CHAPTER 1
Cash Forecasting Methods
Treasury forecasts tend to be built on operational cash receipts and disbursem*nts. Their strategic purpose comes into play when they are developed over a longer period of time, which could be due to a desire to develop medium-term funding, investment plans, or support greater efficiency in the organization’s use of working capital.
There are three time periods used to develop forecasts: short-term, medium term, and long-term. We’ll talk about the different purposes of each period below, and provide you with some key points to consider that are unique to each one.
Short-term
In order for a business to continue operating, the treasury team needs to understand the timing of cash flows so they can make provisions for raising funds — or placing funds in investment. On the extreme end of this is identification of your “burn rate,” or the speed at which your organization uses up its cash. Start-ups are typically most concerned with this, but we saw many organizations start monitoring their burn rate during the 2020 coronavirus pandemic lockdowns as revenues dried up and supply chain issues added a level of uncertainty that was previously unknown.
Short-term forecasts are always likely to be the most accurate. With a clearer view of the underlying cash flows that constitute short-term forecasts, treasury can better make strategic decisions in the following areas:
- Working capital management. If you want to see when working capital is tied up in inventory or AP, monitoring cash flows can help. Things you’ll want to consider include the variability of the company’s costs and steps that can be taken to change the ratio of fixed to variable costs, such as reviewing the funding programs that might be in place.
- Supply chain management. Look for patterns of change over the last two years of your short-term cash flows. In terms of robustness of the supply chain, both upstream and downstream, what do these patterns suggest? When it comes to paying the company’s suppliers, can you be more strategic? And finally, communications: what is the best way to communicate your insights to procurement, sales and the board?
- Short-term funding strategy. There are two key items you need to think about here: flexibility and the cash flow implications of strategies designed to protect against the effect of rising interest rates.
Medium-term
Medium-term forecasting is more difficult. Why? Because the medium term is usually describing the period when payables and receivables are primarily forecasted from either budgets or previous years’ data rather than contracted procurement and sales.
Some cash flows, such as loan repayments and bondholder payments, are known and predictable. Many more remain uncertain (think revenues and tax remittances) as they’re tied to economic activity. So, when you’re developing a medium-term forecast, you have to build it out from sales and procurement in order to understand the expected physical transactions (e.g., raw material costs, production costs, employment costs) and anticipate cash flows over the next 3-12 months. With a better understanding of the nature of the underlying cash flows and their correlation, treasury can help bring more granularity to medium-term forecasts.
Long-term
What is the purpose of a long-term forecast – looking out a period of more than a year? Long-term forecasts are used to support decisions made regarding capital allocation, long-term fundraising and to identify scope for mergers and other capital actions. While knowledge of individual cash flows plays a part, especially in terms of decisions on funding and the raising of capital, there are simply too many unknowns to produce accurate cash position forecasts over the long term.
How treasury adds value with long-term forecasts is by helping management understand the risks associated with different business strategies. For example, treasury can help management appreciate how the capital structure (i.e., the balance between debt and equity) could affect the company’s ability to raise emergency short-term financing, should the need arise.
Understanding how various strategic decisions could affect the company’s exposure to financial risk, and achieving a balance between risk and reward, is another way treasury can add value. Examples of financial risks include interest-rate exposure, timing of capital structure decisions, or foreign-exchange exposure if the company is considering expanding its overseas production facilities.
