Cash flow estimation is a common practice in many businesses where analyzing potential market trends is a required step in planning strategies. Businesses have a number of different areas they can choose to focus on. They might want to develop new products, shore up market share for existing projects or create or cancel marketing plans. There is an element of risk to all of these decisions based on what the business is giving up. Cash flow estimation is a common tool used in risk analysis to help the business judge possibilities from a monetary perspective.
Revenues vs. Costs
In cash flow analysis, the key point is the difference between revenues and costs. This is the same type of difference seen in forecasting budget sheets that help companies prepare for new development. A specific product, project or piece of equipment can be expected to provide the company with a certain amount of revenue, or incoming cash flow. That same asset, through the cost of purchase, repairs and wear will also create expenses for the business during the same time frame, leading to outgoing cash flows.
Cash Flow Estimation
Ideally, the business will be able to choose a project that has much higher cash flows coming in than going out. However, estimating future cash flows can be a complex process. Money in the future, simply put, is not worth the same as money available in the present. This is why companies use a discounted cash flow method to apply a discount rate to future revenues. The discounted rate takes into account inflation, higher costs and other factors that will decrease the value of money to create an appropriate present day value.
A business will often create several different scenarios when examining cash flows for risk assessment. One scenario may include the best of all possibilities, with no repairs needed and the highest revenues for the lowest costs. Another scenario may assume that everything goes wrong with business operations and that maximum costs are incurred with low sales. Other scenarios aim for more practical situations based on trending sales information. Together, these scenarios help the business take a broad look at the strategy and make decisions.
Sunk Costs and Salvage Values
Sunk costs and salvage values are two concepts that frequently show up in estimated cash flow analysis. A sunk cost is essentially a cost that has already been made or must be made no matter what. In this case that cost is discounted from the analysis, since it will not affect gains or losses either way. Salvage value is the amount an asset can be sold for after its useful life is over. This is often a low figure, but still allows for increased revenue at the end of a cash flow analysis.