This enables the company to better match its inflows and outflows. However, this also means that much of what constitutes earnings is not a direct, immediate cash flow. There are a number of items that will appear on an income statement that are either flows that have already occurred, or are flows that have not yet occurred. However, because the transaction was based in that quarter or year, it appears on the income statement. Earnings, therefore, are intended to reflect the firm's economic activity for the period, not its cash flows.
Cash flow forecasts outline what the firm will have left over after it collects all of its money for the period and pays out all of its expenses (Forsythe, 2006). Because this measures the firm's economic activity, it can be used as an alternative to earnings in evaluating a firm's performance for the period. A cash flow forecast, by contrast, allows management to understand how much cash it will need to operate in the quarter and compare this figure directly with the amount of cash it is expected to receive from all sources. Financing cash flows, for example, are an important element of a cash flow forecast that is not reflected at all in the earnings.
It should be noted, however, that because cash flow forecasts are based on predictions of the future, they are subject to considerable deviation from actual cash flow results. While there are a number of ways to construct a cash flow projection, one common way is to base it on previous results. Even when management accounts for estimated growth rates and the addition or removal of unusual transactions, the forecast may still be subject to deviation because of changes in the prevailing internal environment (cost structure) and external (competitive, economic) environments. The firm is apt to assume that performance for the next period is likely to be similar to performance from a past period, but for any number of different and unforeseeable reasons it may not be.
There are some other reasons as well...
Some managers are optimistic in their cash flow projections, sometimes in order to encourage senior managers to green light a pet project for example (Chen, 2007). There may be shifts in the timing of accounts receivable and payable as well that result in deviations. Unforeseen operating delays or problems -- or successes for that matter -- can also result in deviations from cash flow forecasts.
Essentially, when a cash flow forecast is constructed, each figure presented is subject to a set of assumptions. The more assumptions are made, and the more reality deviates from those assumptions, the less accurate the cash flow forecast will be. It is recommended, then, that the firm maintain a degree of flexibility in its cash flow projections. Cash reserves available to should exceed the projection for cash flow required, to avoid liquidity or solvency issues.
Even though there is an element of uncertainty in cash flow forecasts, the forecasts provide us with a reasonable estimate of our cash flow needs, which will ensure that we will always have sufficient cash to meet our obligations going forward.
Works Cited:
Business Week. (2005). Why GM's plan won't work. Business Week. Retrieved May 23, 2010 from http://www.businessweek.com/magazine/content/05_19/b3932001_mz001.htm
Chen, M. (2007). ABC of cash flow projections. International Construction Cost Engineering Council. Retrieved May 23, 2010 from http://www.icoste.org/AACE2007%20Papers/Nashville_pm02.pdf
DeFong, M. & Hung, M. (2007). Investor protection and analsyts' cash flow forecasts around the world. Review of Accounting Studies. Vol. 12 (2-3) 377-419.
Forsythe, G. (2006). Cash flow vs. earnings: Which is more meaningful? Charles Schwab. Retrieved May 23, 2010 from http://www.schwab.com/public/schwab/research_strategies/market_insight/investing_strategies/stocks/cash_flow_vs_earnings_which_is_more_meaningful.html
