Strategy: Finance

Cash management and forecasting

Why is cash forecasting so critical?
One would think that since cash is so crucial to the successful operation of a company, every company would already have the process of projecting it down to a science. Our observation, however, is that until liquidity becomes tight, cash forecasting and management are something companies only perform at the 30,000 feet level, not at the nap of the earth height necessary to provide the insight to manage working capital effectively and make the short term business decisions to preserve a company’s ability to operate during tough times.

We are often called into situations where we find that the company has a short term problem that needs to be quickly addressed (eg, burning cash and its loan facility is either fully drawn or expiring soon). This paper addresses one potential solution to such situations.

One of the key reasons companies with an urgent need to forecast short term cash have trouble forecasting is a lack of the most recent information to accurately forecast in a turbulent operating environment. When we arrive at a company, we typically find that cash forecasting is a treasury responsibility with some assistance from finance. Often, each group has pieces of the required information, but not the complete picture. Neither do they typically have the appropriate insights into either what levers can be pulled to address cash needs nor the impacts on customers and suppliers from pulling those levers. As a result, the existing forecast is often inaccurate, and not detailed enough, to allow for appropriate decision making.

The process outlined as an example below addresses this issue of information (or lack of it) and addresses how a company can work to develop a more accurate cash projection. Typically, this process can succeed only if an appropriate level of importance is placed on it by upper level management. Once that leadership support is in place, a forecasting system can be established that, in our experience, can emerge as a tool to not only monitor cash but more broadly:

·                     Evaluate short-term operational changes

·                     Anticipate liquidity needs, and

·                     Enhance working capital efficiencies. 

One proposed cash forecasting process
A sound cash forecasting process provides enhanced visibility into operations and is a very effective control mechanism for the chief financial officer (CFO)/chief executive officer (CEO). It is an efficient mechanism to evaluate cash inflows and outflows and a company’s ability to meet its commitments. In addition, when used strategically, it can be used as a tool to assist as long-term decisions are contemplated.

This example cash management process can be applied in companies with multimillion dollar to multibillion dollar revenues, regional companies to global Fortune 500 corporations, from retail-based to service-based organizations. Similarly, it can also be applied in healthy companies and in distressed companies. However, we typically see this process applied by distressed companies with one or more underperforming business units. This process is not a multimillion dollar investment to upgrade a current information system. In fact, the cash forecasting methodology that we describe below is non-system based, relatively simple, and can be modeled using standard spreadsheet software. Though we recognize the benefits of implementing a long-term, system-based cash planning tool, the situation in which this methodology is preferable is one in which a company has neither the time nor the money to put in place such a system.

Cash management process—assigning responsibility
Based on what we have seen, this process can be effective only with C-suite level sponsorship. The CEO must strongly support the process, and the CFO must not only effectively articulate the reason the company is undertaking what will likely be a new process with larger organizational involvement, but must also repeatedly emphasize its importance by remaining intimately involved in it. This sets the tone for the organization regarding the importance of the process to the company. The CFO should also:

·         Assign a process leader (usually, the treasurer) who will take the lead in collecting the data, publishing the forecast, and day-to-day management of the process. Once the inputs are received, the data is reviewed for completeness and reasonableness by treasury. Typically, the treasurer will perform a final review and provide the cash forecast to the CFO for any additional input or updates before it is finalized.   

·         Identifybusiness owners who have the latest and the greatestinformation about specific lines in the cash forecast and assign the forecasting duties for those lines to the executive business owner. For instance, the purchasing function probably knows best about most vendor payments and terms. Therefore, purchasing should typically be the business owner for the majority of vendor line items. Similar assignments should be made for other line items in the forecast. Assigning responsibility is how companies address the issue of lack of information mentioned earlier.

Foundation for an effective cash forecasting process
An ideal process for cash forecasting would look like this:

·         Policy development: In order to support the process, policies and procedures should be developed (by process leader and approved by CFO ) that clearly lay out the assignment of responsibility and requirements.

·         Measurement of forecast accuracy: Treasury is typically responsible for measuring the ongoing accuracy of the cash forecast by evaluating the inputs received against actual cash receipt and disbursement activity. Treasury would then be responsible for following up with the input owners when there are discrepancies between what was expected and actual results (commonly referred to as “variances”). The reasons for the variances are documented and provided to the treasurer and CFO for review. Based on the results, a determination is also made to evaluate if changes should be made to the cash forecast process in order to improve its accuracy.

