Cash can be the hardest financial flow to manage, but it’s also the most important at times when sales are constrained and margins squeezed. In the first of a two-part series, Mark Doyle of Parson Consulting examines how to determine the necessary accuracy of cash flow prediction, attain it, and understand the cash flows underlying the balance sheet.
Global downward pressure on consumer prices is holding down sales and profit growth, turning attention onto companies' ability to generate cash. Cash is needed to invest in research, product innovation, marketing, in the top executives and specialists whose demand is outstripping supply, and in the more sophisticated information systems that can drive growth in this competitive environment. Cash is also important in relation to spin-offs, and is the key element for venture capitalists and private equity houses, both now playing an increasing role in the market.
Most companies have well established processes for developing profit forecasts - although forecast accuracy remains an issue even in this well established area. The latest annual survey on financial forecasting accuracy by Parson Consulting showed that one-third of FTSE 350 companies missed analysts' earnings-per-share (EPS) forecasts by more than 10% in 2005.
The challenge for every finance director is to ensure that there is an effective process in place to develop cash forecasts, and to get the business delivering against the forecast. This is particularly true if the company is cash constrained, distressed, or if a covenant is in place. Why is this so difficult? A variety of factors conspire to keep many FDs unsure of the cash flow number, right up until (or beyond!) the period end. Its not unknown for companies to put out a last minute call for cash close to the period end, based on forecasts showing under-delivery against target, and then to find significant over-delivery. This is often delivered by deals cut at a local level, which then adversely impact profit and cash in the following period.
Hard to cash
This difficulty is rooted in cashs basic characteristic: its inherent unpredictability. Sales trends can generally be well predicted, and the profit impact easily modelled. However, the balance sheet is the net result of a myriad of transactions, many of which are difficult to predict accurately. For example, on precisely which day will the payment from our largest customer hit our bank account? Also, many key cash movements are buffered from the underlying business events and trends as they are driven by treasury and tax management interventions, for example hedging.
The key areas to be addressed to resolve the cash forecasting accuracy issue are:
Lets look at each of these four areas in turn.
(1) Required accuracy level over different time horizons
Cash forecasting should generally cover four time frames:
The level of accuracy required and managements ability to accurately predict flows will vary significantly over those timeframes. Hence the first step is to understand the potential impact on your business of missing your cash targets over these timeframes.
This will then enable you to set the parameters for your cash forecasting accuracy measure. For example, a company with a banking covenant in place need only be slightly below its short term cash requirement to have a significant impact on the business, whereas a company with large complex long term capital projects may experience large swings in tactical timeframe cash flows with no significant impact.
Once the parameters have been set, the next step is to analyse current levels of forecast accuracy across the relevant timeframes see fig 1.
For those businesses (and group functions such as tax and treasury) currently falling outside the required parameters, a forecast accuracy improvement initiative must be put in place. This will require a root cause analysis to be carried out, and solutions developed and implemented. The following sections outline some potential problem areas and solutions.
(2) Understanding the cash cycle behind key balance sheet elements
Too often, forecasts are calculated using an over-simplified model of the relevant balance sheet item. For example, creditors may be calculated by taking forecast purchases multiplied by average payment terms. While this can be appropriate for one element of the total balance, there are a multitude of other items within creditors, such as sales tax provisions, holiday pay accruals and capital project payables. All require separate modelling to ensure accurate forecasts.
Each major line item needs to be analysed into elements which have the same or similar cash cycle profiles. Many elements will have low volatility (over and above the normal seasonal business cycle) making it relatively simple to model them and produce accurate forecasts. Examples of these are finished goods inventory, which can be modelled on sales and production forecasts, and trade debtors, using sales forecasts and debtor day profiles.
Again, different aspects of the business may need to be modelled separately to get the required level of accuracy. For example, if export sales have a different seasonality and payment terms compared to domestic sales, separate forecasts should be calculated for each type of business. Assuming that accurate sales and production forecasts are available, finance can provide accurate cash forecasts for these items without requiring further interaction with other functions in the business.
Once the low volatility elements have been identified and modelled, the next step is to examine the more volatile elements that generate greater complexity on an ongoing basis. A good example is the cash forecast for large, ad hoc, multi-year capital projects, as typically found in the natural resource and energy industries. This will require more than taking the phased capital expenditure forecast and applying a simple payment terms model. You will need to work with the project team member responsible for managing the budget to set up the information required at the start of the project.
If, for example, there will be a significant level of capitalised labour, this needs to be forecast separately since it will have a different cash cycle from equipment purchases. Capitalisation forecasts are also required to understand when depreciation will start being charged. Even when the information flows have been agreed, you are likely to need to spend time with the project team on a regular basis to ensure that the original assumptions remain valid.
Next step: Changing processes to reduce uncertainty
Since the volatile elements will be more resource-intensive to forecast accurately, and may even be impossible to predict with confidence, you need to review the opportunities for reducing the level of volatility by changing the underlying business process. Part (2), next week, will focus on changing business processes to produce more predictable cash cycles, and giving cash an appropriate role in business performance management (BPM) and incentive systems.
About the author
Mark Doyle is an engagement director with Parson Consulting, a specialist financial management consultancy, with expertise in performance management. www.parsonconsulting.com [1]
Links:
[1] http://www.parsonconsulting.com