Cash & Liquidity ManagementCash ManagementCash ForecastingInnovation in cash flow forecasting and liquidity risk management

Innovation in cash flow forecasting and liquidity risk management

This article describes an innovative cash flow funding model and an innovative forecasting model to improve management focus on cash - both based on 20 years’ experience of working in treasury and with CFOs.

This article describes an innovative cash-flow funding model and an innovative forecasting model to improve management focus on cash. It’s the kind of detail that should be used as a common language between the group chief financial officer (CFO) and the business units. The models are based on 20 years’ experience of working in treasury and with CFOs in both private and public sector organisations.

Cash is the truth: it can’t be fudged, it can be counted, it’s there or it’s not there. But cash can exist in many forms. From real cash in the pocket to cash in the bank, lines of credit, loans and bonds to inventory, debtors and creditors. All of these represent different types of cash. We term anything that isn’t actual cash as proxy cash, which shows in the transaction accounting systems and is mixed with accrual accounts type accounts. To better understand and manage the continuum of cash, we need to select valid proxy cash accounts that reflect as close a proximity to cash as possible.

The funding model structure, shown below in Figure 1, is a useful format for understanding any business. Typically, it will begin with inflows followed by the various categories of outflow. This design is a new cash flow statement depicting both the strategic and operational aspect of a business. At the end of the exercise, we have a new cash flow statement.

Figure 1 – the funding model structure:

Figure 1 - The Funding Model Structure

Figure 1 shows the 14 parent categories in the funding model, within which we have identified 44 ‘child’ accounts. The model is comprehensive to accommodate all cash-related items, but not all of these apply to every organisation and it should therefore be customised to suit each business.

The opening bank balance for the first month (or day/week) is input and the model will calculate the bank balance for future periods. If there is a leak, it will show in this row. This means that a great amount of detailed data can be analysed, forecast and used to assist management.

The funding model is populated by the business units, either from the accounting system or directly into an Excel template, which is automatically consolidated by the CFO or treasury. A software tool that automates this and other important/useful tasks has been developed.

The funding model provides several benefits:

• It shows actual, budget and forecast data from as far back to as far forward as the user requires.
• It is the basis for generating forecasts.
• It is useful to all stakeholders. For management, it shows the sources of cash and all movements and outflows of cash.
• For providers of finance, it shows the entire cash picture and quickly highlights leakages and potential problem areas.
• It provides an extended format for new ratios that focus on cash and liquidity risk.
• It provides the basis of graphic views that show a clearer cash focused picture in a business.
• Understanding cash in its entirety paves the path to improved cash management, lower liquidity risk, and better control of the important areas of the business.

This should be an obvious approach, but in reality it’s often not adopted. So what innovative tools does the funding model offer?

Innovative forecasting

As a wise – but anonymous – commentator once noted: “A good forecaster is not smarter than everyone else, he merely has his ignorance better organised.”

Users of forecast data seek assurance that projections are as accurate and reliable as possible. Evidence of accuracy and reliability are usually grounded on the following variables:

• Realistic assumptions and expectations.
• Employing the economic and business drivers that influence the funding model figures.
• Valid and understandable calculations are used in the forecast method.

Both internal and external stakeholders require cash flow forecasts. Providers of finance giving overdrafts and various loans, to financing of capital items, and providers of equity and investment capital all require valid and reliable forecasts. The best forecast is one that is solid and cash trumps accrual accounting every time.

The question is which forecasting techniques are valid for a particular purpose? This really depends on the method preferred by the provider of finance, or user of forecast data. Predictive analytics – a term currently in vogue – uses a variety of forecast techniques. The problem is that it’s mostly a “black-box” for the majority of users as the statistical algorithms aren’t readily understood. We developed an innovative alternative method that has shown itself to be reliable and possess the characteristics required by all stakeholders.

Economic and business driver cash flow forecasts:

Our experience is that cash-flow forecasts and modeling based on economic drivers is an intuitively logical, easy to understand and useful approach. A set of economic drivers are selected and each is weighted for its importance. For example bank prime rate, gross domestic product (GDP) growth, inflation, various foreign exchange (FX) rates and relevant commodity prices; only the critical economic drivers are included in the algorithm. This work is carried out by each business unit to keep it in context, and it certainly varies by country where different economic factors are relevant.

The next step is to apply this basket of economic indicators to the various line items in the funding model that drive cash flow, such as cash sales and the various inflows, debtors, non-operational flows and expected capital expenditure (capex) outflows. We run this on a monthly basis for the desired period – usually between two and 30 years – of the forecast. The tools we developed do this relatively quickly and once set-up, even a 20 year forecast can be created within minutes.

Scenarios, assumptions and stress testing for uncertainty:

Scenarios serve many purposes in planning, and provide upper and lower boundaries or bands of possibilities. The scenario terms ‘high road’, ‘low road’ and ‘expected road’ are familiar to many. Usually the high road is a five per cent increase over the expected road and the low road a 12%-15% decrease from the expected road. Scenarios facilitate individual economic drivers to be varied within a context of possibilities. Using scenarios means the element of surprise is limited.

Budgets – developing cash-focused budgets:

Developing budgets is usually a chore, so it’s common for a new budget to reflect the previous year’s budget plus X percent increase. In cash terms however, a 10% percent increase on last year’s budget doesn’t necessarily mean a 10% increase in cash. The cash effect needs to be understood to avoid it becoming an unseen or unintended risk. Budgets should be affordable and should show the sustainability and appeal of the business model for each business.

Managing liquidity risk and sustainability:

Managing risk begins with identifying and understanding the various liquidity and cash flow-related risks in each business unit. Often, analysis and management of cash flow and working capital is inefficient for reasons such as skills or time shortage; management in silos where departments don’t communicate adequately; or simply, poor management. For example, business units could take an early settlement discount, which is more costly than other forms of finance available through the group. Occasionally liquidity might be a priority that temporarily trumps a lower interest rate; the group’s CFO or treasurer will determine both the need and the timing.

The ‘naked cash flow model’ shows the business’s sustainability and viability purely from a cash viewpoint. It is an interesting tool, using eight dimensions along the cash continuum including sales, purchases, inventory, debtors, creditors, cash surplus and gross profit. It graphically depicts the business model of a single business unit at a specific time – but not a consolidated view – based on budget or forecast figures, and it shows the sustainability of the business model from a cash perspective. In some instances management might believe they have a good business plan, but when they examine it through a cash lens find it isn’t what was intended.


In summary, innovative tools are constantly being created to help pull meaning from data and even to generate data such as cash focused forecasts. Treasury management tools focus more on money management, daily cash, bank accounts and FX. This differs from cash flow and liquidity risk management, where Excel is the most commonly-used tool.

Excel has, however, inherent limitations and is risky as it is vulnerable to human error as some documented costly disasters demonstrate. Very few software tools that generate cash flow forecasts exist and only one uses economic and business driver modeling with ‘what-if?’ capability. Globally, interest in cash flow management makes it an area ripe for further innovation as business leaders realise the importance of focusing on cash, as the only real truth of business performance. All other key performance indicators (KPIs) are essentially proxies for cash performance.

The authors of this article continue to develop and field test new ideas relating to these models; they welcome input from financial professionals who would like to collaborate and help develop these tools and the community knowledge base.

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