ASSESSING YOUR CASH NEEDS — February 2016

This post involves Treasury.

Cash forecasting is an integral part of the CFO’s treasury duties. It helps management plan their operations and activities based on expected cash inflows and outflows. In cash forecasting, perfection is unattainable, but estimates consistently close to reality should be the goal of a robust cash forecasting program. As the actual cash forecasts are compared to reality, understanding the causes of the variances from the forecast is critical.

The treasury function entails many facets of an organization. These include, capital structure, financing of assets, benefits, payroll, pensions, and funding operations. To achieve this a robust budget and cash planning function is required. The key driver to this function is cash forecasting.

The cash planning cycle can be summarized as follows:

• Identify cash needs
• Identify sources of cash
• Develop a plan to meet these needs
• Control the cash
• Optimize the use of cash
• Obtain financing
• Invest the excess

To effectively manage this cycle, a business forecast must be developed in tandem with operating managers. To identify sources of cash and cash needs, the forecast must consider revenues, expenses, capital spending, and working capital expectations. The results often takes the form of a budget, which acts as a planning tool to enable the firm to meet its cash needs.

Once the budget is developed, the cash planning process is fine tuned. Key considerations include overall time frame; specific timing of cash flows; industry knowledge; who will use the information; and which methods to use.

The time frame can visualized in the following manner:

• Short term — How to pay the bills
• Intermediate term — Plan borrowing and funding of growth initiatives
• Long term — Funding strategic initiatives with the appropriate structure

The timing entails, when to draw on lines of credit, ensuring adequate borrowing capacity, and how to invest the excess cash. The CFO must have sufficient industry knowledge to anticipate events beyond the company’s control and develop a worst case scenarios. In turn, the CFO must understand who the users of the forecasts are and why the forecast is important to them, so that flexibility can be designed into the forecast. Finally, the CFO must consider which methodology to utilize.

When beginning the cash forecast, the CFO must begin with the big picture and then develop the details that reflect the business environment. We believe the following approach is helpful in this process. The CFO should consider the following elements of the cash forecast:
• Define the objective
• Determine how the forecast will be used
• Define the time horizon
• Select the forecasting method

In understanding the attributes and implications of these elements, the CFO must develop the appropriate format as well as select the various quantitative and qualitative methods to utilize.

It is our view, that the format utilize an integrated set of financial statements with supporting schedules. The financial statements include the income statement and balance sheet. A modified cash flow statement with a company and industry driven focus on cash sources, operational uses, investment uses, funding sources, repayments of borrowings, and distributions to shareholders. Such an approach can address day to day cash flows as well as assess the needs for permanent capital.

The specific techniques used to developed the cash forecasts in the aforementioned format are quantitative and qualitative in nature. Quantitative techniques focus on receipts and disbursements of cash; adjusted cash flow; and matching techniques to actual business patterns.

Detailed forecasts of receipts and disbursements are largely based on input from operating management. They are very useful for planning the payment and funding of short term needs (monthly, quarterly, and annual). Details can range from broad categories to specific customers. Key factors that influence these forecast include credit and collections, inventory management, capital investments necessary to maintain competitiveness, and line of credit availability.

Adjusted cash flow forecasts are helpful for the intermediate term (1 to 2 years by quarter). They are useful for planning capital expenditures, expansion plans, securing term loans, determining the need for additional equity, and distributions to shareholders. Input for these forecasts come from both operating managers and executives. This method can also be used for long term planning (3 to 10 years) and can address issues such as permanent capital structure and exit strategies.

Qualitative techniques are useful for both long and short term applications. They are usually utilized to augment the sources for quantitative techniques. Qualitative techniques include, executive opinions of the state of the economy; sales force polling; industry or econometric studies; public forecasts; and bellwether companies in the same industry. We believe consideration of all factors are important, but that reliance skewed in favor of one source is not advisable.

When the optimal methodologies and techniques are determined, the CFO must then ensure the process is managed effectively. Among the requirements for this task are to assemble the data, document assumptions, monitor results, investigate variances, and make prompt adjustments as new information becomes available.

Cash forecasting is an integral part of the CFO’s treasury duties. It helps management plan their operations and activities based on expected cash inflows and outflows. In cash forecasting, perfection is unattainable, but estimates consistently close to reality should be the goal of a robust cash forecasting program. As the actual cash forecasts are compared to reality, understanding the causes of the variances from the forecast is critical.

Capitol CFO Solutions serves clients in Washington D.C., Maryland, and Virginia. Please contact us for a free consultation.