The Critical Importance of Cash Flow Forecasting

The Hackett Group’s ‘2013 Operating Cash Flow Forecasting Study’ of more than 100 Global 1,000 companies with annual revenues averaging US$5bn found that only about 20% of companies can forecast mid-term (i.e. two to three month) cash requirements within 5% of actual figures – and forecasting accuracy has actually declined since 2009.

Despite the importance of accurate cash flow forecasting, a significant number of companies still are not acting with urgency to improve their capabilities. However, many of those that are looking to improve are targeting working capital management practices. The study’s ‘top performers’ – companies that forecast cash flow accurately – share several other common characteristics, including a focus on employing sound working capital processes that reduce cash flow uncertainty. As a result, they can forecast cash requirements with greater precision.

A Competitive Differentiator

A combination of sustained marketplace volatility and expansion of post-recessionary growth initiatives is continuing to challenge companies’ ability to manage cash. REL’s ‘2013 Cash Strapped Analysis’ shows that for US-based companies across a wide range of industries, cash on hand as a percentage of revenue actually declined from 2011 to 2012.

This type of environment requires companies to have sharp capabilities for both understanding their current cash position and how much cash they may require in the future.

Effective cash flow forecasting is essential to maintaining stable operations and critical to ensuring informed discussions about capital expenditure and investment planning. Indeed, 70% of participants in the study believe that cash flow forecasting is a competitive differentiator critical to realising their strategic goals.

Specifically, they believe it can translate into significant enterprise benefits ranging from greater ability to invest in the business to debt reduction to impact on shareholder dividends – as outlined in Figure 1 below. Even for cash-rich companies, the potential benefits of accurate cash flow forecasting are numerous. They include better returns through more accurate investment of idle cash, the ability to hedge foreign exchange (FX) exposure through accurate cash forecasting across all of a company’s divisions, and opportunities to optimise supplier discount programmes.

Figure 1: Potential Benefits of Better Cash Flow Forecasting

REL cash flow forecasting Figure 1
Source: REL Consultancy

Cash Flow Forecasting Accuracy is Low

Most chief financial officers (CFOs) cite improved forecasting capabilities as an imperative and a high priority for 2013, given the inability of most companies mentioned above to forecast mid-term cash requirements with much precision.

Even more concerning is a decline in cash flow forecasting accuracy over the past four years – including a significant drop in the percentage of companies that can forecast mid-term cash flow requirements within 10% of actual figures – see Figure 2 below.

A variety of factors, both internal and external, contribute to forecasting difficulties. Among these, significant impediments are changes in demand, pricing and/or product mix. Many of the issues are related to the practices and processes that companies use to generate forecasts, such as ownership of the overall forecasting process, analysis used to develop forecasts, collaboration among the various stakeholders involved, data quality, or reliability of data inputs.

The impact of working capital management on forecasting is also extremely significant. At least 60% of the companies surveyed reported that variability in both receivables performance and inventory performance substantially inhibited the accurate forecasting of cash flow. A similar percentage cited changes in their customers’ financial viability, which in turn impacts receivables performance.

Figure 2: Mid-term Operating Cash Flow Forecasting Accuracy, 2013 versus 2009

REL cash flow forecasting figure 2
Source: REL Consultancy

Lack of Urgency

Despite the importance and potential benefits of accurate cash flow forecasting, a significant number of companies are still not acting with urgency to improve their capabilities. More than one-third of companies have no specific goals or initiatives to improve cash flow forecasting competency levels over the next two years. Moreover, as Figure 3 demonstrates, few are allocating resources and/or discretionary project funding specifically to improve cash flow forecasting competency levels over the same time period.

Figure 3: Commitment to Improving Cash Flow Forecasting

REL cash flow forecasting figure 3
Source: REL Consultancy

Why this inaction? For many, the answer may be conflicting priorities. Given today’s market realities, sales and earnings initiatives often take precedence over reporting initiatives.

Targeting Working Capital Management

For a majority of companies (65%), this inability to forecast accurately has prompted a need to implement working capital improvement programmes – well ahead of other strategies such as more stringent spending controls, delayed or cancelled capital expenditure projects or increased short-term borrowing, as outlined in Figure 4.

Many have already taken action on that need, with 56% of companies indicating that they have implemented specific working capital changes in the past six months in order to improve the accuracy of their cash flow forecasts.