·         Periodic review and monitoring of the process: In order to determine that the cash forecast has ongoing visibility throughout the company, weekly meetings should be held with senior management to review. It has been our experience that a weekly thorough discussion regarding the cash forecast often brings to light certain items that are only known by senior management and may have been missed during the process of receiving input from the business. In addition, if the company is experiencing cash shortages, this may be an effective forum to discuss potential solutions.

·         Forecasting window: The window should be long enough to provide meaningful visibility into the net cash from future operations, but short enough to provide a reasonably accurate cash forecast. We typically see companies employ a rolling 13-week period for such forecasts, though this is not universally used. We often see this short-term forecast used in conjunction with long-term, though less detailed, financial forecasts (discussed later).

In comparing the advantages and disadvantages of a long term vs. shorter term forecast, one sees a trade-off between visibility and accuracy. It is understood that a long term forecast will generally be less accurate than a shorter term forecast. However, it is important for companies to have a long term strategic focus in order to anticipate potential issues with cash flow based on known economic conditions or anticipated changes to the business (such as missing sales forecasts). This can allow appropriate time to evaluate and implement short term solutions.

A short term forecast should incorporate appropriate seasonal needs of business and working capital fluctuation. On the other hand, a long term forecast should surface capital investments, refinancing or restructuring (assets sales, for instance) needs well in advance and can be an effective tool in the financial planning process.

·         Frequency: The frequency of updates depends on the financial situation of the company. Typically, a weekly process is sufficient for most companies. However, if the company is experiencing financial difficulty, daily updates to the cash forecast may be necessary.

·         Internal access to forecast: The cash forecast should be treated confidentially within the company and distributed to only designated members of senior management on a need-to-know basis. However, the distribution must be broad enough to allow for appropriate input from, and feedback to, process participants. 

·         Third-party reporting: There may be instances when cash forecasts are provided to external parties. Typically, these requirements are established by lender agreements. Management should evaluate the requirements and determine if any changes are required to the established cash forecast in order to meet the requirements. The goal is not to perform additional work to prepare these forecasts, and as new requirements arise from lenders, the current forecast process should be evaluated to determine if changes are required.

Cash flow forecasting variances—maintaining accountability
The process leader and/or the CFO should communicate clear parameters of accountability to the business owners early on at the launch of the process along with timeline and measures of success. The executives in charge of each business function that forecasts a line item (referred to earlier as business owner) should be accountable for the numbers presented to the process leader. Of course, the responsibility for gathering the data will likely fall to someone working for the business owner. However, though the gathering process will be delegated, we again emphasize that it remains important for the actual business owners to feel ownership for their numbers.

In the context of cash flow forecasting, there are generally two categories of accountability measures:

A.                Accuracy of projections: Acceptable variances between actual and projected cash flows should be defined and stated explicitly when the process is rolled out. For example, it may be stipulated that “the business owners for vendor payments (purchasing function) would be expected to achieve a forecasting variance of no higher than 5 percent on a rolling four-week basis.” These variance thresholds are set based on the nature of the individual business, historical accuracies in predictions, and aspirational levels.

In a situation in which cash flow forecasts of the sort addressed here have never before been attempted, the team will likely face a challenge in initially assigning appropriate variances. In such cases, the variances initially established may need to change as data is analyzed and processes evolve. Variances should be established to be broad enough to be achievable and small enough to be meaningful. Needless to say, some variances are more critical than others and some businesses are more complex than others. Acceptable thresholds on forecasting variances should be set on both a weekly (or monthly) and cumulative basis. It is important to have a clear understanding of the types of variances and how they are measured, tracked, and reported.

There are several types of variances:

Permanent variance: These variances do not reverse from period to period and result in lower/higher than expected cash position. Examples include:

·                     Inflow: For a given week, in case of a retailer with lower than forecast sales on a holiday weekend, there would be a lower cash position resulting in a “permanent” variance between actual and projected cash flow.

·                     Outflow: An increase in raw material prices that was not included in the forecast may also lead to lower cash position and a permanent variance between actual and projected cash flow.

Temporary variance: These are typically timing-related variances that will eventually reverse. For example:

·                     Inflow: If a customer makes a payment on receivables in a week following the one in which it was projected to be received, then there would be a temporary variance for that week in receipts. However, when this payment is received in the following week, this variance would reverse itself in that week. This is the reason it is a “temporary” variance.

·                     Outflow: Late vendor payments (similar logic as above).

Another kind of temporary variance that might occur is when treasury decides to “push” a particular vendor payment. This is a very common instance in a distressed company where the treasurer is constantly looking for cash to bridge temporary low points in liquidity. This results in a variance for that week. It is critical that the business owners are not held accountable for variances that occur due to a treasury push, since this is clearly beyond their control.

