Cash flow estimation involves predicting the future revenues and costs associated with a proposed project or business. The fundamental difficulty with cash flow estimation is that it involves predicting future events, which is often impossible to do with any amount of accuracy. Additionally, cash flow estimation requires a variety of complicated and often interrelated predictions for which a number of factors could cause an incorrect estimation.
Types of Risk
There are three major types of risk involved in cash flow estimation. The first is stand alone risk, which is the possibility of incorrectly estimating the cash flows of a new project or business line if that new activity were the only, or stand alone, activity of the company. The second major type is corporate risk, which is the risk of incorrectly estimating a new project's impact on the company as a whole. Finally, market risk is the chance of improperly estimating a project's effect on an investor's entire portfolio.
In addition to simply calculating profits and losses directly related to the project or business line, cash flow estimation must take into account the opportunity costs involved with using a certain amount of capital, labor or equipment on one project as opposed to another. Even if a proposed project is profitable, if it prohibits the company from engaging in an even more profitable activity, it should not have been pursued. This greatly adds to the difficulty of cash flow estimation, because rather than estimating the cash flow of one project, a company or investor must also consider the potential cash flow of a variety of other potential projects.
Cannibalization refers to the impact a new project will have on existing lines of business. If purchases of a new product reduce purchases of a company's existing products, it is cannibalizing that other product. The negative impact of a new project on existing projects is hard to determine, but is an important element of a comprehensive cash flow analysis.
Given the difficulties of cash flow estimation, a common technique is to use what is known as a scenario analysis. A scenario analysis considers a variety of potential outcomes of a project, for example, best case, likely case and worst case. This provides a range of possible cash flow estimations that can help a company better deal with the uncertainties that are inherent in cash flow estimation.