Cash & Liquidity ManagementCash ManagementCash ForecastingLiquidity Planning – How To Take Control of Your Cash Flow

Liquidity Planning - How To Take Control of Your Cash Flow

If you fail to plan, you can plan to fail. This simple yet undeniable truth has been attributed to great minds from the Sun-Tzu to Benjamin Franklin, and it is as true today as ever. In our microcosm of treasury, in an era of tight credit and volatile stock markets, this truth has come home to stay. Market and credit analysts have come to rely heavily on cash flow as one of the most critical measures of financial stability. Never before has your ability to accurately predict cash and liquidity demands had such a direct impact on your stock price and access to credit markets. The result is a heightened need for a discipline commonly called liquidity planning.

As any treasury practitioner can attest, accounting methods for predicting cash flow hold little relevance to a treasury operation. The method of deriving a statement of cash flows from changes in income statement or balance sheet items are inadequate for predicting the day-to-day operating liquidity necessary to fund your operation. At best, this prediction is accurate one day a quarter; in reality it ignores the peaks and valleys of liquidity requirements inside the quarter. These are the swings that inevitably force you to hold excess cash, scramble to draw on expensive reserve credit facilities or take a charge for an unanticipated currency exposure. For a billion dollar enterprise, this lack of visibility can translate into millions of dollars in lost profits.

Looking Backwards

The prevailing tool of choice for cash forecasting has been statistical trend analysis. This is a process by which you analyze historic cash flow data and use this as a basis to project future cash streams using time series analysis. This technique has the advantage of ease of access to the data since all cash flow information is housed in, or easily accessible by treasury. The process typically starts at the business unit level where the statistical model is developed and known cash flows that fall outside the model are added in. This business unit forecast is then sent up to central treasury usually on a spreadsheet. Spreadsheets are consolidated into one corporate forecast and adjustments are made for discrete items at the corporate level. This consolidated forecast is a static view of cash flows for the forecast horizon. Actual cash flows may be compared to the initial forecast, but few companies go so far as to re-project the coming periods to project a more accurate picture of the remaining forecast.

The major issue facing companies employing a statistically generated forecast is that they are essentially driving in the rear-view mirror. For many industries, last year’s data does not form the ideal basis for predicting what will happen this year. Fundamental changes in raw materials pricing or changes in the economy can have substantial effect on this year’s cash flow. One need only look at the steel industry in 2004 to have a shining example of how huge demand shifts can render historical cash data irrelevant.

Looking Forwards

Liquidity planning offers a much more holistic approach. The process starts by capturing a top-down view of cash flows. This top-down plan means that goals are set at the top of the organization. Applying cash application rules to the operating budgets and plans, a company derives cash flow targets. The resulting cash flow targets and metrics are then filtered down through the organization. A bottom-up planning process complements this top-down plan. The bottom-up view is derived from individual forecasts provided by subsidiaries and business units. The differences between the top-down and bottom-up plans must then be reconciled through a negotiation process to develop the initial plan.

Armed with this plan, a treasury professional can then search for the appropriate financing vehicles or hedge strategies to execute the goals of the organization. Given that forecasts are educated predictions, the most important part of the process is the constant monitoring and adjustment of actual cash flow performance versus the plan. A consistently applied variance analysis can help anticipate and significantly decrease the surprises and bumps in the road that cost money and cause angst with your analysts. A strong liquidity-planning tool allows for the top-down and bottom-up practice, as well as a comprehensive variance analysis and reforecast process. A system of key performance indicators should also be incorporated to provide an early warning mechanism if actual or reforecasted cash flows vary too far from the indicators.

This process can seem overwhelming and intimidating. However, the key to successfully implementing an effective liquidity plan is simplification. What follows are additional considerations to remember when reviewing or establishing this top-down/bottom-up liquidity planning process:

Keep it as simple as possible: This principle is so important that it is worth repeating. More detail in a plan does not necessarily lead to a better forecast. For example, forecasting receipts by a line of products may yield more accurate results than forecasting receipts by specific models. Take the time to figure out what level of detail you will need. You want enough information to produce the results that effectively let you manage cash flows, yet don’t bog you down with massive amounts of data that aren’t really necessary to accomplish the goal.

Forecast and re-plan continually: As noted above, the most important part of the process is to continually monitor and adjust performance versus plan. It may take at least a year to spot a viable trend from monthly reforecasts. This same trend may be identified in a fraction of that time if the reforecasts are calculated on a weekly basis.

Standardize where possible: Standardizing procedures and processes across all operating units and regions ensures simplified consolidation. Ensuring that data is compatible is also imperative to guarantee central treasury is adding apples to apples.

Automate, automate, automate: Review your processes, and if a process can be automated, then do it. Automating the variance analysis from top-down to bottom-up plans, initial plans to actual; and initial plans to re-projections can be a daunting task if left to spreadsheets.

Systems integration is crucial: Akin to automation, ensure that your treasury system is linked to other internal systems that provide source data. No process works efficiently if it is laden with manual processes and re-entering data introduces an enormous potential for errors.

Bill Gates once said: “If your only tool is a hammer, all problems will eventually look like nails.” Armed with just a spreadsheet and a calculator, true liquidity planning is unattainable. Without a doubt, putting a workable plan in place is a project that requires attention, resources and a well-designed system to reach full potential. Considering the tangible payback and the resulting effect on your company’s financial stability, it is well worth the effort.

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