Cash flow management in an uncertain world

As we look ahead to 2021, we have a better appreciation of the fact that emerging risks can quickly disrupt business models and strategic plans. COVID-19 has taught us that a single event can trigger a cascade of risks affecting all aspects of an entity’s operations. The pandemic, combined with global trade tensions, ongoing political elections, continued social unrest in some countries, and other risk drivers, has put tremendous strain on most organisations.

Revenues that were once fairly predictable are no longer stable or even present, and organisations trying to navigate the crisis face previously unseen costs. COVID-19 and other 2020 events have affected almost all aspects of most organisations, making it challenging to pinpoint all potential variables that might affect cash inflows and outflows simultaneously. In this environment, finance leaders should consider taking a number of steps to obtain a better, more comprehensive view of organisational cash flows.

Start with cash inflows

As we think about sources of cash, it might help to think through these questions:

• What are the core sources of cash for our organisation? For most organisations, sales of products or services are the main sources of revenues (and ultimately cash inflows). For others, investment income, contributions, or government funding provide significant cash for the organisation. Within each of these categories, there may be subcategories that might be important to consider separately. For example, different types of customers (eg, commercial, consumer, government, etc.) might affect cash inflows in different ways.
• How is the current business environment (the pandemic, ongoing national elections, social unrest, etc.) affecting each of these core sources of cash? Business conditions may affect each of the core sources of cash differently, and it is important to consider where those differences might be most severe. It may be difficult to determine exactly how each source might be impacted in 2021 by existing economic and other market conditions. For example, payments from some customers may be delayed, affecting the timing of receivables collections. So, it might help to think about three levels of possibilities: “worst case,” “OK-but-not-great case,” and “reasonable, hopeful case.”

Dissect cash outflows

Next, break down cash outflows into the major categories that can help business leaders focus on these questions:

• What are the most significant types of cash outflows for our organisation? Compared to cash inflows, the number and variety of cash outflows can be significantly greater. Most organisations must fund cash outflows related to payroll, inventory purchases, materials, supplies, core services, essential repairs and capital improvements, financing charges, taxes, etc.
• What expenditures can be categorised as fixed or variable? Some cash outflows are fixed, such as debt and interest payments, rent, and IT service centre fees. Others allow for management discretion. Pinpointing the fixed cash outflows, particularly those required by law or contract, can help management focus on those that need to be funded first. Fixed expenditures are at least more predictable. It is also important to highlight those that are variable so we can link them to what drives their variability, such as costs that vary with sales. It will be important to associate related inflows and variable outflows in the analysis.
• How is the current business environment affecting cash outflows? Current conditions likely affect major cash outflow categories differently. For some, the ongoing pandemic is increasing costs (eg, investments in technologies to support a remote workforce) while there may be decreasing costs for others (eg, lower interest expenditures). Variable expenses are likely affected the most, but there may also be opportunities to adjust or defer some fixed payments (eg, some loan/lease agreements may allow for periods of deferment or rent holidays).
• What amount of discretion is available to manage cash outflows? Some cash outflows may be hard to classify as either required or discretionary. For example, payroll may feel more like a fixed expense, but unfortunately, realities of furloughs or layoffs mean there is a portion of payroll that can be discretionary. There is likely a fixed level of payroll needed to operate a business, with the difference representing the discretionary component. In light of this variability, it might help to begin thinking about three simple levels of possibilities. Let’s explore scenarios associated with cash outflows using the example of cash inflows above.

Develop multiple scenarios

The pandemic has exposed all of us to increased uncertainty. Because of this it may be helpful to begin analysis with a focus on the near term (six months or so) and to break down the analysis into at least the three conditions mentioned above: “worst case,” “OK-but-not-great case,” and “reasonable, hopeful best case” scenarios. Separate analyses of cash inflows and cash outflows on a worst-case to best-case basis can provide management with a range of potential outcomes.

Building a worst-case scenario by combining the worst-case cash inflow analysis with the worst-case cash outflow analysis can help management visualise the most dire cash flow scenario. They can then do the same for the moderate and best-case scenarios. Doing so helps management develop “bookends” that identify the range of possibilities. Of course, you can break these down further by combining moderate inflows with worst-case outflows (and vice versa) to develop additional scenarios.

Take advantage of scenario-planning and forecasting tools

There are scenario and forecasting tools that can assist CFOs in modelling different cash flow possibilities. Spreadsheet tools, including Excel, contain features to explore potential future outcomes. There are more sophisticated tools, such as the Crystal Ball add-on software for Excel, that allow for more complex Monte Carlo simulations. See the sidebar, “Excel and Scenario Planning”, at the bottom of the page for examples.

