Transaction treasury - adding up the benefits of cashflow forecasting

My colleagues David Stebbings and Rod Staples have both examined cashflow forecasting from the perspective of the FD and the Treasurer in previous entries on this blog.  Today I’d like to consider the benefits of this practice in relation to M&A transactions.

Companies prepare forecasts in order to plan ahead and ensure that effective decisions can be made at the earliest possible time. Cashflow forecasting aims to identify where, when and in what currency cashflows are expected to occur allowing management the ability to optimise the use of available cash, identify and plan how shortfalls will be funded, and how surpluses will be invested.

Being able to forecast cashflow is one of the most important elements of treasury management. The primary objective is to ensure that the company has sufficient liquidity (i.e. access to cash) so that it can meet all known obligations and to allow it to continue to function. This discipline is valid in the deal space, both in terms of assessing future cash generation capabilities during the deal process and, especially in terms of existing private equity portfolio companies, guaranteeing timely and accurate visibility of cashflow is in place to ensure financial covenants are complied with. Any size of business can quickly find itself more vulnerable to a lack of cash than to a lack of profit.

Operationally, by predicting shortfalls and surpluses the business can improve investment returns, negotiate better borrowing terms and conditions and minimise external borrowing, optimising the use of cash and of borrowing facilities and avoiding shocks. When assessing potential surpluses and deficits of cash, it is necessary to assess not only amounts and currencies, but also the time periods in which the surpluses or shortages will occur.

There can be disadvantages to forecasting as well and these mainly revolve around the time, and hence cost, spent by the business in preparing them. Often pushed from every side, further pressures and questions on the forecast variances to tight deadlines can cause friction. However, in today’s liquidity environment, can any business afford not to forecast its cash?

Time horizons
For cash management purposes there are generally up to three time horizons for forecasting, each serving a different purpose and using different forecasting methods. As the time horizon extends, it becomes more difficult to forecast with accuracy and the usefulness of the forecast can diminish.

The key to reliability and credibility is to ensure that the operational liquidity and tactical forecasts, prepared using different methodologies, are comparable across the common period that they cover (i.e. 0-3 months). By ensuring that the forecasts align within acceptable tolerance and materiality levels, the business creates the credibility to encourage decision making on both a short and longer term basis.

KPIs, incentivisation and change
It is a key part of any process to ensure that the business creates the right framework of KPIs and appropriate incentivisation at each level of the process. This can be a difficult area, and it is important to ensure that there are no rewards for undercasting cash (thereby creating positive variances, but an opportunity loss for the business). Equally, being penalised twice (once for P&L changes, and again for the cashflow impacts) should be avoided.

Longer term forecasts in particular should be subjected to sensitivity analysis, to quantify any uncertainties in the forecast, and any appropriate “what if” scenarios. Information should be reported in a way that is useful to those that use and rely upon it to make decisions. Easy to read dashboards are vital to ensure that outputs are understood by all levels of management, and to instil accountability and responsibility.

There is likely to be some organisational change and "pain" involved, and key steps to a successful implementation include:

• engaging hearts and minds by effective communication;
• ensuring understanding through practical and comprehensible materials;
• embedding disciplines with robust and routine processes; and
• encouraging compliance with appropriate KPI's and incentivisation.

To summarise, a  fundamental part of the cash and liquidity management process is, as for any process, planning ahead. This is particularly relevant in today’s market of less available and more expensive liquidity. Cash is rarely instantaneously available; the delay may be as short as a day for a payment, or it might be a week if the company is chasing an important sales receipt, out to weeks or months if the company needs to raise equity or to borrow in the capital markets.

As a reminder, the  main actions are:

• Liquidity management – ensuring available funds as and when required;
• Minimise cost of funds – take advantage of opportunities to borrow at lower rates;
• Maximise earnings – use and invest surpluses optimally;
• Foreign exchange – manage the currency flows to reduce treasury deals;
• Working capital management – identify changes for corrective action;
• Financial control – compare forecast to actuals throughout the business;
• Investing and funding strategies – identify structural cash shortages and surpluses;
• Strategic investment – funding significant capex or M&A activity from available resources; and
• Strategic objectives – compare longer term variances to influence corporate strategy and anticipate market, economic and competitive changes.

I’d be interested to hear your thoughts on this topic – please use the button below to contact me.  Carl.

Comments

[Wilson Hsieh]

Cash is always the king to the final success of business. Yet, even turmoil of the financial market had severely struck the investments of insurance companies in Taiwan, government guarantee and continued premium income had prevented the insurance companies from being failed. Can this be taken as a normal example?
For transaction purposes, the potential buyer will definitely look into the asset quality, profitability and liquidity of this target to make judgment on whether they should get into the deal or not? Unless this potential buyer is an non-for-profit organization, government or for special purposes, I can not see any reason that cash can be ignored during the transaction review.