Within an organization, important choices are made based on the current and expected liquidity position. It is therefore of great importance that the liquidity position is accurately portrayed and regularly updated. During uncertain times, making a forecast requires extra effort and poses a greater challenge. For example, due to uncertainty, it may be decided to update the liquidity forecast(s) more frequently. The question raised then is what frequency is appropriate and how to deal with the assumptions underlying forecasts made during an economically sound period. In this article we discuss the information, processes and systems that are important for getting (and keeping) a good grip on the development of cash flows. Ultimately, as an organization you want to have a reliable picture at all times of the expected development of the liquidity in the short, medium and long term.
Availability of the right information
In order to obtain the best possible picture of the liquidity position, the quality of the underlying information is of great importance. The realized and projected profit and loss account, balance sheet, investment plans and transactions form an important part of the input. From a theoretical point of view, there are two methods to translate this input into the calculation of the (expected) cash flows; the direct and the indirect method.
- Under the direct method, cash flows are based on individual incoming and outgoing transactions, such as accounts receivable receipts, accounts payable payments, investments and interest payments.
- Cash flows under the indirect method arise from the P&L account and the balance sheet. Thus, under this method, the cash effects of balance sheet changes are also included.
Which method is appropriate depends in part on the length of the specific forecast. Actual bank movements (or an accurate estimate of these), on which the direct method is based, are often available for a relatively short period of time. This makes this method suitable for a short-term forecast. With the indirect method, the cash flows are derived from the projected P&L account and balance sheet. Because of this combination, this method is ideal for medium and long-term forecasts.
The most appropriate methodology depends partly on the length of the liquidity forecasts. In order to obtain a good picture of the liquidity position in the short, medium and long term, various forecasts must be prepared. These forecasts differ in terms of time units (week, month, quarter and year) and length (quarter, year and > 1 year). The matrix below shows the different time lines again, with the different forecasts shown vertically. To the right of the matrix, the appropriate methods for each forecast are shown.
Here, it is often the case that the longer the period over which the forecast is made, the less accurate the forecast. The choices regarding time units and length of the forecast are related to the phase in which the organization finds itself and the type of sector in which the organization operates. For example, in times of economic uncertainty (such as the current pandemic) or in the case of a weak financial position, it is often chosen - sometimes imposed by external financial stakeholders (e.g. special management of a bank) - to produce a short term forecast on a weekly basis. This should ensure that the financial position is brought into focus on a weekly basis, thereby increasing the grip on cash flows.
"In order to get a good picture of the liquidity position in the short, medium and long term, various forecasts need to be made."
However, this does not mean that the financial position is more accurately portrayed by creating more forecasts of different lengths. Indeed, too many (different) forecasts generate a constant time investment that is too great to keep updating them.
When an organization is in a "quiet" period, a monthly forecast for 12 months rolling, combined with a multi-year (annual) forecast for 5 years rolling, may be sufficient. However, consistency between forecasts is crucial. The inputs provided should be consistent across the different forecasts, and the time units of the different forecasts should overlap. For example, if a 13-week forecast (quarterly) is chosen, it will logically align with the liquidity forecast of at least 12 months rolling on a quarterly basis.
Embedding in systems
One of the tools needed to process and update all information is a system that brings together all cash flow information. In practice, a treasury module in the existing ERP system or an Excel file is regularly used. If Excel is used without a clear format, it often turns out to be too complex, confusing and prone to errors. With a clear format, Excel can certainly be a suitable tool. In addition, one can choose to largely automate the forecasting process by means of an application.
The format of the chosen system will act as a means of creating consensus among internal stakeholders on the approach and principles of forecasting. In addition, it will create clarity towards external stakeholders. In order to maintain an overview, it is advisable to subdivide the cash flows into a limited number of items. The following three types of cash flows provide the basis for this:
- Operating cash flow: all cash flows resulting from operations.
- Investing cash flow: consisting of the investments in fixed assets, investments in the form of acquisitions or revenue sales.
- Financing cash flow: all expenditures and income from financing activities (a different choice can be made with respect to interest).
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Getting a grip on cash through the right processes
Besides information and systems, processes will need to be established within the organization to really get a grip on the cash position. Fixed processes bring structure to the preparation, comparison and updating of forecasts. It must always be possible to answer the question of why a particular cash flow differs from a previously prepared forecast.
It is important to be able to explain the difference between two liquidity forecasts of different times. A clear format can help with this. The challenge lies in constantly updating and reconciling these forecasts. If, for example, an investment is postponed, this will have to be reflected immediately in the investment cash flows of the forecasts. Here, clear communication is crucial. This starts with internal communication, by means of regular meetings or calls (so-called cash calls). By scheduling regular cash calls, during which the cash position and expectations are discussed and analyzed, the forecasts remain up-to-date. It is preferable to align the frequency of these cash calls with the frequency of the relevant forecast. In communications with external stakeholders, it is particularly important to provide insight into the risks and opportunities of the forecasts that have been prepared.
Finally, it is essential to compare the actual realization of the cash flows with the forecast that was prepared for the cash flows. The deviations and insights arising from this must be taken into account in the forecast for the subsequent period. After processing this realization, the length of the relevant forecast will have to remain unchanged, a so-called rolling forecast.
Ultimately, grip on the cash position can only be realized through the combination of information, systems and processes. A clear vision on this helps to structure this interplay.