Cash flow forecasting

A Basic Guide to Cash Flow Forecasting

Nobody wants their business to fail. Although it’s impossible to predict the future with 100% accuracy, a cash flow forecast is a tool that will help you prepare for different possible scenarios in the future.

In a nutshell, cash flow forecasting involves estimating how much cash will be coming in and out of your business within a certain period and gives you a clearer picture of your business’ financial health

What is Cash Flow Forecasting?

Cash flow forecasting is the process of estimating how much cash you’ll have and ensuring you have a sufficient amount to meet your obligations. By focusing on the revenue you expect to generate and the expenses you need to pay, cash flow forecasting can help you better manage your working capital and plan for various positive or difficult scenarios.

A cash flow forecast is composed of three key elements: beginning cash balance, cash inflows (e.g., cash sales, receivables collections), and cash outflows (e.g., expenses for utilities, rent, loan payments, payroll).

Building Out Cash Flow Scenario Models

It’s always good to create best case, worst-case and moderate financial scenarios. Through cash flow forecasting, you’ll Cash flow forecastingbe able to see the impact of these three scenarios and implement the suitable course of action. You can use the models to predict what needs to happen especially during difficult and uncertain times.

In situations where variables shift quickly such as during a recession, it is highly recommended to review and update your cash flow forecasts regularly on a monthly or even weekly basis. By monitoring your cash flow forecast closely, you’ll be able to identify warning signs such as declining revenue or increasing expenses.

How to Improve the Accuracy of Your Cash Flow Forecast

In cash flow forecasting, your estimates are based on historical data. This means having accurate historical data is critical. Below are some tips for improving its accuracy:

  • At the end of the week or the month, input your actual results or the cash that was received and cash spent. This will allow you to identify which items you got wrong in your estimates and evaluate why you got it wrong. This analysis may lead you to identify bigger issues and help you make adjustments to your assumptions.
  • Carefully evaluate all of your assumptions. Just because it’s correct now doesn’t mean it will be true for the future. Go through everything, especially when it comes to sales and validate it, by writing is down in your cash flow forecasting report.
  • Don’t forget to include annual payments, loan payments, credit card debt payments, and estimated taxes.
  • It’s almost impossible to forecast where your business is going to be longer than one year out. You’ll introduce more risk and greater uncertainty the further out your financial scenario models go. By using different scenarios as described above you will be able to lower such uncertainties.

Where are cash flow forecasting techniques used in IFRS?

Discounted cash flow model – business valuations/intangibles valuations/impairment testing/fair value less costs to sell of a cash-generating unit/value in use of a cash-generating unit/valuation techniques (see below)

Asset backed securities: Risks, Ratings and Quantitative Modelling – Cash flow modelling of asset behaviour, structural features and revolving structures

IAS 41 Biological transformation when fair value is estimated on the basis of future cash flow and the application of highest and best use to agricultural produce

Goodwill impairment test – Telecom industry

According to an analysis of annual reports, the impact of impairment losses on intangible assets (except for goodwill) on the earnings of telecom companies does not seem that significant. Thirteen companies reported an average €31 million impairment loss on intangible assets with definite useful lives, and two companies reported an average €19 million impairment loss on intangible assets with indefinite useful lives – based on a total sample of 23 companies (Belgacom, BT Group, Deutsche Telekom, France Telecom, KPN, Portugal Telecom, Swisscom, Tele2, Telecom Italia, Telefónica, Telekom Austria, Telekomunikacja Polska, Telenor and Vodafone).

Carrying amount

Goodwill impairment testing requires a comparison of the carrying amount of the CGU which contains the goodwill with its recoverable amount. The carrying amount of a CGU shall be determined on a basis consistent with the way the recoverable amount of the CGU is determined (IAS 36.75).

The following chart gives an overview of how to determine the carrying amount of a CGU:

Net working capital

+

Directly attributable assets (tangibles and intangibles)

+

Allocated goodwill (100% basis)

+

Allocated share of corporate assets

Attributable liabilities where applicable

=

Carrying amount of a CGU

The allocated carrying amount of goodwill needs to be grossed up on an acquisition of less than 100% of the shares, to include the goodwill attributable to the minority interest.

IFRS provides entities the option, on a transaction-by-transaction basis, to measure non-controlling interests (previously minority interest) either at the value of their proportion of identifiable assets and liabilities (partial goodwill or purchased goodwill approach) or at full fair value (full goodwill approach).

