Company-specific conditions set the parameters for cash forecasting, but overall objectives and difficulties remain consistent across all sectors.
Accurate cash forecasting enables companies to ensure liquidity, maximize investment income, minimize borrowing costs, secure new lines of credit, manage currency exposures and anticipate financial risk. Companies that don't produce good cash forecasts are penalized in the markets and by their bankers and business partners. "After witnessing the punishment that the capital markets have inflicted for missing earnings estimates, it is easy to understand why forecasting is a priority for CEOs and CFOs," says Bryan Hall, Atlanta-based practice director with Parson Consulting, a finance and business support advisory firm.
Forecasting is an extraordinarily difficult task, but companies are achieving greater accuracy and pushing their forecasts further out by exploiting new technology and improved modeling techniques and by ensuring that business units submit timely, comprehensive projections. Because the variables involved depend entirely on a company's business lines and cash cycles, no single forecasting approach is meaningful for all organizations. However, most companies share similar forecasting objectives and face common problems. A glance across the spectrum of cash forecasting methods provides a useful inventory of the possibilities.
Objectives and Time Frames
At the more complex end of the cash-forecasting spectrum are large, multi-unit entities in volatile industries such as the energy sector. At Entergy Corp., a New Orleans-based integrated energy company with more than $9 billion in annual revenues, forecasting runs out to five years and covers contingencies ranging from currency fluctuations to weather changes.
The company's objectives for its cash forecasting efforts are twofold. "First, immediate cash needs for unexpected plant outages and other expenses must be covered by investing short in euros and commercial paper," says cash manager Steve Myers. Second, "longer-term operational goals, including acquisitions, dividend payments and stock buybacks, require cash to be held in longer-maturing vehicles that increase return while maintaining a low-risk exposure."
For its short-term purposes, the company's treasury department prepares a 90-day rolling cash forecast for its regulated utility companies to determine short-term investing strategies and to ensure that adequate cash is available to meet working capital needs. To improve accuracy, treasury has identified large recurring payments -- fuel purchases, taxes and dividends, for example -- and large one-time payments such as bond purchases and redemptions. Business units provide treasury with the necessary data weekly by e-mail or interoffice mail, and the forecast is updated each week to reflect the most current information.
In addition to this short-term projection, Entergy's utility finance department prepares a five-year forecast using a financial planning model from consulting firm Utilities International Inc. This forecast enables the company to monitor its overall projected financial condition and to determine whether it needs long-term debt financing. On a monthly basis, the utility finance department coordinates with the business units, which enter their current estimates into the model to update the forecast.
Cyclical Challenges
Companies with diverse businesses or cyclical operations may not be able to generate long-term cash forecasts. In contrast to Entergy, with its five-year forecasts, Gehr Enterprises does not push its forecasts beyond one year. Los Angeles-based Gehr is a diversified multinational company with interests in manufacturing, wholesale distribution, high-tech equipment sales, and commercial and residential real estate holdings. "In general, the accuracy of a cash forecast decreases when the forecast period extends past the business's cash cycle," says David Lifschitz, vice president and CFO. "Beyond that point, the forecast becomes more of a speculative -- albeit informed -- projection based on key assumptions and estimates. In our case, although some of our forecasts extend as far as 12 months, the accuracy of the forecast decreases beyond 60 days."
Some of Gehr's divisions operate in highly cyclical market segments, while others compete in relatively stable and predictable industries. "Consequently, cash forecasting is our vehicle for navigating the fluctuations in working capital," Lifschitz explains. "The ease or difficulty of forecasting is linked to the degree of volatility or cyclicality of the industry and market segment. For instance, collections on sales to mass retailers are dictated by cyclical consumer demands, while collections on long-term manufacturing contracts or real estate leases are far more predictable."
Even for companies with cohesive product lines and synchronized business cycles, time frames for forecasting are often narrow. At The Allied Defense Group Inc. (ADG), an international defense and security company based in Vienna, Va., CFO Charles A. Hasper likes to maintain a rolling 18-month forecast of cash trends. "However, the challenge has been to obtain a credible forecast, on a quarterly basis, for one year," he notes.
Beyond 10 months, revenue is one of the most difficult variables to predict. "Most of our sales volume is based on short-term contracts, which makes us apply some probability weightings to the periods 11 through 18," Hasper reports. "We minimize currency fluctuations by hedging our positions. At this time, currency fluctuations are in our favor since a majority of our business is out of Europe."
ADG's forecasts "assist us in determining the necessary level of cash that needs to be repatriated from our various subsidiaries," says Hasper. "They're also useful for planning financial structures for growth through acquisitions and calculating the amount of excess cash that we have for internal investments related to R&D and capital expenditures."
Professional service firms generally have cohesive product lines, but their business cycles are often more difficult to predict than are those of companies in the manufacturing sector. "Other than the typical first- and fourth-quarter increases and summer slowdowns, we don't see defined cycles in our business," says Mary Bogue Logan, CFO of Avail Consulting LLC, a valuation consulting firm based in Houston. "Because we rely on the buying and payment cycles of our clients, forecasting is not always easy. For instance, when we provide litigation support in relation to bankruptcy cases, we are often subject to the protracted payments determined by the courts."
Logan maintains a rolling 12- to 18-month forecast but stays closely focused on the next three months. "To keep our pulse on projected revenue levels and cash flow, we use a pipeline [report] to track prospective sales," she says.
Enforcing Unit Reporting
Companies can improve their forecasting by building accurate models for receivables and expenses, but the success of such efforts hinges on complete reporting from all departments and business units. CFOs, treasurers and financial analysts commonly complain that their forecasting efforts are compromised because business units fail to submit comprehensive, accurate information in a timely fashion.
