The uncertainty of the COVID-19 crisis presents finance with an opportunity to accelerate the transition from reporting history to a focus on real-time and predictive insights that can help the organisation navigate in uncharted waters. The sudden and severe disruption to most businesses has rendered even effective budgets and operating plans obsolete.
As a result, organisations must develop the capability to estimate the impact of COVID-19 on key measures of financial performance and liquidity. Those looking after financial planning and analysis (FP&A) can make immediate and important contributions during the crisis by focusing on several critical priorities.
The following can help serve as a framework for finance departments navigating the COVID-19 business environment.
Real-time projections modelling. The uncertainty with COVID-19 requires a robust model to estimate the outcomes under different potential scenarios. Developing effective models requires a sophisticated understanding of the company’s business model and critical business processes, especially the revenue cycle and supply chain. Best practice in developing models includes:
- The model should include history as a reference in evaluating projections and also to validate the model.
- Key assumptions must be explicitly identified so they can be evaluated and easily flexed.
- The model must be robust, facilitating sensitivity and scenarios analysis.
- Outcomes on key measures (eg, cash flow) must be auto-generated by the model to facilitate impact analysis and presentation.
Develop scenario analysis and plans. Scenario analysis is an integrated approach that can assist enterprise-wide efforts in dealing with uncertainty. A scenario is a possible future narrative (a story). A “story” will typically impact a number of variables; for example, a recession scenario would likely impact a number of assumptions including unit sales volume, pricing, cost of materials, human capital turnover, and compensation. Scenario analysis will estimate the total impact of the “story” on a company and encourage the development of potential responses.
Scenario analysis utilises a number of tools and concepts that are relevant to COVID-19. These include identifying potential scenarios, critical assumptions, and leading indicators; estimating the impact on the organisation; and developing potential mitigating actions. For additional information on scenario planning, refer to the recent FM magazine article, “Scenario Planning and the COVID-19 Crisis”.
Analysing, projecting, and optimising cash flow and liquidity. One of the most critical impacts COVID-19 has had on organisations is the immediate and dramatic effect on cash flow and liquidity. FP&A and treasury professionals need to project and monitor key drivers of cash flow and evaluate other potential sources of liquidity.
There are two basic methods to report and project cash flow: the indirect and direct methods. The indirect method, as its name implies, is computed indirectly after preparing the income statement and balance sheet. This method adjusts reported income determined on an accrual basis to actual cash flow. It is generally not useful in projecting cash flow in the short term or in identifying key assumptions and drivers.
The direct method (see illustration below) is generally better suited to managing cash flow in the short term or when monitoring and managing cash flow is critical. The direct method is more intuitive than the indirect method, since the cash inflows and outflows are reported directly, as they would appear in a cheque register.
Generally speaking, several key areas have a significant impact on cash flows and warrant significant attention, including payments from customers, payments to suppliers, and payroll. Payroll amounts are relatively easy to project since we generally know the timing and level of payrolls. Payments from customers and payments to suppliers are more challenging to project and are discussed in detail below.
In this example, the company has selected a forecast horizon of three months. This can be expanded if the crisis continues or if the company wants to project cash flow further into the future. In many cases, organisations will need to examine cash flow with more granularity, perhaps weekly or even daily. As we all know from our personal finances, the timing of specific inflows and outflows could result in shortages on a given day, even if cash flow is adequate for the month in total.
Cash flow: Direct method
The cash flow direct method model above presents the “base case”; that is, projected cash flows prior to recognising the impact of COVID-19. We can use this model to project cash flows by flexing critical assumptions under potential scenarios for the duration of COVID-19 and related disruptions to mitigate the disease. Organisations can use these projections to determine additional requirements from lending institutions or under government programmes to provide liquidity.
Focus on revenue and accounts receivable collections. Even in normal times, estimating revenues is challenging. Important revenue drivers include economic assumptions, health of specific customers, industry growth, new product introductions, and competitive forces. In the COVID-19 crisis, every business, every region, and every customer will be impacted differently. This requires us to disaggregate the analysis to look at the impact on specific customers, regions, and industries.
For each given scenario, organisations need to estimate the impact on services or product sales. Are our products or services considered “essential” or “nonessential” by authorities (or customers)? Are our products distributed online or in store? Are they luxuries or necessities? How will each scenario impact the industries and customers we serve or sell to? We can adjust revenue estimates based on various scenarios and assumptions. We can then monitor these critical assumptions and adjust projections based on actual experience.
After adjusting revenue projections, we need to project the estimated timing of customer payments. It is likely that normal collection periods will be disrupted. Nearly all customers will be facing liquidity challenges. This requires us to estimate the impact on our customers’ business. Do we serve customers in the tourism (highly vulnerable) or grocery industry (stable)? We also need to consider the creditworthiness and liquidity of customers: Do we serve large, financially stable companies or small independent businesses? Based on these factors, we can change our expectations on cash collections. Finance teams should maintain collection practices and adjust estimates based on experience and changing circumstances.
Project and reduce cash outlays. Using the direct method of projecting cash flow, we can focus on significant cash expenditures versus expenses determined under the accrual accounting method. Finance managers must monitor and actively manage payables, phasing existing obligations by due dates and actively managing new commitments. Some expenditures will automatically reduce, such as travel, training, new hires, and recruiting. Others require active management, including outside services, payroll, capital expenditures, and material purchase commitments for manufacturing. FP&A can assist in analysing the supply chain to ensure that production schedules, open orders, and future commitments are reviewed in light of expected changes in customer demand for the company’s products.
Track assumptions and leading indicators. FP&A should identify critical metrics and assumptions to monitor in order to navigate through these uncharted waters. How are events and actual experience trending compared to our assumptions? Do the trends increase the probability of one scenario occurring? As more information becomes available (eg, rate of spread), the scenario model can be updated to refine existing scenarios or generate additional possible outcomes.
FP&A should prepare a daily or weekly dashboard to track and share trends with decision-makers. Each organisation should develop unique measures based on specific circumstances; examples of common metrics that would be useful include:
- New cases of COVID-19 in our region;
- Changes in government restrictions;
- Order levels;
- Cash collections and collection periods;
- Purchase commitments and phasing;
- Cash burn rate; and
- Cash balance and available liquidity.
Looking towards the future. After the immediate and drastic impact of COVID-19 subsides, there are likely to be ongoing effects and the emergence of a “new normal”. FP&A can facilitate the thinking about the longer-term and residual effects of the crisis; for example, the effects on tourism, entertainment, dine-in restaurants, distance learning, and working from home.
FP&A should also work with operating managers to develop the plan for the organisation to return to the new normal operations. This crisis has likely highlighted the need to improve our ability to analyse, project, and develop recommended actions. The intense focus on each of the areas discussed above can identify opportunities to incorporate these practices into our routines in the future.
— John “Jack” Alexander, CPA, is an experienced CFO and operating executive turned adviser, author, and lecturer based in the US. He provides advice on strategic and operational planning, forecasting, and financial planning and analysis and is the author of Financial Planning & Analysis and Performance Management, Wiley, 2018. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.