Does cash flow equal cash flow?

Does cash flow equal cash flow?

This is how financial and liquidity planning align!

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Börries Többens

Partner, Financial Services, Finance and Treasury Management

KPMG AG Wirtschaftsprüfungsgesellschaft

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Essential aspects for the going concern of a company are a reliable forecast of future cash flows and making sure that liquidity is available. A reliable planning is meant to ensure that the necessary control measures are initiated in good time. For this, companies regularly consult a relevant financial budget, including an indirect cash flow statement, which is often prepared by the controlling department. At the same time, Treasury also prepares a liquidity planning to ensure the company’s solvency and to identify any potential exceedances. Besides using a distinct approach, these two items usually have a very different timeline, degree of detail and frequency of updating.

Consequently, the results of these two cash flow forecasting methods usually diverge from each other. At worst, one method will foresee a positive and the other a negative operational cash flow. This undermines the trust placed in these planning processes and makes it difficult for the individual departments to explain their train of thought. Reconciling these two seem to be nearly impossible. Trying to align these two often takes place under tremendous pressure, and the reconciliation process uses valuable time and resources and more often than not, the ad-hoc nature of the undertaking does not result in a lasting structure. The problem is that symptoms are being grappled with rather than the root causes. Therefore, it’s usually right “back to square one” with the next reporting or planning.

Looking for the proverbial needle in the haystack: where are the discrepancies?

When looking for the reasons for the differences, financial functions see themselves facing all sorts of challenges. Finding the root cause is often quite difficult because discrepancies could have their origin in varying planning items/units and deviating source systems or data pools.

We took a closer look at the aspects mostly responsible for the diverging financial and liquidity planning.

  • Planning items: Identifying liquidity planning items generally is more a question of setup, depending on where the resources come from (e.g. debit notes or interest rate items) and have no exact counterpart in the financial budgeting process, which consists mostly of P&L or balance-sheet items. In order to arrive at a consistent result, the company should determine the items not relevant to payments in the indirect method. For instance, it is relatively easy to determine the changes in receivables and liabilities. This becomes more complex with some other items, such as procurement and the valuation of goods, which could be partially cash-relevant or not. 
  • Fundamental data: The data pools and reporting systems used for financial budgeting and liquidity planning are explicitly separate and are not reconciled with each other. The result is that different underlying data is used for the two plannings. In the direct planning, usually the value date is used, whilst for the indirect method, the posting date is used.
  • Planning units: The granularity of the financial budgeting is often restricted to the level of the group or the business unit. However, if the financial budget is to be the basis for the liquidity planning, a granularity at the level of the subsidiary is necessary to ensure the ongoing funding of the company. Another challenge are the intercompany cash flows when identifying data to be used.
  • Frequency and granularity: In general, Treasury’s planning is much more detailed in terms of time than that of Controlling, which reduces the comparability of the two results. This is especially the case when it comes to day-by-day delays towards the end of a period, which could cause the value date of those transactions to slip into the new period.  While Treasury may be taking this into consideration during the cash disposition in liquidity planning at the latest, this could cause discrepancies in the financial budgeting.  
  • Planning assumptions: The basic assumptions used to prepare the liquidity planning and the financial budget may not always be the same. For instance, Controlling generally may depend much more on expected foreign exchange rates when thinking of FX rates, whilst Treasury might resort to using forward curves. Similar differences also exist regarding the anticipated business development, for instance in terms of assumptions made for the cost of materials or the creation/reduction of inventory.
  • Depth of information: In some cases, Treasury and Controlling dispose of divergent knowledge regarding the details and situation of various planning items. For instance, Controlling knows more about CAPEX, whilst Treasury has an in-depth understanding of cash development.

Process efficiency is impaired by duplicated work and reconciliation efforts

Even though the fundamental data used is usually quite segregated for each planning (for instance in the form of segregated databases and reporting systems), the content of the two planning approaches often overlaps. At worst, the gathering and processing of this overlapping data is requested from the same data suppliers, such as specialist departments like sales and purchasing. However, once gathered, the data is further processed separately for the financial budget or the liquidity planning. This means that activities often take place twice along the value chain, which causes inefficiencies in data processing.