Variance tracking and reporting:Constant communication and feedback are vital to the success of the forecasting process. As discussed in the prior section, variances should be measured by the process leader and presented to the business owners frequently, typically on a weekly basis. They should then work together to identify the reasons behind the variances—temporary, permanent or push related. The final explanation and tracking report should be reviewed by the CFO on a weekly basis (at least initially when the process is in transition).

As mentioned earlier, since variances are measured on both a weekly and cumulative basis, it is important to understand the distinction between both. From a cash management perspective, both kinds of variances are critical. In a distressed situation, high weekly variances could be precarious, as the company is usually already in a low cash position.

To measure overall forecasting accuracy, however, cumulative variance is often a sound indicator. The reason is that, many times, weekly variances have components of timing, and cumulative variances (over four or eight weeks) tend to even out the timing issues because of the very nature of their calculation.

Business owners should strongly consider updating forecasts weekly to provide the most accurate possible forecast. However, variances should be measured against the initial forecast (provided 13 weeks prior if the company is using a 13-week forecast period). This should provide the parties with a solid indicator of the quality of its forecasting process (and whether further change may be warranted). Resulting improvements should provide the company with a more accurate 13th week forecast to use for its decision making.

B.                 Timeline to achieve the desired accuracy: After setting the desired variances, the process leader and the business owners need to be provided a timeline within which they need to understand and streamline the process, seek clarifications, and achieve the variance thresholds. This part of the process cannot be overemphasized. Initially, when the process is rolled out, there are likely to be a lot of questions from the business owners on the process, variances, and deliverables. While it is important that these questions be answered in a manner that is consistent and fair to all parties, the goal of this exercise should be to have a “working” forecast as soon as possible. Especially in distressed situations, the timelines may be critical as there is very likely a strong need for visibility to projected cash position—both, by lenders and the CFO.

Given the fact that this is an iterative process, the timelines would be dictated by the complexity and cash needs of various businesses led by the business owners and by CFO’s expectations. As described earlier, the forecast is evaluated on a periodic basis and readjusted, as required. Regular measurement and reporting informs the participants (including the CFO) of the effectiveness of the process and the corrections that need to be done in case the variances are not acceptable or if there are specific concerns that business owners might express. In the initial weeks, when the process and the analytics are being fine-tuned, large variances are common. However, such variances should diminish as participants become familiar with the nuances of cash inflows and outflows in their respective businesses and adjust their forecasts accordingly.

Using the cash forecast as a tool for financial management

Providing control and tracking cash
This example of a cash forecasting process may provide a very effective financial management tool. Since the cash forecast is reviewed and refreshed every week, it is a good way to find out if the company is on track to meet its annual budget. Tight correlation between business plan and cash forecast should be desired. Periodic reconciliation between the cash forecast and the budget would be a good reality check on the financial affairs of the company. In case of cash receipt shortfall, for instance, it is easy to know how this would impact the annual plan, what corrective actions may need to be taken, and who would be responsible for implementing those actions.

True to its intent, this process is an example of an effective way to track cash inflows and outflows. Having said that, it is important that CFO/treasurer should be dogged in measuring, tracking, and investigating line item variances, which serve as key drivers in this process.

Managing the soft side
Lastly, to make the cash forecasting a success, as pointed out at the outset of this article, the CFO should explain to all the participants that success of the process is vital to the success of the company and a critical component of financial management. The business owners should buy into this process either by mandate or volition. Without such buy-in, the process may fail. The CFO and the senior management team should acknowledge this organizational investment upfront and weigh it against the potential benefit that they perceive this investment would yield. It is of paramount importance for management to let the participants know the implications (initially versus later, perhaps) of missing their business line’s forecast, and making sure they know that the process should improve along the way.

Putting in place an effective short-term cash forecast is a difficult task given it is often a process that is started at a time in which the company’s management team is deeply engaged in the process of turning around the company. However, rather than being viewed as a nuisance that the unforgiving lenders will or are compelling the company to do, it should be viewed as an effective tool to drive the cash management and operational decision making that will be at the heart of the turnaround. Often, an experienced restructuring professional can provide the skill set and perspective needed to help the company see and execute that vision.

By John W. Little, principal, Deloitte Financial Advisory Services LLP
Ryan Foughty, senior manager, Deloitte & Touche LLP
Sachin Adhikari, senior manager, Deloitte Financial Advisory Services LLP

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