Published: October 01, 2011
It is often argued that cash flow forecasting is not worth the effort, as the time and energy needed to achieve a meaningful forecast is disproportionate. Ask an accountant about a consolidated cash flow, and you will hear a long list of reasons why it is not as simple as it sounds, and takes longer than anticipated. Just think of what cash items have been parked in the balance sheet, pending clarification. If it is hard to do a cash flow statement using historic actuals, then relying on our own guesswork is even harder.
My personal experience as a tutor in corporate treasury, speaking about cash flow forecasting, is that delegates sometimes attend a workshop on cash flow forecasting with, broadly, the following mindset:
To help these delegates understand their real issue properly, I like to respond by asking, What is the objective of cash flow forecasting? Is it about guessing a number as accurately as possible? That is sometimes the vague idea in the treasurer’s mind when starting a cash flow forecasting process. It is then hoped that businesses are able to forecast inflows and outflows, so that treasury can define whether there will be a cash deficit or excess and take appropriate decisions; borrowing or investing surplus funds to optimise interest returns. That view of cash flow forecasting is often at the root of the problems that follow: we are looking at the bottom line with a magnifying glass.
If it is hard to do a cash flow statement using historic actuals, then relying on our own guesswork is even harder.
One then wonders where to obtain the numbers. Some obvious sources are quickly addressed, and may even volunteer a projection of their work. However, the modus operandi of different businesses and departments is likely to vary, plus there are gaps in the areas covered, and the treasurer is at risk of getting bogged down with detail: What system should I use? How do I capture receivables: down to customer level or estimates based on historic patterns, adjusted for other known factors? What about the non-trade items in the business other than M+A and share buy-backs which we already covered?
I have found it helpful to start by defining uses for cash flow forecasts depending on the time horizon, and then building the process accordingly:
The process of making it work is often like peeling an onion: Start with a very simple model for the long-term forecast, where good quality data should be available at group level. It is by nature a top-down approach, starting with EBITDA, adding capital expenditure, interest, tax, M+A spend etc. What sounds easy in theory will soon reveal that the devil is in the detail, with some data being prepared on a different basis from others, with non-cash items yet to be taken out, not to mention the circular logic inherent in interest and tax. The final result then invites us to run some initial scenarios: What if our capital expenditure doubled, or halved? How much would the cash position change if we accelerated, or deferred, our acquisition plans?
We are beginning to build a better understanding of the dynamics at work in our organisation, albeit on a high level.
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Where financial planning data exists, one could embark on the medium-term forecast, covering the next 12 months and moving the time horizon from a year to a month. Month-by-month forecasts can be a highly effective tool to monitor business performance, provided, however, that they are closely matched to the organisation’s generic financial planning and analysis. A good financial planning process will include cash flow projections, and therefore also balance sheets, creating a natural starting point for medium- term forecasting.
Making financial planning data work for cash flow forecasting purposes is well worth the effort: What does ‘cash’ mean in the generic financial planning arithmetic, and how is it defined? Where are the gaps between the treasurer’s view of what ‘cash’ is, and the accountants’ records? Cash in transit is a classic source of variance, expressed as the difference between the cash book balance, and the bank balance. Getting to the bottom of the dynamics creating the difference is another valuable learning experience. Then there is the inherent checking for completeness, as forgotten bank accounts and unusual items come to light.
Cash flow forecasting is all about knowing about payments and receipts before they happen.
Establishing a parallel process purely for cash flow forecasting, on the other hand, would only introduce the need to reconcile the two sets of numbers: Where and why do they differ? One would face the choice of devoting yet more time and effort to cash flow forecasting by attempting to reconcile the two sets of numbers, or accepting that treasury’s forecasts serve a different purpose and cannot be compared to generic financials.
The former option does not appeal. It would be likely to lead to a duplication of efforts. But it is the latter option that I feel is particularly risky: I once worked with a colleague whose previous employer went out of business altogether following a breach of debt covenants. In that organisation, the treasury function had not integrated closely with the rest of Group Finance, and chose to run its own, stand-alone forecasts. Those forecasts continued to project compliance with debt covenants, which later turned out to be based on misconceptions. Therefore, treasury kept reporting ‘status green’ to management for covenant compliance until it was discovered that a breach had already occurred. The company lost not only the opportunity to negotiate its way out of trouble with lenders, but also their goodwill, as lenders were disappointed by the apparent inability to foresee potential issues. A covenant breach soon led to liquidation. The ultimate nightmare for a treasurer!
Having created a long-term and a medium-term cash flow forecast, we then consider whether we want to embark on a tactical cash flow forecast. It would be different from the previous two because we typically do not have financial planning data at hand for shorter time horizons than a month: an all new, stand-alone process needs to be created, with no link to other generic financials. We already know the gaps and complexities, and anticipate a huge increase in the workload involved. But for what purpose? If we were to follow the cliché, and use the forecast for day-to-day cash management, we would need to have a high level of detail as well as accuracy. I tried to achieve that, and found that every answer I got led to more questions. Take payroll as an example: Have bonuses and share options been included in payroll forecasts? What about contractors’ cost? Why has payroll changed that much, anyway? Are redundancy payments part of payroll, or are they in exceptionals? If so, where? How do we treat pension contributions in payroll? What does that mean for the employer’s pending tax payment, who can tell us more and what are the underlying dynamics? The questions go on. I decided that it was a step too far. Instead, it proved more effective to introduce a less formal process for liquidity projections from businesses, looking only at the next few days. Intellectually satisfying it was not. But it worked.
It has been said before that cash flow forecasting is all about knowing about payments and receipts before they happen. I could not agree more. However, it is not an easy, nor perhaps a desirable, task to reconcile a bottom-up cash flow forecast to generic financials.
Overall I found that possibly the biggest benefit from undertaking cash flow forecasts lies in the experience of learning about the workings of one’s organisation. This, in itself, is what the treasurer should strive for.
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