The first choice will result in the same amount of goodwill as the existing IFRS 3. The second choice will record goodwill on the non-controlling interest as well as on the acquired controlling interest. Recognising full goodwill will Cash flow forecastingincrease reported net assets on the balance sheet. Although measuring non-controlling interest at fair value may prove difficult in practice, a simplified grossing up of goodwill – resulting from transactions where the full goodwill method was applied for impairment test purposes – will no longer be necessary.

Where the full goodwill method is applied, any impairment of goodwill related to non-controlling interests will also have to be recognised, and any future impairment of goodwill will therefore be greater. In general, though, impairments of goodwill should not occur any more frequently, as the current impairment test is already adjusted by the grossing-up of partial goodwill for a less than wholly owned subsidiary.

Indeed, if the purchaser paid a control premium, the partial goodwill approach may overestimate potential impairment losses due to the simplified grossing up of (partial) goodwill for impairment test purposes.

Recoverable amount

The recoverable amount of an asset is defined as the higher of the fair value less costs to sell (FVLCTS) and its value in use (VIU). IAS 36.19 emphasises that it is not necessary to determine both values: if either of the two measures exceeds an asset’s carrying amount, the asset is not impaired, and the company is not required to estimate the other measure.

The following table summarises the differences in the concepts of FVLCTS and VIU:

Fair value less costs to sell

Value in use

Reference

Hypothetical buyermarket participants’ perspective

Internal value – company perspective

Valuation hierarchy

Income approach only

Cash flow projections

Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting

  • Eliminate all owner-specific synergies
  • Adjust all projections such that assumptions are consistent with those of market participants
  • Consider restructurings as well as enhancing investments if usual in the market
  • Consider cash flows related to financing and taxes

Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting

  • Recognise all synergies
  • Eliminate all effects from restructurings, if no provision in accordance with IAS 37 has been made
  • Eliminate all effects from enhancing investments; only maintenance investments should be incorporated
  • Exclude cash inflows or outflows from financing activities
  • Exclude income tax receipts or payments

Cost of capital

Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting

Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting Cash flow forecasting

  • Generally, IAS 36.55 requires applying a pre-tax discount rate; regularly in practice, post-tax rate is used to determine an appropriate pre-tax rate
  • Discount rate to be determined using the WACC of the CGU or company as a starting point
  • Some CGUs may require the use of WACC derived from a peer group
Something else -   IAS 36 How Impairment test

When the FVLCTS is derived by using estimation techniques such as a discounted cash flow, some of the restrictions imposed by IAS 36 on the VIU approach do not apply. For example, the cash flow projections can include the effect of restructurings, reorganisations or future investments in the network.

This is because all rational market participants would be expected to undertake these expenditures and reorganisations in order to extract the best value from the purchase and, hence, they would have been factored into the acquisition price. Thus, in cases where a restructuring is anticipated but has not yet been provided for, a valuation based on the FVLCTS might be higher than one based on the VIU.

It is important that when comparing the carrying amount with the recoverable amount, entities ensure that the carrying amount of the CGU being tested for impairment is calculated on a consistent basis with the cash flows included in either the FVLCTS or the VIU calculation. A FVLCTS valuation, therefore, should be compared with the assets of the CGU including any tax balances, whereas a VIU recoverable amount would be compared to assets excluding the associated tax.

Fair value less costs to sell

IAS 36 describes the hierarchy to derive the FVLCTS as follows (paragraphs 25-29):

  1. Best evidence: arm’s length transaction less cost of disposal
  2. Otherwise: market price less cost of disposal
  3. Otherwise: best information available to reflect the amount an entity could obtain (in an unforced transaction)

Fair value for the purpose of estimating the FVLCTS is defined as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Due to the frequent lack of comparable transactions for single assets or CGUs, the FVLCTS for an impairment test in practice is often approximated by using discounted cash flow techniques, applying a market-based measurement.

Fair value is a market-based measurement, not an entity-specific measurement

This method requires eliminating all owner-specific synergies from the cash flow projections other than those synergies that any market participant (hypothetical buyer) would be able to realise. The cash flow projections should be adjusted so that the assumptions are consistent with those of market participants. However, the standard provides no further specific guidance to applying discounted cash flow techniques when deriving the FVLCTS.

Something else -   Offsetting

To ensure that the FVLCTS is determined on a basis consistent with the assumptions of market participants, comparisons with analysts’ estimates and the observable market values of comparable companies should be performed.

