Working Capital Magic - From Customers to Cash Flow

Cash Forecasting and Price Volatility

In many industries, including those dealing with commodity goods, pricing changes are rampant and can make generating an accurate cash forecast especially difficult. The only way to deal with these fluctuationsis to have a solid cash forecasting methodology to address the dynamic nature of pricing changes, customer payment habits and changing business conditions.

The best approach for cash forecasting will focus on defining a reasonable scope and an appropriate level of precision. This in turn will lead to being able to easily compare actuals to forecast values and determine variances.  The challenge is to easily access distributed financial data in a timely manner, store historical cash flow data for trend analysis and allow simulation of multiple cash forecast revisions based on multiple sources of input. These sources of input could be individual collector information, promises-to-pay from customers as well as historical payment data.

When dealing with pricing changes, you need to identify trends and cycles from the past and apply them to the cash forecasts. If pricing changes are seasonal, for example, the reflected payment history can be taken into consideration while generating the forecast. Similarly, each forecast revision can be updated to reflect other criteria such as known projected pricing changes, thresholds set by collectors, etc. In this manner, simulations of different forecasts, along with realistic acceptable variance levels, can bring a higher level of predictability to cash flow processes.

Short term cash forecasts based on receipts and disbursements are even more powerful when you go beyond billings and vendor invoices - the real power lies when you take into account anticipated events on the supply and demand side.  More on this later...

Cash Forecasting for Fun and Profit

In today’s real time enterprises, getting a tight grip on cash flow is top on everyone’s to-do list.  Working capital improvement projects are getting a lot of buzz in major corporations.  If you add to this some of the requirements from Sarbanes Oxley Section 404 demanding that any material changes pertaining to a company’s finances be accurately predicted and managed, you know accurate cash forecasting is going to play a key part in how companies do business.

The following key excerpts highlighting A New Approach to Cash Forecasting from an article by Veena Gundavelli from Emagia show that this is really a collaborative enterprise-wide process.

Treasury groups rely on short term cash forecasts to understand projected surpluses and deficits, drive investment strategies and ensure sufficient liquidity.  In most companies, short term cash forecasts are modeled using one of two methods – the receipts and disbursements method and the distribution method.   The receipts and disbursements method involves simply comparing separate schedules of projected receipts and payments to determine liquidity and cash requirements.  This method may not be useful for many companies because it assumes a relatively uniform and unchanging stream of cash flows.  Similarly, the distribution method, which involves allocating cash flows throughout the specified time period, drives marginally higher levels of accuracy but does not take into account the dynamics of real world events.

Studies have shown that less than 27% of treasury groups feel satisfied with their current levels of accuracy.  The high degree of variance that corporations see when comparing actual results with cash flow projections can lead to costly hedging of funds required to cover liabilities and unforeseen risks. 

As treasury and cash management groups continue to place emphasis on the importance of cash forecasts, a new approach is required to quickly generate improvements.  The latest studies have shown that many of the challenges that companies currently face can be addressed by implementing the following tools and process changes within the organization.

Some of the key recommendations that are being tossed around about improving cash forecasting include:

1. Remove barriers to accessing information – The most important step is to quickly integrate data from disparate systems into one easily accessible source of information.  All relevant data such as outstanding balances, promises to pay, scheduled payments, off balance sheet liabilities, etc…from different parts of the organization needs to be available to all parties involved in the forecasting process. This data should also be reflective of the most up-to-date information that is based on current business events.

2. Develop a reliable consensus forecast – Putting the proper organizational procedures in place for cash forecasting is critical.  By focusing on developing a data driven, consensus forecast, companies can greatly improve the accuracy of the results.  Consensus forecasting entails combining multiple inputs from different levels of the corporation and developing a reliable forecast using a collaborative approach.  The latest cash forecasting tools allow companies to effectively manage this inter-departmental process.  As revisions of cash forecasts are developed, managers and treasury groups can manipulate data inputs and gauge results before finalizing the most realistic forecast.

3. Take into account changes in business conditions – All successful predictive functions need the ability to simulate the effects of varying business conditions.  Cash forecasting needs to be performed with an eye towards incorporating changing market conditions, contractual agreements and the varying ability of departments to achieve goals.  For example, cash forecasting should include performing “what-if” analysis on different levels of projected receipts and disbursements, varying payment discounts and simulating different levels of collections efficiency.  This is where a collaborative process along with intelligent cash forecasting tools allows companies to project results over multiple scenarios and proactively improve risk and liquidity management.  Also, cash forecasts should be “rolling” and updated to utilize the latest business information such as actual receipts and promises-to-pay.

4. Gauge the results of better cash forecasting – Finally, on an ongoing basis, companies should not only measure cash forecasting accuracy, but also the effects of the resulting decisions.  As forecasts are generated, companies need to be able to compare various business scenarios and also assess the possible resulting actions.  If higher accuracy led to higher investment gains in the short term, the process should be carefully analyzed to assess how the improvements were achieved.  Alternatively, if lower accuracy resulted in costly foreign currency exchange exposure or the inability to cover short term liabilities, then the root causes of the inaccuracies also need rigorous investigation.

It would be interesting to see how different industries address cash forecasting.  My initial guess is that companies which have high margins and tend to be cash rich, probably don’t put too high of an emphasis on cash forecasting accuracy.  But low margin companies who also get slammed with high costs of capital probably have to squeeze every last dollar out of short term investments and borrowings.  Also, a fantastic set of postings on forecasting can also be found at Synergy Partner's blog.

Time to go water my plant...  I think I see some signs of life...