20 I AFP Exchange November 2016

TREASURY ESSENTIALS

LookingAHEAD

What are the steps to creating a reliable cash forecasting process?

There are specific steps that are necessary to create a reliable cash forecasting process. If executed well, the upfront investment in cash forecasting can have strategic implications for enterprise risk

management (ERM), capital deployment and asset rationalization objectives.

Start with understanding inflows and outflows A deep-dive into the numbers is quite enlightening and highlights duplication, mis-

categorization of inflows/outflows, cash not being forecasted/counted, etc. Common themes/benefits include:

• The nature of collections/payments: Some collections could be rebates from suppliers and payments can be refunds to customers. These need to be forecasted separately from regular collections/disbursements.

ANKUR BHANDARI

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• Clear forecasting responsibility: This entails clearly defining the collection/

disbursement account structure and making any changes to it so that forecasting responsibility can be specifically assigned.

• Accounting cash vs. actual cash vs. available cash: Differences in checks received but not deposited, payment float, etc. can impact the cash balance significantly. It is important to understand how these impact accounting cash balances vs. actual bank balances. It also important to quantify trapped vs. usable cash.

• Bank accounts: Ensure that the list of accounts with treasury is the same as accounting. A good discipline is for treasury to reconcile the treasury cash balances with accounting balances at the end of each reporting period.

Direct vs. indirect cash forecasts

There is a longstanding debate of whether to use direct or indirect cash forecasts while setting up a cash forecasting system. Ideally, while a cash forecast that ties into the P&L makes sense, it is usually difficult to implement one in the short term. Reconciling direct and indirect cash forecasts is sometimes challenging since the direct method is based on the nature of expenses (more elemental in nature) and the indirect method aggregates expenses by the functional area (additional segregation, consolidation, allocation, etc.). Allocation of overheads/payroll expenses further complicates the issue. Furthermore, in international organizations, there can be variances in charter of accounts/accounting systems, etc. across the organization that create additional pushback to an already unpalatable request.

The direct forecast is attractive, since in most organizations some large expenses like payroll are relatively stable in terms of the amount and timing. Usually specific people are responsible for payables that can help in forecasting these. Collections can be forecasted based on sales and billing data, etc.

It is a good idea to triangulate between the two at least for monthly cash forecasts or

longer. This process becomes better over time and brings to light important insights into the functioning of payables and receivables and can even provide early warning signs about revenue problems.

Short-term vs. long-term forecasts

A common mistake is to use assumptions related to long-term cash forecasts and derive short-term cash forecasts from these. While the method seems conceptually appealing, it rarely achieves consistently accurate results since it ignores short-term balance sheet volatility that almost invariably eclipses the monthly ‘cash flow from operations’. The balance sheet volatility usually plays a smaller role in long-term forecasts since it will be a smaller percentage of a one-year cash flow number vs. a one-month cash flow from operations. Further, the DSO and DPO assumptions in a long-term trend may more closely follow long-term trends than in the short term.

Short-term forecasts reflect a significantly higher amount of knowledge around factors that impact receivables, payables or other one-off events. On the other hand, for medium- to long-term cash forecasting, relying on direct cash forecasting can result in numbers that are disjointed from reality.

Encouraging businesses to start off with short-term cash forecasts and then aligning these with the three-month/six-month cash forecast helps them mature their cash forecasting ability and avoids any gaming at their end.

Mathematical techniques/simulationI have found a judicious use of Monte Carlo

simulation and regression analysis extremely useful for cash flow forecasting. At the very least, it is a good sanity check for forecasts submitted by business units. An example of Monte Carlo simulation for forecasting collections would involve breaking up historical collections activity by customer and comparing the dispersion around the mean for each customer. These will yield positive, neutral or negative distribution graphs for each customer. This knowledge can be used in a Monte Carlo simulation model fitted to the current receivables portfolio to simulate the likely

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TREASURY ESSENTIALS continued

collection and combined dispersion around a mean. This will enable us to assess the probability and dispersion around the mean/median. It will also help identify the customers causing the volatility and enable corrective action.

