This is the ninth topic and tenth article in a series on leading practices in corporate treasury.

Cash forecasting is an essential and powerful tool that allows corporate treasurers to better understand the future of their company’s most precious liquid asset: cash. By predicting future cash inflows, outflows and liquidity requirements, it enables organizations to seize relevant opportunities while also serving as an early warning system for potential cash shortfalls.

Today, corporate treasurers deal with economic uncertainty, increasingly competitive market conditions, and operational, financial and market risks that have been intensified by geopolitical tensions.

Against this backdrop, it is imperative for treasurers to make accurate and effective cash forecasting a focal point for their organizations so that better financial decisions can be made during times of rapid change.

Here are our recommendations on how corporations can reap the benefits of cash forecasting to optimize cash buffers and realize cash shortfalls. The proper implementation of these leading practices can vary depending upon the complexity or size of a business’s operations. Nonetheless, there are some consistent aspects that stand out.

Forecasting means different things and has different purposes

Treasury is often looking at a short-term cash forecast, trying to determine what the liquidity needs are, whereas the financial planning and forecast from a controller’s area is often income statement oriented and meant for longer-range planning.

“A short-term liquidity forecast has a different purpose than a multi-year balance sheet forecast. Corporate planning forecasts are usually a forecast of profit and loss. The forecast by treasury is a balance sheet forecast that begins with the mantra that cash is king. It is meant to optimize short-term cash and focuses on cash, capital expenditures, investments and debt, as these and other categories have a direct impact on liquidity,” said Craig Jeffery, managing partner at Strategic Treasurer, a leading treasury consulting firm. ⃰

Treasurers shouldn’t get trapped into reconciling cash forecasts and financial forecasts. They should be cognizant of the fact that focusing on the balance sheet tends to sit squarely in their domain. Conversely, the income statement focus for forecasting typically resides with the controller.

High volume of data and complex relationships between variables

Traditionally, treasurers have used statistical models such as moving averages, exponential smoothing and regression analyses that rely on repeating trends in data to forecast an outcome.

The use of regression analysis and other statistical models has been and continues to be helpful at the macro-level. However, as business cash flows are a function of a large number of variables, including industry trends, cost of sales, business sales cycles, seasonality and collection patterns, statistical models may not fully capture and process the complex patterns and relationships between these variables.

To attain additional sophistication beyond statistical models, identify complex patterns in cash usage and achieve a well-oiled, accurate, real-time, reliable, flexible and efficient cash forecasting process that will be quick to adapt to changes in the business environment, we recommend the adoption of machine learning (ML) and artificial intelligence (AI).

ML, AI and other automation tools can adapt and adjust the forecasting model. They can also capture information at the micro-level, such as at a customer level for accounts receivable collections.

“AI and ML are arguably the biggest sea change coming to treasury teams, and it will move quickly. Treasurers are realizing the challenges of building AI- and ML-infused capabilities internally, and are instead adopting AI and ML forecasting capabilities within their existing systems. The rapid anticipated adoption here will empower corporate treasurers with transformative new practices and approaches, from treasury management to foreign exchange to payments,” observed Jeffery.

Emerging technologies like ML and AI more accurately predict operating cash inflows and outflows, determine the optimal level of operating liquidity required to support fluctuations in working capital, and improve the overall quality of the forecast.

While we expect to see a parity reached between the use of AI/ML and regression analysis in forecasting in the years ahead, we advocate for the importance of identifying your data and data sources and determining the forecasting horizon and forecasting tools (spreadsheets, ERP solutions, TMS, budgeting and statistical tools or dedicated forecasting platform) that are best suited to support your organizational strategic goals.

Know that significant investments in technology for enhancing treasury systems and cash forecasting capabilities will help treasurers build a robust foundation to automate the collection and consolidation of forecasting inputs, gain an accurate view of cash balances and transactions, and equip themselves with business intelligence to help them strengthen their role as a strategic business partner.

Testing and Variance Analysis

Treasurers are responsible for owning cash and ensuring liquidity on every day of the month and year. An accurate forecast and analysis is required to know when, for example, peak cash need will be. So they perform different types of analysis and include calculations from many others in the organization to secure liquidity in all circumstances.

Any cash forecasting process relies upon a well-designed forecasting model. This model must be tailored to the objectives of the corporation and its business needs. Remember, this model needs to be simple (not over designed or cluttered with unneeded details), tested, constantly monitored and adjusted where necessary.

Testing your models (whether in sample or out of sample) ensures the model represents reality. This is a healthy way of performing reasonableness checks (also called a reasonableness test) with previous data and performance numbers, defensible assumptions and projected performance.

Running multiple models at the same time to see which ones work better in different what-if scenarios (fall in sales, increase in demand, debtors extending payment times, and more) provides useful comparisons and leads to more insights.

A forecast model typically collects two types of cash flow data: actual data and forecast data. One of the keys to cash forecasting excellence is closely monitoring the accuracy of the forecasts or following up on the deviation between your forecasts and your actuals.

