning include:
- Cash Budgeting: This method involves creating a budget based on a detailed assessment of an organization's expected future income and expenses. It is used to estimate cash flow and determine the amount of short-term financing that may be necessary to meet the organization's needs.
- Financial Forecasting: This approach involves predicting the future financial performance of an organization based on historical financial data and current economic trends. It helps organizations plan ahead and identify potential opportunities or risks.
- Cost Reduction Strategies: This approach involves identifying and implementing strategies to reduce the cost of goods and services, thereby increasing the organization's profitability.
- Risk Management: This approach involves assessing and managing the risks associated with an organization's operations and investments. It helps organizations identify sources of potential losses and develop strategies to minimize them.
Suggested literature
- Greenberg, R. R., Johnson, G. L., & Ramesh, K. (1986). Earnings versus cash flow as a predictor of future cash flow measures. Journal of Accounting, Auditing & Finance, 1(4), 266-277.
