Cloudy or Clear?

Fundamentally a simple concept, forecasting cash flow nonetheless proves elusive in practice.
Jason KaraianJuly 28, 2004

When managers at Leica Microsystems get a call from their treasurer, Burkhard Straub, they know it’s serious. Ever since he joined the €540m ($662 million) German high-tech optical device maker three years ago, business unit heads have had to submit rolling monthly cash flow forecasts covering three, six and 12 months — if the treasurer spots a variation in an actual versus forecast of more than 15% for the three-month projections, “I have no limitations as to whom I can speak with to set up a project team to improve the forecast,” notes Straub. “When colleagues see my name pop up in their email, they know it’s important, and I get a good response.”

That response has translated into a “remarkable improvement” in forecasting cash flow at Leica, enabling “an improved return on the funds invested, quicker pay-down of debt and a reduction in foreign-exchange transactions,” says the treasurer.

Ebb and Flow

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Straub should consider himself lucky. Most finance managers grouse that their companies aren’t producing cash flow forecasts as quickly or as accurately as they should. In a global survey sponsored by working capital consultancy REL last summer for GTNews, a treasury news portal, only around one quarter of the 231 companies polled said the accuracy of their cash flow forecasts was “high” or “very high.”

What’s more, another survey — this one carried out earlier this year by research firm BDRC on behalf of ABN Amro — found that while 82% of 61 European treasurers polled said cash flows could be predicted with reasonable accuracy up to two or three days ahead, the figure fell to 72% for a week’s horizon, 12% for six months and 2% for more than two years. For CFOs who need to supply investors, bankers, analysts and business partners with a clear financial outlook, alarm bells should be ringing.

Part of the problem is scale. Getting a reliable picture of future liquidity requires continuous collection of information right across the entire organisation. That’s much easier said than done. “Cash flow forecasting is absolutely core to a business, but there are so many people and departments that impact the quality of a forecast that it’s a challenge to get it right,” says Bas Rebel, manager of the cash flow management practice at Zanders & Partners, a Dutch treasury consultancy.

Mario Tombazzi, a consultant at JPMorgan Treasury Services in London, agrees, adding that “collecting accurate and detailed information on cash flow projections can turn people off if the process becomes too onerous.” The truth is, he says, that without clear direction coming from finance, “the people who provide the data don’t see the benefit of their efforts,” and for this reason, underestimate the problems they cause when supplying finance with poor-quality data that’s fed into forecasts.

Carrots and Sticks

But there are ways to bring colleagues in line. Peer pressure is one. At Leica, Straub uses SimCorp software to publish monthly rankings of business units’ cash flow performance compared with forecasts. “You find that some people don’t like to be last for too long,” he notes. “It’s getting competitive.”

Plans are also afoot to strengthen the stick Straub uses to punish units with consistently poor forecasts. “If they forecast an outflow of X, and the actual result is an inflow of Y, I will charge them the interest on the delta I could have invested if I had seen this cash flow accurately,” he says. “That will focus the mind.”

At Pilkington, a £2.8 billion ($5.2 billion) UK-based glass manufacturer, CFO Iain Lough prefers carrots over sticks. In early 2002, the company wanted to shore up its balance sheet by boosting annual free cash flow to at least £100m. To reach that target, the board put at the core of the exercise an internal ratio comparing net cash (which excludes working capital) to net trading assets. Lough ran the numbers, and a net cash return on net trading assets of 14% for the group is consistent with the £100m free cash flow target.

Lough monitors this ratio monthly for each operating unit, “taking something that began as a concept for the group as a whole and turning it into a specific tool for managers to know what’s required of them,” notes Lough. “If the guy who runs our auto-glass replacement business in Argentina has an asset base of, say, £20m, what we ask for is £2.8m net cash flow as his contribution to the pot.”

Since December 2002, 40% of each manager’s annual bonus is tied to achieving this ratio. The result: net cash return on net trading assets rose to between 14% and 16% for the six months ending March 31st this year from around 7% when the project began. This translated into record free cash flow of £207m in Pilkington’s latest financial year. “Nothing’s perfect in this world, but there’s been a very good correlation on the charts we draw in the annual budget and the trend of cash flow over the year,” says Lough.

Still, when it comes to the accuracy of Pilkington’s forecast, as long as 12-month free cash flow projection remains on the right side of £100m, Lough is not troubled by the actual figure. “It sounds a bit trite, but that’s about it,” says the CFO.

But incentive programmes and the like can only go so far to improve wobbly cash flow predictions. Technology, of course, is also crucial. “The feedback we get is that corporates want to be better at forecasting cash flow, so we’ve improved those tools in our software,” explains Lee Wright, London-based managing director of SimCorp. A host of treasury software vendors like SimCorp, XRT, Trema and SunGard offer new and improved web-enabled applications to improve the access and functionality of forecasts produced by central treasury.

The rub? There’s a big gulf between what corporate clients say they want and what they actually go out and buy. “We haven’t really seen the uptake yet,” laments Wright.

Box Office Star

For his part, Jan Van Der Haegen is happy he turned to software to improve cash flow forecasts. When he joined Kinepolis, a €191m Brussels-based cinema owner, as treasurer three years ago, “the company worked very hard on the general annual budget but didn’t really have an idea of its impact on cash,” recalls Van Der Haegen. “I saw that there was marked seasonality in the income stream … during the year cash flow was very volatile, depending on things like the weather, holidays and the films on offer. I wanted to capture that.”

This is where software from XRT comes in. Now, before the general annual budget is signed off, the treasurer plugs the plan into the software, and with a push of a button, he receives a liquidity forecast that chimes with the budget figures. Because predicting the next blockbuster film is anybody’s guess, Van Der Haegen’s aim is to keep the firm’s cash flow stable over the year, avoiding costly short-term borrowing to fill shortfalls or the opportunity cost of unexpected surpluses lying idle.

“The only thing we do based on the liquidity plan is shuffling — treasury doesn’t cancel or add anything new to the budget,” says Van Der Haegen, noting that marketing programmes are often slid into different times of the year. The results so far are encouraging — last year, more predictable cash flows, in part, allowed Kinepolis to cut net debt by a quarter, and annual interest charges by a third, on the year before.

While such technology can be hugely beneficial, finance managers agree that the only way to improve forecasting meaningfully is to enable a better flow of data between the enterprise-wide systems used by operations (ERP, for example) and treasury management systems.

The key is automation, says Leica’s Straub. By the end of the year, he wants to roll out IT/2 NET, a web-enabled add-on tool, to his treasury software that pulls in information from non-treasury systems automatically. “I want to make the information that subsidiaries provide more accessible, and also open up the treasury system as an information tool for them, so each unit makes decisions with cash flow in mind,” says Straub.

So does this mean that treasury, that quintessential “back office” function, will encroach on operations’ turf? Straub, won’t say, but concedes, “That’s always a bit touchy. It’s not always easy to convince people to do what’s best for the whole company rather than what’s best for their personal interests.”