Rank possible cash flow solutions

The analysis may reveal periods where forecasted cash flows are negative or are below management’s risk appetite. Proactively anticipating cash flow squeezes will lead to better outcomes (and less stress) than waiting until the crisis is present (when some options may no longer be available).

Identifying the available options and then organising them by ease of implementation will provide management a road map to use as conditions unfold. Some options may be worth pursuing now, while others can be used as needed. Here are a few examples to consider (not necessarily in order of preference, given they likely vary across organisations):

1. Identify expenditures that can be delayed or halted. Certain business decisions that involve potential cash investments may be attractive but not necessary for the near term. Identifying those expenditures that can wait may provide the easiest cash flow management option.
2. Rebalance inventory management. While maintaining adequate inventory of products is critical in order to secure the cash inflows associated with an eventual sale, there may be certain items that are especially costly to hold in inventory and there are likely other products where a reduction in inventory level is acceptable.
3. Renegotiate supplier/vendor terms. Market demand for certain products and services may have fallen, allowing more opportunity for buyers to renegotiate prices and terms with key suppliers and vendors. Organisations may find there is more willingness on the part of suppliers and vendors to renegotiate key terms on a more favourable basis.
4. Leverage benefits of financial markets. Interest rates are at all-time lows. These market conditions may provide organisations opportunities to refinance debt to more favourable terms. Organisations may also want to explore options to secure or increase lines of credit, should the need arise in the future. Lenders may also be willing to defer loan principal or interest payments for periods of time until conditions improve.
5. Identify assets or operations that might be sold. There may be investments or other assets that can be sold to generate cash. There may also be less productive business units or operations that could be divested to generate or preserve cash.
6. Evaluate payroll options. Compensation and related benefits are often one of the more significant cash expenditures for organisations. In some cases, personnel costs vary with sales volumes, while in other cases those costs have more of a fixed nature. A pause in filling open positions is one technique for managing personnel costs. Unfortunately, other techniques, such as temporary salary reductions, furloughs, layoffs, or cuts in benefits, can be more heart-wrenching.
7. Consider government funding options. While there are often many strings attached, government funding may be an option for some organisations. Management should stay abreast of legislative developments at national and regional levels to ensure readiness to act if funds become available.

Revisit regularly

Thinking about liquidity isn’t a “one and done” activity. Keep in mind that these analyses are mere estimates. As time passes, new facts and circumstances will arise. Assumptions used to prepare an earlier cash flow analysis are likely to change, meaning the analyses need to be regularly revisited and adjusted. Lessons will be learned that can be used to improve forecasting techniques.

— Mark S. Beasley, CPA, Ph.D., is the KPMG Professor of Accounting and director of the Enterprise Risk Management (ERM) Initiative in the Poole College of Management at North Carolina State University. Bruce Branson, Ph.D., is a professor of accounting at NC State and serves as associate director of the ERM Initiative. To comment on this article or to suggest an idea for another article, contact Neil Amato, an FM magazine senior editor, at Neil.Amato@aicpa-cima.com.

Excel and scenario planning

Scenario analysis is a powerful tool to explore the range of plausible outcomes within a set of defined boundary conditions. By exploring a range of outcomes, an organisation should be better positioned to anticipate shocks that affect its ability to successfully negotiate an evolving future.

Excel provides several options to explore scenarios. One popular tool is the Scenario Manager, found in the What-If Analysis menu on the Data tab. Scenario Manager will allow the user to vary inputs to as many as 32 individual components of your cash flow forecast to build a relatively sophisticated model. Multiple scenarios (eg, worst case, OK-but-not-great case, and reasonable, hopeful best case) may be compared alongside one another to build a more comprehensive view of potential outcomes. Another option in Excel is also on the Data tab — constructing an Excel Data Table. A Data Table also allows users to vary inputs and easily observe changes in anticipated future cash flows.

A Monte Carlo simulation is a tool for preparing more robust forecasts and exploring alternative future states. Add-on software, such as Oracle Crystal Ball, coexists with Excel and allows users to define probability distributions (rather than simple point estimates) for the various input variables (eg, different cash sources and uses) and simulate an outcome over a significant number of trials, often 10,000 or more. The advantage here is that the user is not wed to a small set of potential outcomes (ie, three future states) but can model across an entire range of possible outcomes. The result can provide insight into the likelihood of experiencing a cash shortfall and the potential magnitude of the shortfall at various probabilities.