Both planning approaches (but especially financial budgeting) are often strictly time-bound, for instance during the budgeting or the end of the quarter. This also means that the reconciliation of the planning results often takes place under great pressure. Frustration caused by the validity of the individual cash flows could therefore linger because there is not enough time to reconcile these properly.

Better transparency and efficiency due to planning alignment

There are several advantages in overcoming the challenges of a misaligned financial and liquidity planning. For instance, the discrepancies between Controlling and Treasury are reduced, and the remaining deviations become more obvious. Analyzing the discrepancies in detail offers the chance to go to the root of the problem and to improve the understanding of the different results.

The effort necessary to reconcile both plans is reduced upon aligning plan assumptions and processes, resulting in a more efficient work process. There are other time savings if there is a high degree of integrated automation, so that the pressure can be reduced further when preparing the plannings. Process efficiency may be improved when preparing the medium and long-term liquidity planning by automatically fetching the plan data from the financial budget. The same is true for backtesting. The alignment allows comparability, which makes the analysis of plan discrepancies quite a bit easier. 

On top of that, both parties can benefit from the other’s knowledge if you have integrated processes and data flows present in an aligned planning. Treasury often has a good overview of the development of individual cash-relevant items in the near future. Controlling, on the other hand, often has better business know-how needed to map the long-term planning horizons to each other. A systematic exchange of these experiences helps both parties with their planning. Beyond that, often both sides need to calculate KPIs and thus need the experience of the other party. For instance, in the case of covenants, both short-term as well as long-term input parameters play a role. A targeted exchange of knowledge creates synergies. An alignment method makes for a systematic realization of these.

Doing your homework: aligning the framework conditions and the process steps

In order to align Controlling with Treasury, certain conditions must be met. To begin with, the alignment of the framework conditions of the financial and liquidity planning must be a given. Specifically, this means that the items in the liquidity planning have to be selected in such a manner that they have an immediate counterpart in the financial budget, for instance net sales in the financial budget is opposite to cash receipts from net sales in the liquidity planning. In doing so, the elements without cash effect, such as write-offs, provisions or accruals and deferrals, have to be identified. For instance, it is necessary to explicitly separate provisions into untilization and increase/reduction in the financial budget in order to be able to include the components with cash effect arising from a use in the liquidity planning. 

The data used for this is the historical cash flow at the level of individual items, including the relevant date of the posting document and the value date. These could be made available through various data analyses or for instance through tailored software, such as a dedicated SAP application. Using the data history, one can calculate the actual Days Sales Outstanding (DSO) and Days Payables Outstanding (DPO) in the past. The knowledge acquired here may be transferred to the plan values in the financial and liquidity planning.

The DSOs and DPOs are used to plan working capital for the financial budget. For medium and long-term liquidity planning, DSOs and DPOs are used for each planning item to determine the expected value date of the cash flows and thus to distribute the financial planning data. Like this, all cash flows in the liquidity planning correspond to those of the financial budget in their absolute amount. For a short-term view, a separate reconciliation of the specific plan assumptions is necessary for each plan item. 

Therefore, it is necessary to align not only the plans but also the data flows and the resulting reports. Like this, many different but heterogeneous recipients in the different departments may be kept up-to-date with a centralized report. This saves time for internal reconciliations and makes for more accurate decision-making.

Review individual opportunities and costs

Aligning the financial and the liquidity planning is a great opportunity to lessen both costs and risks in corporate management. However, getting there requires much time and work. Therefore, a company should weigh its options carefully whether it makes sense to radically align the financial and liquidity planning and whether this is even possible with the systems that Treasury and Controlling use. To begin with, it is highly recommended to do a backtesting before beginning the project in order to validate and assure the quality of the future forecasting methods. Immediately thereafter it should be determined which assumptions are considered important by Treasury and Controlling in order to avoid frictions at a later stage. 

Source: KPMG Corporate Treasury News, Edition 106, November 2020

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