In these gloomy days of financial crisis and high borrowing rates, cash flow forecasting has made its way from the backrooms of treasury departments to the front line in the boardrooms. Why? Because without it, companies of all business areas and size have understood that without a very good grasp on their liquidity patterns, they simply have no chance to survive – no matter how good their profit and loss (P&L) looks on paper.
Margins on P&Ls are nothing more than fictitious money. You cannot pay your suppliers, payroll or taxes with margins, but you most certainly can do that if you have either cash in the bank or appropriate credit lines in place to cover your shortfalls. Consider margins on paper as unrealised incoming liquidity, very much like in currency hedging – it is not realised until it is in the bank. Go and try to explain that one to any sales director and vice president.
In the past few years, cashflow forecasting has developed and evolved from being just an academic exercise to the biggest headache for cash managers, treasurers and chief financial officers (CFOs). Since the collapse of Enron and the arrival of Sarbanes Oxley (SOX) 404, the focus has shifted from revenue/profit to cash and working capital, and the burden has now landed on treasury organisations to not only keep companies afloat but also produce cashflow projection with longer outlooks. As such, treasurers are now in the front line of their organisations and taking the lead on their accounts payable (A/P), accounts receivable (A/R) and sales organisation in order to co-ordinate this complex Bermuda Triangle, which if not controlled and understood could turn very quickly into a very black hole leading directly to Chapter 11.
The Perfect Cashflow Forecast
How can you achieve the perfect cashflow forecast? Here are three tips:
1. Make it fit by performing your own little internal due diligence
Cashflow is like a designer suit that needs to be tailored to the size, style and flavour of the organisation. In short, understanding the business we are trying to forecast. For example:
- What are we selling? In some industries, companies need to outlay cash to buy equipment or stock before they can sell it on, which leads to cash out before cash in.
- Know who you are dealing with, whether that is private firms, small businesses, government, financial institutions, etc. Depending of who your customers are, their payment habits, cycle, and processes can have a negative effect on your cash if you are not prepared to accommodate.
- Know who you are buying from. If customers will do whatever possible to stretch out their payment terms, suppliers, on the other hand, will pull the opposite way by forcing short payment terms and might go as far as offering an early payment discount. In a tight cashflow situation, I am not in favour of early payment discounts.
2. The engineering phase
Choosing the right model cycle is key to successful cashflow result, a bit like choosing the adequate car for one’s family. If you have four kids and a big dog, you would not buy a two-door BMW convertible but a more adequate people carrier. This situation is similar: if you do not have to worry too much about keeping positive cashflow because you are sitting on a pile of cash, then a lean, mean weekly cashflow cycle might just be enough.
However, if you are in a more stringent, low-margin, suffering-long-payment-terms environment, which is very common in the software environment (unless you are Microsoft, of course), you will no doubt have to default to credit line usage to keep the beast moving and as such, will have no other choice than outlaying a daily cashflow to ensure that your lines are managed within boundaries and also avoid excessive interest expense. That is more demanding, as you are adding a layer of complexity to the exercise and does require at least a three months outlook, particularly if you are working with external banks rather than in-house funding.
Once you choose the right vehicle for your lovely family, you need to be able to fill it with the appropriate luggage, which will give you the support you need to ensure a good journey.
So the best way to begin the engineering phase is to start with what we know and identify the more volatile items, which for most companies comes out of A/R. That is unless you are a utility company or a financial institution that collect from their customers through direct debits – in that case, the surprise factor is taken out.
The hard part comes when you try to bring it all together in the most accurate way – this is where you experience a hard pushback from various players.
Anyone who has been given the task to put a cashflow together has experienced at one point or another the “What do you mean you want a cashflow to the end of the summer? But that’s impossible and it would not be any good anyway.” Personally, I love it when people say that because it is so easy to prove them wrong – and before you know it what was considered a one-time exercise brought on by one crisis or another has become part of the regular, daily, weekly workflow.