Compare your actuals with your forecasts to understand where you are doing well and where you have to improve, and to track down the causes of the inaccuracies. This is an essential step in the forecasting process to avoid repeating similar forecast errors in the future.

Review cash flow forecasting variances regularly, preferably analysing them on a daily basis. Large variances should be investigated and promptly escalated to improve and power the quality of forecasts. Technology tools can help automate this practice.

History is a friend and foe

Although it’s impossible to fully predict the future, historical cash flow data from your corporation provides insights on how to reasonably forecast what lies ahead.

“For stable cash forecasting processes or well-established businesses with several years’ worth of data to work from, historical cash flows are excellent starting points for making projections,” commented Jeffery.

Past data in such instances, particularly for companies that experience a similar volume of sales year after year, without huge peaks or dips in demand, can provide valuable insights to estimate cash flow for the year to come. However, relying solely on historical data or merely looking backward for changing business models could turn out to be counterproductive.

Changing business models or corporations with aggressive growth plans have many variables and complex relationships between these variables, all of which can affect demand and sales history. Accounting for all of the variables can increase the accuracy of treasury’s projections and optimize liquidity. So for rapidly changing forecasting models, historical data may need to be enhanced with other data or inputs, and that means adoption of adaptive forecasts.

Building flexibility into the design of the forecasting model is necessary, as it will allow for unusual or black swan events to be factored in. The model must be able to update and apply new assumptions and challenges (uncertainty over inflation, currency fluctuations, interest rate movements, LIBOR transition, supply chain disruptions, Russia’s war on Ukraine and China’s COVID wave) so that it provides value in the long-term.

History is often a starting point, and massive amounts of historical data can be used to find useful patterns. However, while the analysis of historical data is necessary, it is not sufficient to succeed in uncertain times.

Banking data and financial statement data

Corporate treasurers ought to manage and maintain daily cash flows, and this includes the monitoring of group-wide bank account balances (at a minimum by bank, bank account, currency and entity) in a single place that then is collated to determine the cash position.

The cash position can be extended to compare actual cash flows to forecast, which is an important step in going from cash position to a full cash flow forecast. A comprehensive cash flow forecast, along with the ability to measure actual performance from bank statements, provides greater assurance to treasurers that previously committed operating or free cash flow targets will be met.

It is recommended that corporate treasurers upgrade to new technologies that can connect or integrate with their banking partners via application programming interfaces (APIs). Maintaining corporate-to-bank connectivity through bank APIs ensures greater access to high quality and consistent financial data. It also makes the flow of transaction and account data instant, secure and up-to-the-minute. This provides corporate treasurers full visibility of the global cash position and enhances their ability to forecast more quickly and manage cash flow with precision.

Automating the aggregation and normalization of bank data across global bank accounts and scouring through banking data and accounting entries is very useful, but only up to a point. Financial statement data helps in generating more accurate forecasts.

Such datasets offer a wealth of insights into cash flow management, debt management, supplier relationship management, financial performance and profitability that can streamline a corporation’s cash and treasury management activities.

Financial system data tends to be harder to access and control for quality with regards to the future, but it is of immense benefit when it is highly up to date. It is an excellent source for generating forecasts, reports and data models to make informed, strategic decisions and for performing real-time visibility and analysis. This makes it a consistent and accurate source of information up to a certain point in the future. After that, other methods of forecasting are necessary.

Understand the major one-off items and communicate effectively

Your cash forecast must account for major one-off expenses that can significantly impact cash positioning (either positively or negatively) and provide more visibility into how strategic decisions will impact your corporation’s financial health.

These one-time items or costs can arise from various areas (legal, procurement, sales and more). They may not be standard expenses or appear in the financial statements until it is time to make payment. However, it is recommended to include any one-time purchases that treasurers foresee into the forecast as a safety measure and for greater accuracy.

As with just about any other successful process within a company, it is important to determine or establish materiality limits using professional judgment and discretion. Remember, too low a material threshold may impose a reporting burden, without real benefit.

Treasury must bear in mind that effective communication is one of the keys to accurate cash flow forecasting. The treasurer must clearly communicate the forecasting process and requirements to the team. An effective forecast requires inputs from a variety of individuals throughout the organization who can provide important figures and valuable insights that will increase understanding of what drives the numbers.

Able forecasters will need strong communication skills in order to explain what information is needed and when describing the output of the forecast to the shareholders, Board of Directors or CEO.

Conclusion

Timely, efficient, automated, real-time and accurate cash forecasting is an important element in proactive liquidity management and provides actionable insights into future cash flows both on a group-level and per business unit, cash pool or currency.

If prepared well and used appropriately, cash forecasting will minimize the cost of funds, maximize interest earnings, create hedging opportunities, monitor investment and funding strategies and optimize working capital. Adopting our recommended leading practices will help treasurers develop a solid foundation on which efficient and accurate cash forecasting is built.

 

⃰⃰ Disclosure: Strategic Treasurer owns CTMfile.