Today threats of default, sovereign contagion and credit market freeze are risks a treasurer must heroically manage. Despite this now daily risk and uncertainty, direct measurement of corporate operations is ongoing, using cash as the primary metric. Cash is king because generating cash from operations over time is a wealth-creation principle that sustains business.
Ordinarily, when operations suffer a temporary downturn, a business may be able to buy time through asset sales to raise necessary cash. Credit may or may not be available, and asset markets may or may not be fairly priced, if available at all. Combined with fuzzy cash counting, uncertainty of these economic times leaves the most diligent treasurer challenged to facilitate reliable cash forecasting – a key input for strategy and risk planning.
Good managers prioritise their operating strategy initiatives based on their relative wealth-creating impact. Failure to achieve sufficient cash generation with these strategic decisions means the business may be headed for troubled waters or worse.
Counting currency and coin as accurately as possible is a must for forecasting reliably to drive strategy and tactics.1
Working capital strategy seeks to maximise the efficiency of the value chain throughout the operating cycle. First, inventory management practices must be optimal. Secondly, receivables collection days must be managed for reliable turnaround. Thirdly, payables disbursement must be executed efficiently, identifying and taking discounts where advantageous.
Short – to Medium-Term Forecasting
A reliable short – to medium-term (1-90 days) cash forecasting effort requires direct, comprehensive and objective observation of cash inflows and outflows. Categorising these receipts and disbursement transactions at a high level as operating, financing and investing (OFI) activities helps organise the information flow, providing directional help for tracking down root cause of missed or inaccurate observations. The net cash inflow or outflow from each of these activities changes the cash position.
In a technical context, a cash observation function has an information architecture derived from mapping business processes, distilling key data series and items, and defining additional calculated items in a format that allows comprehensive management of cash flows and changes across the enterprise.
Another key technical element is pooling. The manner and method of pooling implementation is critical to efficient information flow for organisations with multiple bank relationships. Effective pooling facilitates timely and transparent information flows, e.g. currency translation or regional cash availability unobstructed by country capital controls.
If you have experienced chronic issues with lack of cash item information, big surprise adjustments, or bad data in any of the OFI areas, consider using a free master data management (MDM) tool, e.g. talent to jumpstart an ‘observation excellence’ effort in your enterprise.
Steps to initiate such an effort are outlined as follows:
- Plan for a single OFI category including net present value (NPV) business case and return on investment (ROI) drivers.
- Review scope with data owners and document their processes and timing.
- Identify data series and items to develop data dictionary.
- Create a daily report format: use rolling weekly, monthly or quarterly reporting intervals.
- Enter projected or known values for the full 90-day period.
- Schedule brief follow-up consultation with data owners and begin data updates protocol.
- Document ROI of more efficient management of cash flow observation and forecasting.
- Highlight largest percentage contributors to cash position changes and missed item reports.
- Kick-off observation excellence for a second OFI category.
Management needs accurate cash position observations to efficiently manage the timing of receiving accrual-based payments, non-discretionary outflow disbursements, variable growth disbursements, discretionary capital investments and strategy planning. Inefficient and chronically inaccurate cash observation is not an option for a manager hoping to run a sustainable business.
Keys to Effective Observation
While many daily cash position tracking strategies will start with an empty sheet, spend most of the period monitoring events and then try to reconcile at the end of the period all relevant transactions, a good observer practice will be to start with previous period values, maintain a list of expected transactions with approximate values and confirm execution and amounts throughout the period while identifying unexpected cash events. An observer would want to estimate in advance, at the very least, the major cash inflows and outflows by size.
In Figure 1, key data series and items are presented by category. This is a rudimentary information architecture for identifying observable cash inflow and outflows. Depending on the complexity and industry of your enterprise, an ‘observation excellence’ effort may define a substantially more comprehensive information architecture for your cash tracking system.2
Figure 1: Cash Flow Source Matrix – Observation Data Series and Items by Category
Source: Reserve Capital Value
EBITDA For Medium-term Forecasting?
Some organisations may be tempted to rely on a common industry metric for comparing company performance, known as earnings before interest taxes depreciation amortisation (EBITDA), as a base metric for cash forecasting.
Sales, a large component of EBITDA, is reported under accrual-based accounting principles and may or may not be easily adjusted or related to changes in the cash position. This may not result in a satisfactory cash forecasting protocol for management strategies designed to create value.
As stated above, good cash observation techniques take into account required increases or decreases in cash to support changes in the operating cycle. However, an adjusted net income metric (net income adjusted by balance sheet items including: current depreciation, accounts receivable (A/R), accounts payable (A/P), inventory, etc) is used for medium and long-term forecasting. Usually this metric is available on a monthly or quarterly reporting cycle.
In short, operating profit measures fluctuate more widely than sales and initially leave out critical observation of working capital financing for the operating cycle. In a statistical sense, these measures can be adjusted up or down with sales volatility but this requires a direct knowledge of cash outflows to set the adjustment factors to make reported ‘profits’ an approximation of cash impact.
Analytical tools have made it more practical to estimate and forecast cash flow through adjustment factors derived from analysis of detailed cash changes and applied to operating profit metrics. Key to analysis of cash sources and uses is to evaluate multiple reports over time when available.
When reporting cash flows to assist management of strategies for value creation, try isolating cash used for the operating cycle and cash used for financing and investment. Reporting transparency calls for distinguishing between discretionary and non-discretionary cash flow in the OFI categories. Typically, it is advantageous to use an operations based definition of working capital that differs from the usual balance sheet definition of net working capital as current assets current liabilities. Operating working capital (OWC) may be defined as A/R + inventories + prepaid expenses – A/P + accrued expenses.
By managing the cash conversion cycle efficiently, managers achieve two important benefits for cash flow value creation:
Minimise cash tied up in the operating cycle.
Maximise the cash productivity of the operating cycle for all future operations.
Managers monitor the days of inventory, the length of receivables collection or days of sales outstanding (DSO), and the amount of payments owed to streamline the value chain and inform observers of unforeseen impacts to the cash position.3
Good cash observation techniques can have a significant impact on efficient management of working capital. The ROI for an ‘observation excellence’ initiative can start before the effort is completed. When sales accelerate, management will not have to estimate how much additional capital has been employed to support the growth or whether managers have created value through the operating cycle with the increased sales. Both of these key questions can be answered accurately in minimum time by an effective cash observation and forecasting system.
1Reported earnings may stay positive during periods of net cash outflow.
2While some firms may have issues related to solvency from time to time, here we are concerned with maximising managerial efficiency of business and financial operations as a going concern. We are focused on managing operations over the cash conversion cycle for value creation. Thus some of our terms and concepts may be somewhat different than those commonly used to define indirect accounting reports or measure firm liquidity as it pertains to solvency at the end of a single reporting period.
3Increases in sales are not necessary to achieve liquidity enhancing results through better operating working capital (OWC) management. The key takeaway here is to gain visibility over critical value chain functions to enable proactive value creating or defensive liquidity management strategies throughout the operating cycle.
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