When it comes to cash forecasting, the primary goal of treasury is to ensure the organization has enough cash to meet its obligations over a certain time period. Thanks to most organizations partaking in the trend of having a forensic-level focus on cash, treasury has a much clearer view of the dynamics of and correlations between the various cash flows that make up the forecasts. With this enhanced knowledge, forecasting can be improved across all spheres of the organization — to everyone’s benefit.  

Cash forecasting methods

Treasury forecasts tend to be built on operational cash receipts and disbursements. 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.

Applying these 10 best practices in cash forecasting, treasury can be more nimble and agile to take advantage of strategic opportunities. Read more.

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.

Bookmark AFP’s comprehensive guide to cash flow forecasting here. Read more.

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.

Building a cash forecasting model

There is no single, correct way to develop a cash forecast. That said, there are a number of decisions that need to be made as part of the development of an effective forecast. 

1. Identify the data available and necessary to complete the forecast. This varies from one organization to another for two main reasons. One, some organizations may only want to forecast large-value items. And two, some organizations may only forecast central group positions, leaving business units responsible for managing their own short-term cash positions. The questions your treasury team will need to consider include:
• Will forecasts be prepared at the business-unit level? This may be important if the group devolves payment decisions to business units
• Will forecasts be consolidated at the group level? If so, does this reflect the treasury’s ability to move funds efficiently between group entities? Note the importance of exchange controls and restrictions on intercompany loans in different locations
• If forecasts are consolidated, should all business units be part of that consolidated forecast? Should recent acquisitions, or divisions expected to be divested, be forecasted separately
• Will forecasts be prepared in a base currency, or will separate currency forecasts be prepared?
• Will the forecasts incorporate a reserve or safety margin to accommodate inaccuracies? If so, how will the treasury determine these?
  
  
2. Establish the best sources for data. Once the data sources have been identified, the team will need to ensure the same level of data is provided from each submitter. Avoid duplication by ensuring that each piece of data is provided by only one source. Some potential sources for data include:
• The treasury management platform, whether a workstation or a set of spreadsheets.
• Company planning documents, including business plans and sales forecasts.
• Centralized financial departments, such as accounting and shared services centers.
• Business units and operating companies, e.g., accounts payable and accounts receivable.
• Automated bank data feeds and bank statements.
  
  
3. Classify the data for accuracy and completeness. Regarding accuracy, you’ll want to determine if the data is a certain item, such as a tax payment or loan repayment; a predictable item, such as payroll; or a less than predictable item, such as contingency for repairs.
   
   There are two more points to consider under this step: whether the data is available, and whether the submitted data is complete. Even when you’ve identified a potential source, some data is not going to be available early enough to be entered into the forecast. Also, you may identify a potential source for the data, but what is submitted may not be reliable in terms of accuracy or frequency of submission.  


4. Set the forecast timeframe. Most companies forecast a daily cash position, but the nature of your business determines the other forecast horizons. The greater the variance of the submitted data, the more frequently you’ll want to calculate your forecasts.
   
   
5. Select the method to create the forecast. This is determined by the quality of the data and the time period of the forecast. If the data is reliable, there won’t be as much need to manipulate it. When it’s less reliable or incomplete, you will need to manipulate it to some degree in order to produce a meaningful forecast. Be sure to consider any technological constraints in your decision. Although statistical modeling can be done using spreadsheets, dedicated forecasting software is generally more powerful.
   
   
6. Daily management of the system. There are a number of checks which need to be made on a daily basis. These include check expected data, check any unexpected data provided, and reconcile data with external information, if possible.
   
   
7. Identify output. Finally, you’ll want to review the forecast output. Cash position forecasts should give a good indication of likely balances, which is information you can rely on and share with decision-makers.

Learn more about cash forecasting with AFP’s Treasury in Practice series.