At Avail, every manager and director engaged in selling and managing client work meets weekly with Logan and the company's CEO to review the funnel of opportunities and proposed and sold work. "Minutes from these meetings are circulated, which creates peer pressure to keep them current and accurate," Logan says.
ADG avoids the problems that arise when units don't submit the necessary information by making submissions of cash flow forecasts a requirement under corporate policy. "Each unit submits an annual cash flow projection as part of the annual budget process," Hasper explains. "Updates to those submissions are required as part of the quarterly forecasting process."
Each ADG subsidiary president is responsible for cash flow projections and is supported by a subsidiary financial manager who prepares the forecasts. The projections are then submitted to ADG's corporate offices for consolidation. "The presidents, along with their respective controllers, are responsible for driving the business for the quarter to the projections submitted," Hasper says. "Bonuses are affected if results come in under or exceed the forecasts for the entire year."
At Gehr, sales executives participate in the longer-term sales forecasts, and sales and operations managers contribute to routine updating and maintenance of short-term projections. Credit managers and division controllers participate in monitoring accounts receivable and forecast updating. Purchasing executives are involved in forecasting purchases and inventory levels.
"Input from operating units is submitted routinely through scheduled reports and updates," says Lifschitz. "Corporate finance holds periodic meetings to update the long-term outlook. In addition, the review of cash flow is a key component of monthly operational reviews. Ad hoc meetings are also held during critical periods in the business cycle."
Technology and Modeling
Because cash forecasting relies on information that is highly company-specific, no dominant technology or modeling system has emerged. But the number of viable options has multiplied in the past five years. Many organizations have developed worksheet-based approaches or have implemented treasury software that models daily deposit trends and planned payments in order to determine liquidity needs.
"This modeling approach works extremely well for immediate cash forecasting and presents a bigger opportunity for organizations to leverage modeling to improve overall forecasting," Parson Consulting's Hall points out. "Overall, companies should not use two disparate systems for forecasting, but rather integrate the two to improve the efficiency and accuracy of both."
At Santa Clara, Calif.-based Sun Microsystems, integrated cash forecasting is part of the company's process excellence cash management (PECM) initiative, a holistic approach built on Six Sigma quality control techniques that span all functional areas and all aspects of the cash life cycle. Sun's treasury function adopted PECM in 2003.
"We use the direct-method cash flow statement for internal planning purposes," says Navneet Govil, Sun's assistant treasurer. "For every element of the cash flow statement, we have business and finance owners to help drive accountability across the enterprise. We also use quarterly Web-based dashboard reviews for collections, disbursements and other cash flows."
The dashboards show the expected level of cash flows, quarter-to-date actual cash flows, and the range of expected cash flows. "PECM has resulted in an increased level of cash flow predictability and a defined band of variance that has greatly enhanced the company's cash planning abilities," Govil reports.
At Entergy, treasury is responsible for tracking actual activity as part of the forecasting process. It uses PeopleSoft Financials 8.4 to perform this task. The tool "is very useful due to its capability to capture our cash position, actual receipt information and outgoing payments, and its valuable reporting functions," says Jan Anderson, financial analyst.
Gehr uses Control, a financial management application from KCI Computing, for modeling. "We have separate models for inventory, purchasing, revenue and collections, where we simulate different assumptions," says Lifschitz. "The output from these submodels feeds our cash flow model. KCI Computing's Control brings a higher level of predictability to our cash forecasts."
Avail uses an internally developed Excel pipeline report tied to highly customized CPA software designed specifically for financial services consulting firms. This approach allows the company to track real-time revenue and gain an accurate picture of its chargeability ratio, a critical measurement of its business. "We experimented with several sales-tracking systems and Oracle before we settled on this combination," Logan notes. "Given the sometimes lengthy collection cycles of our larger engagements, we work closely with our bank and have secured a working capital facility that allows us to borrow against our receivables and unbilled services. Based on a debt-to-income and predicted chargeability ratio that we constantly monitor and maintain, we can secure the needed working capital."
Melding Forecasts and Goals
Cash forecasting often remains disconnected from organizations' broader plans and projections. "Two key issues -- focus and timing -- make integrating the process difficult," Hall says. "All forecasting should include a P&L, balance sheet and cash-flow perspective. How-ever, when we look at what most participants are doing during the forecasting process, we find they are focused on expense and/or revenue and little else."
Cash forecasting should cover four time frames, says Hall: immediate (daily to weekly), operational (monthly to quarterly), tactical (annual), and strategic (beyond one year). "At the longer time dimensions, developing the cash forecast involves an understanding of capital investments, acquisitions and the operational returns a company expects. But at the other end of the spectrum -- the immediate cash forecast -- integration falls apart." Companies can achieve greater integration by modeling daily deposit trends and using the results to improve overall forecasting.
Even the best cash forecasting systems cannot capture all of the industry-specific risks and economic volatility that companies face. At Entergy, some critical variables are notoriously unpredictable. "Fuel price volatility, weather and temporary timing differences make cash forecasting challenging at times," Anderson reports. "Based on historical data, treasury is able to forecast revenues fairly accurately. However, major storms -- such as hurricanes, tropical storms and ice storms -- can potentially cause widespread outage in our service areas, which negatively impacts revenue and increases cost."
The fact that Entergy can generate meaningful short- and long-term forecasts and integrate them into its broader business goals in a sector where the weather plays a major role gives hope to companies that face more predictable challenges.