For most telecom operators, estimates of the main key performance indicators (KPIs) – e.g. market share, ARPU, EBITDA (earnings before interest, taxes, depreciation and amortisation) margins – and of discounted cash flow values are covered by analysts’ reports and other market studies. Such information should therefore be used to validate the company’s cash flow projections and the resulting FVLCTS.

The FVLCTS should generally be further checked for reliability by performing a comparative market analysis. In the telecoms industry, “multiple” approaches can be applied which determine the enterprise value as a multiple of, for example, subscribers, sales or EBITDA. These multiples generally should be derived from the same peer group as that on which the company’s cost of capital is based.

According to the standard, the hypothetical costs to sell the asset or CGU have to be deducted from its determined fair value. In practice, the costs to sell often are estimated as a percentage of fair value (e.g. deducting 1.0% from the discounted cash flow value). These costs reflect incremental costs directly attributable to the disposal of an asset or CGU, excluding finance costs and income tax expense (IAS 36.6).

Examples of such costs are legal costs, stamp duty and similar transaction taxes, costs of removing the asset and direct incremental costs to bring an asset into condition for its sale. However, termination benefits (as defined in IAS 19 Employee Benefits) and costs associated with reducing or reorganising a business following the disposal of an asset are not direct incremental costs to dispose of the asset (IAS 36.28).

Value in use

Value in use, or VIU, is the net present value of the future cash flows expected to be derived from the continuing use of an existing asset or CGU and its disposal at the end of its economical useful life (IAS 36.30). VIU therefore reflects the company’s view using company-specific valuation parameters. This includes recognising all identified synergies. The standard gives much more guidance regarding VIU valuations than FVLCTS.

Cash flow projections should be based on reasonable and supportable assumptions that represent management’s best estimate of the range of economic conditions that will exist over the asset’s remaining useful life or in the CGU (IAS 36.33). The projections should be based on management’s most recently approved financial budgets or forecasts and should not exceed a period of five years, unless a longer period can be justified. Projections beyond that point should be extrapolated by using a steady or declining growth rate.

These projections should be extrapolated over the remaining useful life of the primary asset in the CGU. In the case of an indefinite useful life of the CGU, specific care has to be applied when deriving both the sustainable cash flows after the detailed planning period and the terminal value.

In practice, reasons for telecom companies to extend the planning period beyond five years could include the duration of licence agreements or anticipated regulatory decisions with expected significant impact on future cash flows. In general, however, operating cash flows are difficult to forecast beyond a period of five years due to the rapid pace of development of the industry.

Many telecom companies state in their annual reports that they have based VIU calculations on management-approved business plans of five years or less, extrapolated to up to 10 years by using steady or declining growth rates.

The standard sets out specific conditions relating to the cash flows to be used in determining the VIU. Future cash flows have to be estimated for the CGU in its current condition (IAS 36.44). The effect of planned restructurings for which no provision (in accordance with IAS 37) has been made should be eliminated from the financial projections (IAS 36.44(a)). Estimates of future cash flows should also not include amounts expected to arise from improving or enhancing the CGU’s current performance.

Most network operators have significant capital expenditure programmes in place. It is often difficult to determine whether items of capital expenditure complete, maintain or enhance the network asset. Furthermore, the realisation of synergies related to goodwill is very often significantly dependent on new products or enhanced services to be offered in the future.

As these may require significant investments in the network, such new products and services can only be eliminated from cash flow projections by revising the underlying business plan as a whole. Maintenance cash flows are permitted to be included in the VIU calculation. Estimated cash outflows required to prepare for use an asset or CGU in the course of construction together with any expected cash inflows should also be included in calculating the VIU. However, future capital expenditure that extends the network’s reach or enhances its performance may not be included.

In light of for example an economic recession, cash flow projections should be carefully analysed, both as to whether and how the implications of the financial crisis are reflected in expectations. For example changes in estimates for revenue, growth rates, margins and capital expenditures might be expected, as the demand for new products and technologies, greater capacity and higher bandwidth might have declined.

Given the significant level of volatility in the financial markets and in the expectations of telecom companies’ performance since the crisis began, the date when the projections were prepared should also be considered, along with other external factors, such as foreign exchange rates. In particular, international telecom groups that were anticipating significant growth in emerging markets should perform a thorough review of their expectations regarding the short- and mid-term development of the market opportunity and of the country’s currency.

Forecasts should, where possible, be compared to market evidence and are likely to reflect a much higher probability of a weak economy in the short to medium term. If necessary, projections need to be adjusted to reflect current market expectations.

