Better forecasting: know your cash flows.

Having problems with your cash flow forecast? If your answer is "yes," then you are not alone. Most organizations, both public and private, have ineffective forecasting processes and methodologies. A recent survey by Treasury Strategies Inc. indicates that more than 70 percent of treasurers have plans to review or improve their cash flow forecasts this year. The good news is that all forecasts can be improved--regardless of how sophisticated or complex.

This improvement may come just in time. Rising interest rates and a general expansion of economic activity have elevated the need for cash flow transparency. Better returns on short-term investments, combined with an upward-sloping yield curve, provide strong financial benefits to those companies that can term out their cash portfolios. An increase in M & A activity, compliance requirements of Sarbanes-Oxley and the American Jobs Creation Act also require firms to be highly cognizant of their future cash positions. Treasurers that can best predict the state of their short-term liquidity will excel in this new economic climate.

Reaping the benefits of forecasting may require your organization to overcome significant challenges. In many companies, a centralized cash forecasting process exists but has achieved poor results. Variances to the forecast are frequent, and the source of the variance is unknown or not easily identified. When the source of the variance cannot be pinpointed, the root cause is often not readily explained.

The solution to this pervasive problem lies with an intimate understanding of the specific cash flows that make up the forecast. While inadequate models and quantitative techniques are often blamed for inaccuracies, the real culprit is the information that enters the forecasting tool. When variances do occur, the forecaster must have sufficient knowledge to immediately identify the root cause of the variance. Good cash forecasts are intuitive and yield no real surprises.

Specific Cash Flows

The first step to obtaining this detailed understanding of cash flows is a comprehensive mapping of all receipts and disbursements. This process will reveal the existence of "bad" data and suggest ways it can be cleansed.

For example, it may be found that a certain bank account is being used for both lockbox collections and small tax payments. The commingling of these inflows and outflows makes it difficult to isolate the true level of receipts. Using this data will require that these tax payments be removed and, to be most effective, a revamping of the banking structure to include only single-purpose accounts will also be necessary. All cash flows should be systematically analyzed in this manner to ensure data is of the highest quality.

When all inflows and outflows have been identified, the next step is to measure the day-to-day fluctuations and seasonal effects of each cash component. This process will reveal the source of potential variances and confirm the seasonal factors that need to be included in forecast modeling. From this, the cash flows that are likely to be most trouble-some in the forecast process can be isolated. If resources are limited, it is best to focus your attention on these highly volatile components.

For organizations with decentralized business units that prepare their own cash forecasts, aggregating those projections at the corporate level can add an additional layer of complexity. In many companies, forecasting methodologies are inconsistent across business units. This makes the forecast results not directly comparable from one business unit to the next. Cash flow mapping and volatility measurement at the business unit level can help the forecaster diagnose and correct problems that occur at the corporate level.

When cash flows have been thoroughly analyzed, improvements to forecast accuracy are frequently seen. The cash flow mapping exercise will recommend communication channels for the efficient flow of forecast information, and the measurement of specific cash component volatilities will suggest the need for seasonal factors in the forecast model and highlight potential problem inflows or outflows to keep your eye on.

A deep dive into the cash components of each business unit will help the forecaster better understand aggregate corporate-level flows, as well as identify forecasting problems and "best practices" within the business units.

Although labor-intensive, a thorough analysis of cash streams will yield substantial improvements to even the most intricate forecasting processes. One treasurer was able to decrease forecast variances by more than 76 percent. When treated as a "black box," forecasting models will always generate inaccurate results and, worse, results that are not correctly applied. Every effort should be made to ensure that forecast data is of the highest quality and every component of the cash forecast is documented. Only then can your company achieve the generous rewards of a well-understood forecast.

Michael Hunstad is a Senior Consultant with Treasury Strategies Inc. (www.treasurystrategies.com) in Chicago. He can be reached at 312.443.0840 or [e-mail].