How to optimize cash flow with better forecasting Featured

8:00pm EDT June 25, 2010

The rewards of accurate cash flow forecasting may have never been greater than they are today. For example, companies may find that the current scarcity and cost of short-term funding alternatives make it more important than ever to predict, manage and optimize their cash flow, says Gabe J. Galioto, vice president and treasury management officer for PNC.

“In today’s economic climate, the behavior of customers and vendors — even those you have worked with over the long term — can be hard to predict,” says Galioto. “And given the pace of change, relying on historic trends may also be inadequate.”

Smart Business spoke with Galioto about some cost-effective techniques for dealing with the challenges of improving cash flow forecasting.

Why are conventional systems inadequate?

Traditional reporting systems typically focus on accounting-based, or book, cash balances and don’t recognize actual cash on hand. At the same time, conventional bank reporting systems and databases don’t typically retain adequate historic data, and nonbank solutions have not yet advanced to support more effective forecasting. Further, more than 10 years of corporate restructuring has reduced the availability of treasury resources.

What is the first step toward cost-effectively improving forecasting?

It’s possible to significantly improve the precision of your forecasts without incurring prohibitive costs. You might start by taking inventory of your resources.

  • Re-examine your forecasting tools and their level of precision. What data do you have available?
  • Define your requirements in terms of how frequently the forecast should be updated and the length of the forecast horizon.
  • Make a candid assessment of your current process. How accurate, effective and timely has your recent forecasting been?

As you advance this effort, you may find you will need to strike a balance between the cost of improving effectiveness and the business penalties incurred by lack of precision.

Once you have a handle on your available resources, what is the next step?

Forecasts can be more effective when they are focused on underlying in-flows and outlays rather than on aggregate net cash flow. At a minimum, segregate and evaluate primary cash flow components, including lockbox receipts, supplier payments and payroll.

Once primary components are established, consider how to focus your forecasts. Is historical trend analysis alone sufficient? Should you consider fundamental analysis of key events/dependencies? This requires combining a focus on data with discrete business analysis. Examples include known payroll cycles, check run frequencies and loan payment commitments.

You might look at day-of-week and day-of-month dependencies. For example, day-of-week collection patterns of a typical lockbox operation may show large concentrations of Monday deposits. You may also want to consider day-of-month patterns, noting deposit concentrations surrounding the dates that follow statement-based billings.

Consider the merits of a fundamental view of primary customer/vendor terms and behaviors. Focus on major trading partners and assess behaviors that stray from long-standing practices. Once you improve your understanding of primary cash flow components, residual balances can be addressed through more simplistic historical trend analysis.

How do you keep improving your process?

There are a number of steps you can take toward continuous improvement, such as a regular variance analysis in your cash flow forecasting procedure to determine how accurate the model was. Consider:

  • Evaluating the impact of unusual or unexpected events during the time period.
  • Analyzing variances between the forecast and actual outcomes to determine if modifications are needed in your process.
  • Discerning how structural changes may impact historical trends. These can include changes in customer behaviors, postal system initiatives and payment system evolution. If you recognize structural changes or trends, consider a heavier weighting to more recent data observations.

How can you work with other areas of the organization to improve precision?

Review the level of coordination that exists with operating units and functions. Incorporate expected impacts from new events. Are new product launches with extended terms on the horizon? Any recent shift in minimum order sizes? Initiatives to shorten collection cycle times? Is accounts payable thinking about extending average payment terms?

Consider operational changes to encourage more timely planning, such as restricting last-minute wire transfer or manual check requests and requiring senior management approval for any exceptions to these rules.

What are some characteristics of effective cash flow forecasting models?

The most effective models often don’t focus on a single expected state. Consider expanding your model’s flexibility to include the impact of a variety of assumptions and scenarios. Focus and plan for worst case. Precise cash flow forecasting is not easy, but companies that succeed can optimize their cash flow and significantly improve decision-making and best practice behaviors.

This article was prepared for general information purposes only and is not intended as legal, tax, accounting or financial advice, or recommendations to buy or sell securities or to engage in any specific transactions, and does not purport to be comprehensive. Under no circumstances should any information contained herein be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon this information is solely and exclusively at your own risk. Please consult your own counsel, accountant or other adviser regarding your specific situation. Any views expressed herein are subject to change without notice due to market conditions and other factors.

©2010 The PNC Financial Services Group, Inc. All rights reserved.

Gabe J. Galioto is vice president and treasury management officer for PNC. Reach him at (412) 768-1819 or