The forecasting of cash flow has long been a staple at many companies. Few people pass through the treasury department of any organization without participating in a cash flow forecast. Nevertheless, the accuracy of these forecasts varies widely.

Many companies’ forecasts are developed through arcane processes and disconnected spreadsheets. Putting them together requires a great deal of effort, yet the forecasts’ creators lack accountability, and process ownership is unclear. The constant across companies is that treasury professionals generally try to avoid being saddled with this responsibility. Usually, treasury professionals see little upside for coordinating a company’s cash flow forecasting efforts, yet they may face the wrath of C-level executives if forecasts are missed or come in late.

For the treasury team—and for the company as a whole—inaccuracies in cash flow forecasts are more costly today than ever before. Because of turbulence in the external economic environment, as well as investors’ and analysts’ increased interest in corporate cash flows, senior management are paying more attention than ever before to the forecasting process. The treasury department is also under increasing pressure to intervene and make significant process improvements.

In most companies, the forecasting process has been a complex and demanding orphan, marked by a number of major shortcomings, including:

  • insufficient dedicated personnel to properly carry out the task;
  • limited systems support, which may relegate the process to a series of unrelated spreadsheets dispersed throughout the company;
  • the lack of a formal mandate or performance measurement process, which would motivate business units to allocate time and resources to meet expectations for accuracy and schedule;
  • a lack of standardized forecasting methodologies and assumptions for business units to refer to in preparing the forecasts;
  • limited ability to carry out proper variance analysis on missed forecasts; and
  • a disconnect in the treasury function, which is tasked with compiling forecasts that are generated by the business units.

This final point is particularly disconcerting. In many cases, treasury professionals do not have the authority to compel the business units to give them access to information that would enable the treasury department to determine the veracity of submitted forecasts. Likewise, many companies lack a performance measurement process that would enable the treasury department to hold business units accountable for variances in their cash flow forecasting.Baldoni_PQ1

Although one would expect a steady stream of process improvements to correct these issues, most companies have a history of ignoring forecasting challenges. One reason is that many organizations have maintained strong positive cash flows or have had access to ample credit, so they have not felt a need to allocate resources to reengineering their cash flow forecasting process. Another reason is that senior executives often fail to view forecasting as a useful decision-support tool; in many cases, the forecasts are used only by the treasury department for monitoring short-term liquidity.

In recent years, many companies have begun to fundamentally change how their forecasting tool is valued and applied. There are three key reasons for the shift.  First, some companies started having trouble securing liquidity in the market. Second, the extended economic slowdown has led to greater volatility in earnings and cash flows for many companies. And third, many Wall Street analysts are now using cash flow as a barometer of a company’s future health.


New Efforts Demand New Focus

When companies decide to work on improving their forecasts, their first steps often focus solely on setting parameters for accuracy. They ask: What changes do we have to make to reduce forecast variances to a maximum of 15 percent, 10 percent, or even less?

But this approach is akin to the tail wagging the dog. It focuses companies on a series of symptoms benchmarked against an arbitrary goal, which usually causes them to misdiagnose the problems driving their cash flow variances. What they really need is deeper information, enhanced technology, redefined metrics, and improved guidance for business units. A company can spend a great deal of time streamlining cash flow forecasting, but efficiency does not necessarily ensure a forecast’s effectiveness.

Even a highly efficient process can result in large variances if it does not identify slippages in business performance. If the forecasting effort fails to incorporate the impact of key business drivers, all the process improvement in the world will not produce an accurate projection of where the company is going. Thus, when trying to improve the forecasting effort, companies should pursue a portfolio solution rather than a simpler, one-dimensional “accuracy fix.” To have a significant impact on cash flow forecasting, companies should invest in four main areas:

  • Improving the methodology, access to cash flow forecasting data from the businesses, and related systems around the cash flow forecasting process.
  • Developing aggressive variance-analysis methodologies. One such methodology might be a requirement for business units to automatically provide an analysis to the treasury department when the variance is above a certain percentage.
  • Identifying key business drivers, then incorporating them into a monitoring system that provides alerts early enough so that the company can recognize cash flow shortfalls and take corrective action before the end of the reporting period.
  • Expanding the role of cash flow metrics in the company’s internal performance management processes so that business unit leaders are effectively motivated to deliver high-quality forecasts.

Emphasizing these four areas in concert will in most cases result in more accurate forecasts.