Figure 4: Effects of Uncertainty and Inability to Forecast Cash Flow Accurately

REL cash flow forecasting figure 4
Source: REL Consultancy

Characteristics of Top Performers

The study’s top performers – those that are able to forecast cash flow most accurately – share several common characteristics. Specifically, this group:

  • Forecasts mid-term operating cash flow within 10% of actual figures (compared to only 28% of the study’s peer group).
  • Completes forecasts in less time – 89% of top performers are able to prepare forecasts in two days or less (against 24% of the peer group).
  • Requires less effort to complete forecasts – only two full-time equivalents (FTEs) are needed to complete the forecasts (against four FTEs for peers)

Top performers also share several common drivers of top performance in forecasting, one of which is employing sound working capital processes that not only improve efficiency and effectiveness but also reduce uncertainty in their operations, enabling them to forecast cash requirements with much greater precision. This focus extends to all elements of working capital management, including accounts receivable, accounts payable, and inventory.

More Efficient Accounts Receivables Processes

Top performers have honed accounts receivable (AR) processes to operate more efficiently and improve the predictability of their receivables and cash flow. For example, they are more likely to have established efficient transactional processes that make it easier for customers to conduct and complete business with their organisations, from purchase through payment, as per Figure 5a. Such processes enable top performers to shorten the time required for posting customer purchase orders, applying cash, and resolving disputes.

Top performers are also more likely to have effective processes for managing disputes with customers that enable them to reduce or minimise cash flow uncertainty arising from such situations (Figure 5b). For example, they have standardised approaches for proactively identifying and resolving disputes and/or conduct root cause analyses to identify and address sources of disputes.

As a result, top performers are less likely than the peer group to have significant levels of overdue receivables, a key factor in removing some of the uncertainty that impedes accurate forecasting. In the study, three-quarters of top performers reported past-due receivables of 20% or less, versus 69% of peers.

Figure 5a: More Efficient Transactional Processes

Figure 5b: More Effective Dispute Resolution Processes

REL cash flow forecasting figure 5a and 5b
Source: REL Consultancy

Automated and Standardised Accounts Payable Processes

In accounts payable (AP), top performers benefit from greater automation and standardisation. They are far more likely than peers to automate AP processes such as supplier invoice receipting, processing, and discrepancy management – see Figure 6a below. Automating these processes not only increases efficiency; it allows them to post invoices and resolve discrepancies faster, thereby increasing the visibility and accuracy of upcoming supplier liabilities and expected cash outlays.

In addition, top performers are more likely to use standard payment terms (Figure 6b), another capability that makes it easier for them to project future cash flow because it instils greater predictability around the timing of their payments to suppliers. Half of top performers reported that they use standard terms 80% or more of the time, while only 39% of peers report that level of standardisation.

Figure 6a: Automation of Accounts Payable Processes

Figure 6b: Use of Standard Payment Terms

REL cash flow forecasting figures 6a and 6b
Source: REL Consultancy

More Effective Inventory Management Practices

While inventory forecasting presents some of the same challenges as cash flow forecasting due to the many internal and external variables, 57% of top performers report that they are able to forecast inventory within 5% of actual numbers – see Figure 7a below, a key ingredient to maintaining the right inventory levels to support business needs. This correlates directly to more precise cash flow forecasting because inventory strategy and targets drive upstream performance of receivables and collections, as well as downstream payments to suppliers. In contrast, only 19% of peers reported such a high degree of accuracy in their inventory forecasts.

Perhaps even more significant is the influence these inventory practices can have on cash flow forecasting. Fully three-quarters of top performers believe that their inventory management practices have an impact on the accuracy of their cash flow forecasting (Figure 7b).

Figure 7a: Inventory Forecasting Accuracy

Figure 7b: Impact of Inventory Management Practices on Cash Flow Forecasting Accuracy

REL cash flow forecasting figures 7a and 7b
Source: REL Consultancy

Strategic Implications

Companies today are taking action, and homing in on working capital management as a means of improving their processes, which in turn helps reduce uncertainty and strengthen their ability to forecast accurately.

Improving working capital management as part of a balanced, holistic programme that considers all five drivers of top performance – organisational alignment and collaboration; the ability to turn predictive information into insight; technology; the capabilities for measuring and managing accuracy; and working capital processes – can have an even greater impact.

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