From the September 2015 Special Report issue of Treasury & Risk magazine

The Use of Cash Flow Forecasting as a Risk Management Tool

Corporate Earnings continue to be negatively impacted due to FX volatility and the impact is hitting the bottom line through diminished shareholder value. Cash flow forecasting, as a component of FX and liquidity risk management processes, can be the key in the preservation of corporate earnings and the realization of greater economic value generated offshore. Put another way, not having cash flow forecasting embedded as part of a broader set of FX and liquidity risk management initiatives is in effect jeopardizing the value of future sales revenues in non-functional currencies, not locking in the cost of goods sold and hence may impact restated earnings.

FX risk is now a key driver of corporate earnings volatility and hedging earnings has become even more critical given the increasing share of corporate profits coming from overseas.1 The strengthening US dollar is driving North American based multi-nationals to better manage their currency translation risk to protect against diminished returns when restating their offshore earnings. While the majority of multinational corporates hedge to varying degrees, many US corporations have reported negative impacts from USD strength in recent quarters and the potential for more downside risk in coming quarters. FX Volatility is having a material impact on corporate earnings.2 With history suggesting continued US dollar appreciation in the current cycle, there is an increasing need for corporations to review their FX and liquidity risk management practices and policies.

While there is nothing new in putting a currency hedging program in place to protect value generated from commercial activity offshore, enterprise wide visibility over future cash flows and anticipated currency positions provides a basis for the program’s effectiveness. On-demand visibility into the future aggregate cash position by date by currency across the organization is a prerequisite to enable identification of natural offsets and opportunities for internal hedging resulting in a reduced need for external hedging. A single chart or dashboard is required that presents the cash position by date by currency to a commercially meaningful time horizon. Measuring the accuracy of prior forecasts by date by currency enables a more informed next action minimizing future repair of hedges put in place or the early breaking of deposit contracts if liquidity buffers get stressed. Irrespective of industry or geographic location being considered, there are a number of best practices to consider:

Circumvent structural complexities

Having accurate and timely visibility over a consolidated actual cash position across various geographic and structural dimensions is the first step in preparing a forecast. Mobilizing cash to “Header Accounts” through automated sweeps or manually through wires allows Treasury to view the consolidated actual cash position through the minimum number of accounts, circumventing structural complexity and inefficiencies which may be hard wired into corporate financial management ecosystems today. Where these liquidity structures are in place, it is the header accounts that may then be included in the aggregated forecast cash flows. The next step is to overlay the actual cash positions with forecast data (for example, pertaining to AP and AR and other booked transactions) from ERP systems and then overlay that with any large future episodic cash flows not contained within the ERP such as expected flows arising from Tax, M&A and capital expenditure. All this requires close liaison between Treasury, Tax, Corporate Finance and other parts of the organization.

Adopt multiple methodologies

There is no silver bullet with respect to preparing the forecast. Multiple methodologies are often adopted depending on flows being forecast, frequency of reforecasting (cycles) and forecast horizon being considered. Recognizing that business cycles are not linked to a financial year, generally it is now recognised that a more frequent rolling forecast — versus, a fixed financial year budget — is the more effective basis to manage liquidity and FX risks. Forecasts prepared for the purpose of managing these risks should be realistic projections underpinned by valid business and economic assumptions as opposed to commercial targets which can generally be more aspirational. The frequency of the rolling forecast should not be too rigid either. That is, the more volatile the environment, the more frequent a revised forecast is required. 

Figure 1:  Forecast Variance over Time indicating the range of methods typically employed by corporates to prepare the financial forecast.

Focus resources on what makes a difference

Once the cash flow forecast is prepared, consider how best to focus your efforts on preserving the future value of non-functional currencies expected to be generated by the underlying business. An option may be to reduce the number of currencies being actively managed by Treasury to those where the greatest risk/volatility resides. Coupling cash concentration structures with a policy to convert non impactful (low materiality) currency positions immediately into functional currency can further reduce the “operational noise” in the system. Management of liquidity and FX risk may then be more focused on the highly impactful currencies.

Incorporate Historical Forecast Variance Trend Analysis

Gaining insights into the accuracy of historical forecasts by currency can help determine whether the future forecasts provided are reliable and actionable. This historical trending of forecast variance over time should not be confused with an absolute measure of forecast variance. While forecast variance reports are typically the difference between the most recent forecast and the actual outcome, forecast variance trend analysis is achieved through rules based matching of actual events against all historic forecasts of those events going back in time through each prior forecast cycle. This gives rise to a plot showing the history of variance for each forecast back to when the first forecast was made for a particular event or combination of events. Irrespective of the forecast methodologies adopted to predict the currency flows that are expected to be generated or absorbed across the business, historic trending of forecast variance over time can be the key to deducing the instrument and/or instrument tenor to mitigate the liquidity and FX risks arising. While episodic events can always disrupt future predictions, this approach gives a confidence measure to determine how far out from the event horizon a forecast currency position can be deemed reliable for action to be taken. The benefits of getting this right are clear:

  1. Effective hedging of future earnings without need for multiple “repairs” to offset mistakes.
  2. Greater yields on investments due to their longer tenor without incurring losses through early breakage due to unexpected liquidity shortfalls.

In conclusion, with continued FX volatility expected and with the back drop of interest rate uncertainty and geopolitical tensions, putting in place an effective cash flow forecasting program underpinned by reasonable economic assumptions is key in the implementation of an effective liquidity or FX risk management program. Systemic visibility over future cash flows and currency positions by future date can then enable identification of natural offsets and opportunities for internal hedging and thereby reducing overall external hedging costs. Historical Forecast Variance Trend analysis is the key to determining the correct next action in the market to hedge or invest effectively. 

Figure 2:  Forecast Variance Trend Analysis showing historic forecast variance over time for both a USD and EUR actual position today. The dashed line for the USD forecast variance shows an upper and lower range of forecast variances over time as calculated versus the actual USD position today and each day over a prior period. 

1  Treasury Priorities 2015, Treasury Advisory Group, Citi
2  2015 Q1 Corporate Earnings Currency Impact Report, FiREapps

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