Pieces of advice for producing accurate cash flow forecasts

The difficulty to produce accurate cash flow forecasts:

Cash-Flow Forecasting, the top priority for treasurers

Managing cash flow is one of the most critical skills business treasury leaders must or should possess if they want to effectively contribute their companies’ growth. Even if you have a well-thought-out strategic plan, it doesn’t mean anything if you haven’t generated a cash flow forecast that enables to anticipate cash needs and borrowing levels of the group.

Cash-Flow Forecasting (CFF) remains always (over the last years) the top priority for corporate treasurers of MNC’s for obvious reasons. But it is also a priority because this key process remains generally highly manual, on XL spreadsheets and approximate / no accurate given the way the are produced. We can also mention the time to produce them and the difficulty to automate and to stress test results.

When the storm arises and when you are facing a cash flow crisis, any EUR counts and must be properly managed. This process is always an issue as it covers several departments and affiliates too and potentially involves several IT tools to coordinate and get data from. Therefore, a good cash flow forecasting process starts by sitting down with its finance, FP&A and accounting/consolidation teams and going through, in details, the income and cash flow statements to determine how money is cycling through the group. Better cash flow forecasts help generating more net profits, properly assess the sizing of credit facilities, and estimate the net excess cash and/or credit facilities use. However, it remains complicate to produce accurate cash flow forecast because it involves measuring and monitoring many variables and making educated guesses about the performance of the group. As working capital management, it also involves horizontally other departments and vertically affiliates. But there are best practices and tips treasurers could follow and apply.

CFF may be used or is an aid for the following objectives:

1.???To set borrowing limits and minimize cost of funding

2.???To maximize interest earnings

3.???For liquidity management

4.???For FX risk management

5.???For setting & monitoring longer term investment and funding strategies

6.???For financial control

7.???For monitoring & set strategic objectives

8.???For monitoring various lender & investor ratios

9.???For budgeting for capital expenditure & project appraisal

10.?As a tool for working capital optimization

Cash flow is more important to monitor than profits.

Too many CFO’s rely on the monthly profit and loss statement to gauge future cash flows (certainly because they are unable to produce effective cash-flow forecasts). Although the P&L is vital, it does not give an accurate picture of the future flows into and out of the company. The cash flow statement is the go-to document to understand the liquidity needs of the business and operations. Obviously, the CFF doesn’t factor the non-cash expenses, such as depreciation and amortization. It tends to reflect all the cash outflows and inflows from operating activities (accounts payable and accounts receivable payments), investing activities (purchases of fixed assets of plant, property, and equipment) and financing activities (sales of equity or bank borrowings). To create useful cash flow forecasts, treasurers must first learn the ins and outs of the operating cash flow statement. To have a successful project, the team (including the treasury) must get the full support and sponsorship from the CFO. If not, it will never fly properly.

Know your company’s CCC (i.e., the cash conversion cycle”).

Understanding the company’s cash conversion cycle (i.e., the amount of time it takes for a EUR spent to make its way back into the company bank account) is essential to managing and maximizing the group’s cash flow. As a main gear of the complex process, the treasurer should spend enough time with the finance and accounting chiefs to comprehend how money is flowing into and out of the company from vendors and clients. It implies to take time to understand the underlying businesses of the group. Review variable costs (labor and raw materials or taxes, for example), fixed costs (rent, utilities, certain salaries, and business insurance) and other significant expenses (investments in equipment or software and machineries, for instance). The accuracy of the forecast depends on knowing the timing and frequencies and amounts of revenue and expenses that (may) affect the cash flow.

The assessment of seasonality impact

Usually, every business faces and experiences some seasonality, or at least impacts of external factors, like weather changes, holidays, seasons, etc... There are bound to be months when clients are more active in purchasing the company’s products or services. Nevertheless, seasonality can have a significant effect on the company’s cash flow. A good cash flow forecast should anticipate when cash outlays and cash receipts are higher or lower so treasurers can better manage the group’s working capital needs.

Generation of multiple scenarios and stress testing

To succeed, business leaders should prepare for market changes. Craft a few different cash flow scenarios or assess market changes so the group is not caught off guard if client demand slows. Having a couple of models or assumptions will help the company act decisively (rather than react defensively / anticipate rather than react) to mitigate any adverse effect on the company’s liquidities, if revenue slows, for any reason. Conversely, if sales pick up, the forecast should help the CFO to better allocate resources to grow the business.

Horizon: monthly or quarterly to annual or pluri-annual forecasts.

We can advise to clearly specify the type of CFF (and potentially different CFF) we intend to develop and maintain. Building cash flow forecasts for the short (weekly or monthly), medium (quarterly) is more the treasurer’s duty, where the long(er) (yearly or even more) terms, are a CFO and FP&A head of objective. The needs of the operations should dictate which time frame is the most valuable. Monthly or quarterly forecasts generally are more useful for stable, established businesses, but also for treasury. Projections are essential for companies scaling up or going through significant changes, such as a restructuring or merger/acquisition.

We should make distinction between short-term CFF for treasury purposes, based on direct methods, and medium and long-term CFF for FP&A/finance purposes, mainly based on indirect methods.

Review, control discrepancies, adjust, correct, and repeat again to generate discipline and awareness.

Once build, it is important to review it often, and revise as needed. It should not be an annual theoretical exercise. The needs of clients are always shifting, evolving, as well as the business models. The economy is ever-changing, and recent crises proved we must remain agile and proactive. Revisiting the forecast will help the company respond and adapt faster than the competition. It is a long-and never-ending process to be repeated to gain in quality and reliability. Building a business requires liquidities, and having a reliable forecast enables to make better decisions on how to maximize the return on invested capital. Predicting better allows CFO’s to will be able to better position the company, to better predict cash needs (if any) and help the group for generating future growth.

How useful is CFF?

In summary, CFF is an essential tool to help CFO if forecasts are well-prepared, using reliable data, produced using time-horizons appropriate to the company’s specific business, updated regularly to reflect changes experienced, or known future events and checked to compare actuals to expected figures. It must be redefined over time and reviewed regularly to identify discrepancies, to improve accuracy. CFF imposes a minimum of discipline that only comes from controls, incentives, reports to assess and enhance results. If you do not control speed on the highway, you don’t need to fix speed limits. However, many companies, as shown by surveys, make poor use of forecasts and as result the whole process fall disrepute. Do only launch project if your ultimate objective is not to automate it through a modern ad hoc IT tool if you are ready to install and control a minimum discipline within finance and with the full support and sponsorship from the CFO and C-suite. Cash-Flow Forecasting projects remain necessary but painful. However, “Quo laboravit, eo major est voluptas” would have said Publius Syrius.

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Fran?ois Masquelier, CEO of Simply Treasury – Luxembourg April 2023

Disclaimer: This article was prepared by Fran?ois Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).