I truly believe that companies that do not examine what their liquidity may look like in advance, not only never achieve their potential but also end up shooting themselves in the foot as they are forever running around trying to fill the holes of large tax payments or dividend payouts, when they could have prepared in advance to ensure that they had the funds in place to cover those extraordinary cash outlays. As those items tend recur quarterly, bi-yearly or yearly, they are easy to plan for.
In my personal opinion, a cashflow is made of two parts. What I call the hard forecast (four to six weeks ahead) and the soft forecast (six weeks and beyond). Any cashflow that tends to go beyond budget is, in my eyes, like shooting into the twilight zone and a waste of energy because they cannot be substantiated, particularly in these hard times where business futures are very uncertain.
The hard forecast will be built on solid realised data, while the soft forecast will put together a mix of previous year forecast and sales forecasts/budgets. If put together well, they will roll one into the other as the weeks roll over without too much of a shockwave, effectively rendering the whole cash management process much more comfortable, efficient and predictable.
3. Going public
Once the engineering phase has been completed, this is where the real fun starts – the ‘going public’ phase.
This is where treasurers who are not afraid to go to the front line will make the real difference. You can have the most sophisticated car on the market with all the options possible, but if you cannot drive it, then what’s the point?
Managing and driving a successful cash flow is like running a political campaign: one needs to bring all the influential parties around them, and then lobby agressively:
- Lobby with your sales forces to reduce payment terms, and/or get client to release early payments.
- Lobby with your A/P department to push back supplier payments, or flush out cash if you have overstepped your initial forecast (being predictable is absolute key).
- Lobby with your operations to push out inventory if required. Anyone who has impact on the liquidity must be brought into the loop, because if they aren’t brought in, hitting bullseyes on that quarter-end balance will forever remain a forever losing battle.
Finally, through my own trial and tribulations of controlling this ‘uncontrollable’ animal, I have also discovered the most powerful golden rule of successful cashflow forecasting: putting your cash where your cashflow is.
Fundamentally, once the end balance has been finalised, steer the ship to hit that number right between the eyes. Overshooting is an absolute no-no, for it will only get rewarded by a “How can this happen?” comment. Falling well short of predictions will bring nothing more than “What on earth happened?”. We can easily forgive sales organisations for missing their budgets and find them excuses, such as the bad weather, the recession, the credit crunch, or the football season, but treasurers, cash managers and CFOs are not forgiven or excused for bad cashflow forecasting, as we are expected not only to predict the future but also to deliver the future without fail.
Mastering this engine is absolute paramount not only to keep companies alive and moving, but without it, adding the top layer of longer-term investment and merger and acquisition (M&A) becomes nothing more than fiction – many companies have forgotten that cash initially derives from the core business. The operative cashflow is the heart of the machine, and without it, it is very hard to sustain any organisation, let alone grow or attract outside investors.
Weathering tough times internally by revisiting the cashflow process cycle, components and methodology can not only keep companies away from going down the bankruptcy road but also bring a new lease of life and dynamism to any organisation. One just has to try. Filling the shortfalls through external borrowing from banks or using recurring factoring facilities will only lead to make the hole deeper down the road and require even greater cash injection to get back to black.
Finally, cashflow forecasting is not just another Excel spreadsheet: it is a powerful management tool that – if analysed properly – can reveal the structural and strategic weaknesses of any given organisation. Successful chief executive officers (CEOs) will take their cashflow apart and strategise accordingly either by declaring cutback programmes, change of business stream, or may decide to look to centralise and consider M&A activity.
Cashflows are very powerful management tools that can act as a compass if used properly. They are most definitely a necessary evil, similar to an internal audit. We hate them but we cannot avoid them.
Finally, I have found that the best way to succeed in this gruelling and unforgiving task is to have fun with it and not be afraid to apply out-of-the-box thinking, as well as communicate effectively with all parties concerned. Good luck with your forecasting programmes.
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