Treasury professionals are today’s great prognosticators. They are charged with predicting the future to help organizations prepare of a variety of situations. Accurate forecasting is essential to be able to understand working capital needs, ensure adequate liquidity and maintain a state of active readiness to address emerging cash requirements. With accurate forecasting, treasurers help the organization protect liquid assets and ensure adequate liquidity at a reasonable rate over both the short and long term.
However, the key word is accurate. Treasury professionals face five key challenges when developing forecasts:
1. Understanding organization’s cash flows and how they change over time
The larger the organization, the more complicated the cash flows will be. Consider the company that has several “businesses” created via acquisition, or that has expanded globally into new markets. Payment terms will most likely vary across the different businesses, complicating the data. In another scenario, some departments, like tax, may make large, urgent payments without communicating them to treasury until right before they are due.
A high volume of transactions and larger value transactions made throughout the organization can also affect the accuracy of the forecast. There may also be situations where cash flows are quickly changing or approaching a material threshold. It’s safe to say, greater attention should be paid to cash flows that are evolving to ensure the forecasting results accurately reflect the expected cash flow. With all these complexities and variables in mind, it becomes clear a treasury management system (TMS) can be an invaluable tool to help treasurers understand and track the data.
2. Gathering the right data for the type of forecast
Once you understand the data, how do you pull the data into your forecasting model? Transactions that occur in high volume yet have low individual impact on the organization’s cash position can usually be obtained from well-established data systems already in place in the organization. Sources of this data include bank feeds and AR, ERP and other systems that automatically send information to the TMS or are extracted and manually managed within the treasury department.
Other less frequent, large value transactions such as tax payments, investment maturity dates and capital expenses could affect the accuracy of the forecast if not well managed. For example, large tax payments may simply be reported when they happen by the responsible individual. Treasury professionals must be aware of the timing of the payments and be on the lookout for data to be reported.
3. Managing the forecast data workflow process
Once you understand what data you need and where the data will come from, it will be necessary to set up processes to get the data when you need it. Depending on the complexity of the firm’s operations, getting consistent data in a timely manner may be challenging.
The first step is to secure a commitment from department heads outside of treasury to provide initial data for testing and modeling. You may also obtain additional insight about independent variables that will impact the forecast when talking to subject matter experts in the business who have a detailed, current understanding about the data you need.
Creating the best data workflow process will usually require:
- Knowing when data is entered into systems or updated.
- Modeling some of the data manually (e.g., spreadsheets) and gaining additional insight over various time periods.
- Clarifying the cause of any significant anomalous numbers.
- Setting up data feeds.
4. Selecting the right forecasting method(s)
Pinning down the right forecasting logic is key to providing the most accurate forecast. Start by looking at what category of cash flow you will be forecasting:
- Operating flows – Cash flows from normal business operations, i.e., receipts and disbursements.
- Investment activities – Investment flows are significantly more important than operating or financing flows for most companies.
- Financing cash flows – Transactions related to a firm’s financing activity, such as capital contributions and long-term notes.
The most relevant characteristics of the flow must also be considered in order to fine-tune the forecasting logic. Consider whether the transactions are:
- One-off or recurring?
- Consistent or variable?
- Seasonal or due to regular business cycles?
- Rapidly changing or a secular trend?
Modeling and back-testing with enough data will help you see which model performs best over time through various cycles and economic environments, and will allow you to choose the most effective model for your forecasting needs.
5. Improving the forecasting model over time (variance analysis)
Analyzing the accuracy of the forecast by manipulating data manually on spreadsheets requires time most treasury departments can ill afford. That’s why the power of treasury management systems to perform variance analysis is a cash forecaster’s best friend. A TMS allows treasurers to compare a forecast to actual results over a chosen time frame and quickly identify any differences. The reason for any disparities can be evaluated and understood, creating a feedback loop for improvements in the forecast model.
With the new information, you’ll be able to
- True-up the forecast in the near term when something was received early or late.
- Update the forecast model based on better or additional information.
With a TMS, you can also manage multiple forecast models at the same time for real-time comparison. The system allows you to identify the strengths and shortcomings of each model, adapt to the results, retest the data (historically and real-time) and easily adopt the newly vetted program for even more accurate forecasting results.
To continue to explore the challenges and solutions for accurate cash forecasting, download our eBook, Accurate Cash Forecasting.