Selecting a Forecasting Method

One of the most critical decisions a company makes as it works to improve cash flow forecasting is its selection of the forecasting method that is most appropriate for the company. Generally, an organization can use one of three methods to prepare cash flow forecasts: historical trend analysis, top-down trend analysis, and bottom-up business unit forecast.

Historical trend analysis. This process applies various analytical techniques to a time series of historical data, such as actuals for several prior fiscal quarters or several years’ worth of cash collections and disbursements or revenues and expenses. The techniques may range from simple trend analysis—for example, examining the time series to detect patterns—to regression analysis or more sophisticated stochastic methodologies, which can reveal subtle movements in sales and cost of goods sold (COGS) collections, among other things.

The result of such an analysis, performed by the treasury or planning department, becomes the basis for the assumptions used to model cash flows. This approach is particularly attractive to companies that lack the level of detailed forward-looking data needed to develop more granular forecasts.

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Top-down trend analysis. This approach centralizes cash flow forecasting within the treasury function. In this approach, the treasury function performs an analysis of high-level financial forecasts to identify relationships between different components of the data. For example, analysts might note correlations between projections and the timing of certain events in the sales-receivables-collections cycle, or they might see a relationship between inventory and the COGS as a percentage of sales. When these types of relationships are apparent, the treasury team can use models to project future movement in balance sheets, profit and loss (P&L) statements, and cash flows. Note that this approach is dependent on the availability of high-quality, high-level, current year forecast data.

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Bottom-up business unit forecast. This approach gives the business units responsibility for providing the data required to produce accurate forecasts; they can use either the financial-statement model or the collections-and-disbursements approach in preparing their forecasts. When members of the treasury team receive cash flow projections from all the business units, they consolidate the data into a corporate cash flow forecast. Within this methodology, the business units are responsible for performing a variance analysis on their own forecasts for each period.

The reasoning behind this approach is that since the business units have the most comprehensive understanding of their plans, they are in the best position to provide the most reliable forecasts. Although the approach tends to produce more accurate results than treasury-centric forecasting, the quality of predictive skills can vary widely among the business units, and the treasury function may not always understand the assumptions behind the different forecasts it receives.

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Upon reviewing these approaches, you may decide that they are interesting but are hardly rocket science. That is exactly the point: Good cash flow forecasting is more about process improvement, methodology selection, and technological support than it is about high-end algorithms or arbitrarily selected benchmarks for accuracy. A review of the pros and cons of each method should help reveal the one that will work best in your company’s environment. From there, you’re ready to develop a road map to solid forecasting in your company.

When trying to determine which method is appropriate for your organization, keep in mind that the best option may be a combination of the approaches. Even if you choose the bottom-up option for the company as a whole, an abbreviated version of one of the other two methods may serve as a high-level sounding board, developed by the treasury department and used to evaluate the accuracy of business unit cash flow projections. This approach would enable senior management to validate the forecasts provided by the business units and provide support for executives to push back with some hard questions when the business units submit their numbers.

Further Considerations

The selection of the right approach should also involve consideration of several other factors. One is the intended use of the cash flow forecast. Will it support liquidity management, corporate funding efforts, and/or growth planning? Another is the type of forecast required—receipts and disbursements vs. balance sheet.

The time horizon for the forecast (short, medium, or long term) is another important factor, as is an evaluation of which technologies are available, and whether implementing new technology is an option. Also, companies should look at their history of forecasting and determine how accurate the projections they receive from their business units are, along with how important it is to the company to have a single “owner” of the forecasting process for purposes of accountability. These factors represent some of the many elements that need to be reviewed when choosing a forecast method.

The execution of a successful forecasting process is seen by some companies as a formidable task. It does involve the triangulation of business information, forecasting methods, and technology. But companies should be heartened by the fact that they are not alone in their need for quality forecasts. Numerous tools and support services are available to assist them in their efforts.

Ultimately, companies can rest assured that improving cash flow forecasting is an initiative with substantial rewards. The penalties imposed by the investor community for not improving the quality of forecasts can be substantial.

Note: The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP. 



Bob BaldoniRobert J. Baldoni brings over 30 years of international treasury advisory experience to his role as the National Leader of EY’s Global Treasury Services practice. His team is responsible for providing a broad range of treasury services to global organizations, including treasury organization and design, bank account and relationship management, liquidity management, financial risk management, investment and debt management, and treasury technology.