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Manage liquidity with improved forecasting

October 7, 2022 Article 6 min read
Sean Pattison

Cash flow, liquidity, and forecasting are critical when facing uncertainty. Companies can take these four actions to ensure they can manage for a stronger financial position.

Worker wearing an apron using a handheld tablet computer.Cash flow, liquidity, and forecasting are always important for companies, but given the current state of the economy, world affairs, and the ongoing uncertainty that continues to follow, to say they’re critical now is no overstatement. Some companies have managed the disruption better than others. Some will see a smoother path forward, while others will continue to manage suppressed volumes and uncertainty around level of demand. Many businesses struggle with the impacts of unexpected changes to orders and the resulting impact on inventory levels and purchasing requirements. In addition, lenders who provided grace periods for interest, principal payments, and covenant compliance are returning to normal levels (increased) of monitoring.

Circumstances all point to the critical need to optimize liquidity and maintain precise visibility of current and future working capital needs. Don’t get caught blindsided by an unanticipated shortage of cash or the additional costs of managing unbalanced inventory. What can companies do to ensure they’re in a stronger financial position? Start by taking these actions:

1. Improve costing, margin, and profitability data.

First and foremost, businesses need to have a solid handle on costing and margins — at the SKU level. We can’t emphasize enough the importance of this foundational step. Pay particular attention to common blind spots: excess overhead, expedited freight costs, mismanaged inventory that can lead to supply chain disruption, resulting in expiration issues and excess carrying costs. These costs can quietly accumulate into a significant cash burn for companies.

If your data isn’t accurate, it’s impossible to reliably forecast profit and loss (P&L) or your cash position. And it’s impossible to make sound decisions. Start here, with accurate costing and margin data at the product level and use that data to build your models and forecasts.

Mitigate supply chain disruption head on. 

2. Know your current working capital cash position and supply chain flexibility.

Whether you’re finding your business on the upside or downside of an economic cycle, cash management and forecasting are critical. 

On the downslope of an economic cycle, can you cut costs fast enough to break even and adjust to a new-normal revenue top line? Understanding your fixed-versus-variable cost and what you can do to reduce fixed costs and convert to a more flexible operation plays a vital role during the decline period. Generating cash by selling underutilized assets may help extend a company’s runway but is generally not a reliable long-term option.

As the macro economy recovers, companies that are rebounding faster than expected may also struggle with liquidity and sufficient working capital. The need to invest in additional inventory, add capacity through equipment investments, and pay excessive overtime can throw your margins out of whack and put significant strain on cash flow in the short term.

Future events can and will likely change your working capital needs, so be prepared for both a quick recovery and a downside decline. You’ve likely heard the saying about being one large order away from going out of business. It underscores the importance of forecasting, which when built on accurate costing and margin data, helps you make appropriate decisions quickly. Do you turn away certain business and let your competitors seize it? Downsize your company by eliminating poorly performing products lines, shedding assets, and rightsizing your cost structure. Companies need to be able to act quickly before it’s too late, and the unintended consequences of an unexpected market situation or a sharp increase in commodity pricing can catch a company off guard and lead to short- or long-term liquidity concerns.

3. Run various liquidity scenarios and develop integrated financial models.

Using a dynamic 13-week cash flow forecasting model can help companies make more informed business decisions and better understand the liquidity risk in the short term as they adapt to unexpected market dynamics. Review 13-week cash flows every one to two weeks.

Also be sure to run multiple what-if scenarios to understand profitability, working capital needs, and liquidity under various positive and negative scenarios. How does the picture look if revenue is up 20%? If expedited freight costs rise by 20%? What if revenue drops by 20% and commodity costs rise by 20%? What if the advertising budget is increased by 20%? In each scenario, what are your mitigation factors? How much additional liquidity will be needed to maintain operations or compliance with external financial covenants?

For the medium- and longer-term outlook, use integrated financial models to assess cash flow, liquidity, and P&L. Be sure to build in covenants with lenders to ensure you have the resources available to honor various timelines.

Review your models on a monthly or quarterly basis, evaluate how you performed against forecast, then make adjustments and extend the analysis out further in time.

4. Prepare for (potentially difficult) conversations with lenders.

Whether you’re doing well and are considering borrowing more or face ongoing challenges, you may need to have candid and transparent discussions with your senior lender.

Having your 13-week cash flow forecast and integrated financial models ready can help facilitate tough discussions and convey the story behind the numbers. You’ll want to share recent results, the reasons why, and your immediate path forward (with your 13-week cash flow forecast). Use your integrated financial models to illustrate your vision and expected results longer term.

The more informed the senior lender is the better they can support the company and its turnaround plan or increased funding requirements. Lenders don’t like surprises, so understanding and communicating the various potential outcomes will go a long way.

Benefits of forecasting

Forecasting — with accurate costing and margin data — not only helps you know where your business stands in terms of near-term working capital needs and availability; it also helps you identify and assess financial and operational strategies. Key attributes to consider when developing forecast models include: creating a structure that’s the appropriate level of detail; developing assumptions pages where all inputs are located and colored-coded for ease of use; keeping the end in mind when developing models so you can create the output pages that are helpful to make decisions, and highlighting various scenarios to provide to required third parties. Other factors to plan out are: will the forecast be updated with actuals on a monthly basis? Will a monthly budget-to-actual be required to understand variances and misses? This will allow you to make additional enhancements to the model as your company moves continually forward. Dynamic forecasting helps manage and predict your cash gap under various scenarios. In a time of inevitable uncertainty, forecasting helps you manage through challenging situations that arise and, ultimately, emerge stronger.

Some challenges and barriers of understanding the short-term liquidity and cash position, include needing to have a different mindset than the typical management maintains. It’s important to have a true “Direct Cash Flow” mindset — what’s my actual cash balance (net of outstanding checks and receipts in-transits) and on a weekly basis, what do I expect to receive from customers and then forecast required cash disbursements and with available cash what other disbursements the company can make. 

Recent uncertainty has forced most companies to rethink and modify existing cash forecasting models or establish new models. If you’ve already developed an effective dynamic cash forecasting model, don’t let it lose importance in your organization. Continue to maintain it and utilize the model for strategic decisions. If your organization has been able to thrive without a dynamic cashflow model, it doesn’t mean you won’t need it eventually. It’s always important to have contingency plans and perform an assessment of your current financial and future liquidity.

Confident about your future liquidity? Lean into risk the right way 

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