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Many companies, squeezed by higher interest rates and market volatility, are showing a new appreciation for the importance of free cash flow forecasting. Unfortunately, most companies are not very good at it. Many have responded instead by increasing balance sheet buffers to soften the impact of forecasting variances.
A recent EY-Parthenon analysis of 2,400 of the largest global companies found the following over a seven-year period between 2017 and the first quarter of 2023.
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Read morePrior to 2020, interest rates and market conditions made forecasting easier and variations less costly, and many companies placed less emphasis on cash forecasting approaches compared to other priorities, such as revenue growth and cost cutting.
Better cash management and cash forecasting are coming together as priorities for many businesses that are finding that their agility and resilience have weakened precisely as these capabilities are most needed. Now, with financing costs more than doubling since 2021, they are rediscovering the value of cash flow forecasting to stay nimble in a disruptive and challenging market.
EY research shows that more companies are including free cash flow guidance in investor reports and on earnings calls. It is a positive trend that is likely to continue as cash becomes increasingly recognized as an important factor in enterprise valuation and market success.
While good cash management is a familiar finance department goal, many companies spend less time focusing on cash forecasting, which is particularly difficult to do well, because of a variety of complex factors and the difficulty achieving visibility into them. Company leaders can watch for key signs of poor cash forecasting as a first step to addressing the problem.
Cash forecasting enables the financing, investing and operational activities that help companies manage their cash positions across short- and long-term time horizons. The best-run companies also develop a strong cash culture that reinforces beneficial cash-aware behaviors throughout the organization.
A company that has only a vague idea of when cash will be coming in and available for use, compared to when it must make payments to meet its obligations, will tend to stockpile cash or inventory as a hedge against uncertainty — and that is an extremely expensive way to manage risk. We have seen repeatedly in recent years that companies that maintain adequate liquidity while continuing to invest strategically have greater operational resiliency to respond to changing market conditions. (How to drive operational resilience with better cash management | EY - US)
Many companies have a cash forecasting process that provides monthly cash estimates based on historical trends. But this is very different from methodically identifying specific cash drivers in the business and managing them efficiently. Also, because it is a general approach, it does little to educate employees and create a cash culture throughout the business.
One common obstacle to proper cash forecasting is that in large businesses sales and procurement personnel, whose decisions have meaningful impacts on cash flow, operate without close coordination with the finance team, whose members have the best visibility into the cash flow and understand the importance of good cash leadership.
A typical example is a sales team that agrees to preferential sales terms — a longer period to pay — to close a deal. The team is rewarded for the win, but the easy payment term means the cash is not available until later.
Companies with a strong cash culture are good at bridging the visibility gap so that operational employees understand how their decisions affect the company’s cash flow.
Self-diagnosing a cash forecasting weakness can be tricky because metrics can be easily misinterpreted, masking underlying problems. For example, if the forecast includes cash flows that are overestimated and others that are underestimated, they might cancel each other out when aggregated. Likewise, inaccurate cost and revenue forecasts can offset each other.
Situations like these can result in a forecast that appears accurate overall while the component parts may be hiding significant inaccuracies. Poor underlying data could also combine to indicate a problem is better, or worse, than it is. Other variances can occur due to discrepancies between the timing of cash flows and amounts, overdependence on historical data, poorly defined benchmarks and other variables.
There are signs to look for that may indicate a cash forecasting problem that can be corrected. It is important to look at both the financial and functional impacts of cash forecasting. For example, a company that must frequently use revolving credit, issue emergency debt or seek financing on short notice to float its operational needs may have a cash forecasting problem. An organization that stockpiles cash as a buffer against worst-case scenarios or is paying uncomfortably high interest expenses should also consider improving cash forecasting.
In operational nonfinance functions, symptoms may include difficulty explaining forecasting variances with operational drivers, or sales and operations planning and supply chain forecasts that cannot be reconciled to the finance forecast. High levels of unexplained revenue shrinkage or excessive amounts of early or delayed payments can also signal a problem. When sales teams are pressured to collect payments from customers, or if procurement departments are delaying payments to suppliers, these may also be signs of poor cash forecasting performance.
A company with weak cash flow forecasting may also have difficulty conducting future planning or scenario analysis due to discrepancies between the estimated cash on hand and the actual performance. A possible cause is a lack visibility into operational blind spots that may be throwing off estimates.
Reliable cash flow forecasting allows companies to confidently plan critical financing, investing and operating activities. It is the foundation for a liquidity strategy that supports day-to-day operational financing with reduced asset exposure and borrowing costs. With reliable long-term forecasting, leaders can make better decisions about multiyear capital investments and can track their financial performance more readily.
Companies with good cash forecasting can achieve up to an estimated 90% quarterly accuracy compared to enterprise-level cash flow targets by making cross-functional visibility of cash flow drivers an enterprise-wide priority. Companies can do this by establishing good data connectivity practices and using advanced analytics and machine learning to gain visibility and insights into operational cash flow drivers. Other key elements are strong communication with operational teams to drive continuous improvement and standardized forecasting methodology and reporting.
Companies that establish accountability for cash forecasting can quickly track variances to the operational teams or processes that are causing them, with the organization gaining an opportunity for positive feedback and culture building.
When done properly, companies should be able to extend their forecasting horizon up to 90 days with strong accuracy throughout and have a liquidity approach that sets dynamic minimum cash levels based on the cash flow for a similar period.
A successful cash flow forecasting improvement project includes four key elements:
Cash forecasting can be a powerful way for companies to improve their flexibility and resilience to address challenges in today’s environment of high interest rates and market volatility. The many operational activities that directly or indirectly impact cash flows daily can be difficult to discern, however, and cash flow forecasts often mask the underlying problems, making it difficult to diagnose the issue. Companies can address many cash flow forecasting issues through greater visibility into operational processes like sales and procurement, and by establishing a strong, mutually reinforcing culture of proper cash flow practices and accountability.
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