Cash forecasting: Difficult, disappointing and more urgent than ever

Weak cash flow forecasting often prevents efficient liquidity management for companies, raising costs and weakening long-term planning.

In brief

• Cash forecasting guidance regularly fails investors by underperforming compared to revenue forecasting capabilities for major companies.
  
• In an environment of inflation and interest rate volatility, more companies are recognizing the cost of their weak cash forecasting capabilities. 
• Companies that balance adequate liquidity with the ability to make strategic investments have greater resiliency to respond to changing market conditions.

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.

FCF vs Revenue Guidance Performance & Accuracy 

Free Cash Flow Guidance Performance

How to know if you have a cash flow forecasting problem

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.

Create a path to better cash flow forecasting

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:

• Operational forecast improvement – The finance department must have a good understanding and measurement capabilities covering the operating processes that impact forecasts. This step includes the enhancement of trade account forecasts to improve operational cash flow accuracy.
• Cash flow impact analysis – An analysis can help company leaders assess the impact on cash flow of operational improvements and strategic initiatives.
• Value chain data connectivity – The organization should tap different data sources to achieve a comprehensive view of cash flow drivers and impacts in operational value chains (order to cash, procure to pay and forecast to fulfill). Better visibility into operational cash drivers can help improve forecast results and support processes such as vendor negotiations and cost-reduction initiatives.
• Technology integration – Forecasting teams can benefit from advancements in artificial intelligence and machine learning to improve forecast accuracy and use integrated planning tools to help automate consolidation, generation and reporting activities. With the efficiencies gained, effort can be reallocated to understanding and addressing operational cash drivers.