Information collectionWhile country/department fi nance heads

should put together the forecasts, these should be fi nalized and validated by regional treasuries with regional CFOs. This is important since the sum of parts may not be equal to the whole on account of a variety of factors, including cash forecasting maturity of units, one-time items, and divisional level expenses that the units may not be aware of. Furthermore, the CFO may be in a better position to take out the unsystematic volatility from the forecasts as he assesses the forecasts as a portfolio.

While a reputed planning system works best for forecasting, an inexpensive workfl ow/data aggregation tool can be rapidly deployed to aggregate pre-formatted worksheets. Further, these tools can also ensure appropriate authorization before these are submitted to treasury.

While monthly forecasts are the norm, fortnightly rolling cash forecasts are best practice since they can address mid-month corrections, especially towards managing year-end/quarter-end expectations. It also helps keep the teams focused on proactively managing the cash and avoiding last minute surprises. Timing can vary depending on the monthly close cycle, though forecasts should typically be ready by the seventh of each month.

Executive reportingDaily cash balance reports to executive

management are quite common and ideally should be leveraged to show a graph of daily cash balances over the past months and a trend line for the rest of the year. This is somewhat daunting since variances tend to be highlighted and so should be undertaken once the cash forecasting process is relatively mature. This is especially powerful if the chart also depicts the minimum cash needed to

run the business. For this presentation, any restricted cash should be highlighted as should any one time large cash outfl ows e.g. M&A, capital activity that might be i� y. This is all the more powerful if an assessment of the collection excess/shortfall is added to the analysis.

Variance analysis needs to be carried out monthly and reported upon with rigorous discipline and business units should specifi cally spell out remediation action. Fishbone diagrams and Pareto optimality are useful tools to identify potential issues and lay out detailed project plans to remediate variances. It is important to note two things. High variances whether positive or negative are both indications of a broken process and should be addressed with the same urgency. Often only negative variances attract attention, which ignores endemic problems that surface later. Second, clear responsibilities need to be laid out for corrective tasks and timelines. This is especially important while setting up a new cash forecasting process.

Month-end is exactly the time when the CFO has the maximum number of questions around reasons for variance/forecasts. A defi ned calendar which has the agreement of all the parties supported by a cash management policy that lays down the law of the land helps in keeping the organization responsive to executive needs, balance expectations and plan resourcing. Sometimes business units focus on having 100 percent of the close completed instead of giving reasonable estimates. This needs to be discouraged if close takes too long. If cash forecasts are not available by the sixth/seventh of each month, they lose their value to the CFO considerably.

Managing cash vs. forecasting cashInstead of just being responsible for managing

expenses, responsibilities should also be laid out for managing cash—collections and payments. This does not suggest we hold back payments but there must be a process in place where responsible parties are actively managing sources of cash infl ows/outfl ows and forecasts and are held responsible for these.

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Despite all e� orts, there is an inherent volatility in many items related to the cash forecast which cannot be solved for a variety of reasons, e.g., collections, inventory levels etc. Sometimes this is a function of lack of investments in systems. A single digit for cash forecasts sometimes does not capture inherent volatility in the cash forecasts that cannot be forecasted. This is infi nitely useful in explaining random variances to executive management and avoids having to force-fi t explanations from one cycle to another. This helps management accurately understand inherent variability, focus short-term corrective action on what can realistically be changed, investments/prioritization in the medium term, and areas that need the maximum attention. Techniques include creating correlation matrices that can be used to identify and model out correlations between elements of the cash forecast, etc., which can help bring improve forecasting ability.

Many times CFOs /CEOs would like a quick read on where cash will end up couple of days before Dec. 31 and they will expect this is very close to the actual number. Operationally it makes sense to expect this and proactively reach out to the business units rather than trigger a last minute drill. While factors like FX usually settle down by this time and expenses are all but known, collections can still be volatile especially since some customers may try to ‘manage’ their year-end cash balances by delaying payments. This introduces volatility and a treasurer’s good judgment and experience are very valuable to estimate where things land.

In conclusion, my experience in the world of cash forecasting suggests that while it is an art and a science, the more the science, the lesser the ‘art-burn’.

Ankur Bhandari advises companies on treasury and fi nance best practices and was treasurer at Omnicare and BearingPoint.