In addition, long-term interest rates used in the projections should reflect market participants’ long-term estimates concerning inflation and economic growth. Thus, the growth rate assumption for terminal value should be consistent with the interest rate used. Given the significant impact of terminal value calculations on the overall discounted cash flow valuations, an extension of the projection horizon – or at least a performance of sanity checks – may be appropriate.

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With respect to calculating terminal value, any investments required to secure licence renewals should be considered when estimating long-term cash flows. Many operators assume that future renewals will be at amounts significantly lower than those paid initially.

Moreover, assumptions regarding sustainable margins have to reflect the long-term expectations of performance, especially with regards to regulation and the competitive landscape. Due to the significant impact that the terminal value can have on the overall enterprise value, these assumptions should be reviewed particularly carefully.

Cost of capital

The interest rate applied to discount the expected future cash flows to their present value is a key factor in impairment tests, as small changes in the discount rate can have substantial effects on the estimated value of a CGU. In practice, the discount rate is usually based on the weighted average cost of capital, which is determined by using techniques such as the Capital Asset Pricing Model.

In determining the VIU, the standard generally requires using pre-tax cash flows (IAS 36.50b). Deriving pre-tax discount rates is not always possible, though, as observable performance measures in the market are based on earnings, which include corporate taxes.

Thus, in practice the VIU is generally calculated on a post-tax basis – assuming that pre- and post-tax calculations deliver the same results by using the company’s weighted average cost of capital and estimating the pre-tax discount rate by reflecting the specific amount and timing of the future tax cash flows. This approach is supported in the standard (IAS 36 A17, A20 and BCZ85).

The discount rate generally should be determined using the WACC of the CGU or of the company of which the CGU is currently part as a starting point. However, CGUs in some businesses may require the use of a beta derived from a peer group. Using a company’s weighted average cost of capital for all CGUs is appropriate only if the specific risks associated with the specific CGUs do not diverge materially from the remainder of the group.

Where the FVLCTS is derived by a discounted cash flow approach, the discount rate should be derived from the perspective of a hypothetical buyer. To ensure conformity with the market participants’ view, it is best practice to derive the discount rate based on a representative peer group.

Market participants might expect a different rate of return from a mobile network operator to that of an internet services or broadband access company, and they may also expect a different rate of return on the same business across different geographies due to country specific risks. The weighted cost of capital is calculated as a post-tax rate.

In general, components of the cost of capital may need to be adjusted in the current recession to take into account industry-, geographic- or company-specific risks arising from current market conditions. The question of whether to apply current debt margins in determining an appropriate cost of debt can be answered only on a case-by-case basis.

Factors which might influence the decision include whether the company is funded for the short term or the long term, the necessity of any future (re)financing, promised versus expected yield and volatility in observed spreads. Overall, any decreases in discount rates should be carefully scrutinised because, given recent events in the capital markets and the increase in risk premia and credit spreads, the cost of capital is likely to have increased.

Example in excel – Fair value less costs of disposal

The attached excel sheet (IFRS 13 Fair value less costs to sell) comprises two sheets in separate TABS:

  1. the Calc sheet which shows the calculation of the fair value of equity with three inputs the WACC (or discount factor) and the indefinite growth factor and residual multiplier in respect of the residual value.
  2. the Input sheet which shows four years input (in absolute numbers)of historical data (with year 0 consisting of 9 months historical data and 3 months forecasting) and 4 years of forcasting input (in change % over the previous year).

WACC is calculated on this page.

Now there is one scenario fully detailed, this scenario is considered the basic or normal scenario. Two other have been prepared a worst-case and an aggressive growth scenario. These scenario’s are weighted to mitigate the risk of overvaluation. By changing the weight of each scenario the reasonableness of the weighing can be tested.

Worst-case

Basic

Aggressive

Fair value

69,799

116,118

162,390

Weighing factor (total 100%)

25.0%

60.0%

15.0%

Weighted fair value

111,479

Cost of disposal

The cost of disposal have to be determined based on the expected costs from contracted lawyers, auditors and consultants.

Here it is assumed that the following costs are expected:

Lawyer

3,000

Audit

1,750

Consulting

2,500

Roadshow

500

Documentation

1,500

Total

9,250

Fair value less costs of disposal

From the calculations results the following amount of fair value less costs of disposal 102,229 (111,479 -/- 9,250).

Example in excel  – Value in use

The attached excel sheet (IAS 36 Value in use impairment example calculation) comprises one simple sheet with a few inputs and is rather self explanatory.

Please note the data in the two sheets are not consistent so the calculations are not inter-related.

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