The process of securing solvency must be designed to be as effective and efficient as possible.
Securing solvency is the core mission of cash and liquidity management. This process must also be designed to be as effective and efficient as possible. ‘Liquidity planning’ refers to the planning of inflows and outflows of liquidity with a horizon of 3 to 15 months.
Discussions typically involve two different approaches: direct liquidity planning, in which each item is individually derived from the source data (e.g. revenue, purchasing, personnel), as well as the indirect approach, which is based on the statement of cash flows derived from balance sheet and profit and loss account planning.
The aim of both methods is to determine operating cash flow. The investment cash flow required to determine free cash flow, and finance cash flow, are measured identically under both methods.
Under the direct method, each item is measured individually, such as e.g. cash inflows from revenue, cash outflows for vendors or personnel payments. Under the indirect method, the result is corrected to reflect non-cash factors, such as amortisation and depreciation and provisions. The quality of the indirect method, however, is largely a factor of the frequency of the forecast process by controlling, temporal granularity (i.e. planning in annual, quarterly or monthly tranches) and the existence of a planned balance sheet with the same parameters as the planned profit and loss account.
Based on this textbook method, both paths should lead to the same result. In practice, though, deviations are regularly seen between operating cash flow based on the direct and indirect methods. These deviations require a relatively high amount of effort to explain. The reasons for this are the at times complex corrections of net income for a period to take account of non-cash events such as changes in provisions or valuation adjustments or shifts in periods (revenue in period A does not necessarily lead to an outflow of the same amount of liquidity). This is why most companies refrain from a reconciliation between these methods; this also owes to a lack of any further insights gained.
Conversely, however, the question arises as to the need for direct liquidity planning if the planned cash flow statement is already sufficiently precise and hence essentially sufficient for the calculation of capital requirements.
The main argument against introducing direct liquidity planning is the need for an additional, new process, as well as an additional planning logic; e.g. deriving cash flows from parameters such as revenue or costs. Associated with this is the development of additional expertise to carry this process to a better outcome than that achieved through the cash flow statement.
Every planning process also involves a plan-actual comparison in order to align and steadily improve quality at the item level. Using the direct method to determine actual values (via movements in statements of account) involves additional effort; depending on the system in use, it also leads to results of differing levels of granularity. Eligible in this connection are the use of virtual accounts for individual liquidity types, automated evaluation of information from account statements in the treasury management system, or rules-based search of posting information in the ERP system.
The arguments for direct liquidity planning are mainly drawn from the disadvantages of indirect liquidity planning, first and foremost among these its lack of quality. What is the reason for this?
Are new technical solutions the way out of the dilemma?
With the direct method, the determination of operating cash flow is a function of numerous cash parameters. Modern tools are able to enrich historical cash flows with other business-relevant attributes. Examples of this are product-group-based breakdowns of cash inflows from revenue. This provides a higher degree of detail in historical data, which can serve as the foundation for use of automated and learning methods in predictive analytics. The systems available today are capable of processing these mass data. The higher the granularity of past data, the more significant the determination of statistical patterns. As a result, in future the derivation of algorithms for the extrapolation of historical cash flows will be more transparent and dependable.
In the absence of a cost-benefit analysis, deciding on one variation or the other is difficult to do. Added to this is the assessment of the quality of the existing planned profit and loss statement and the planned balance sheet in terms of liquidity.
But the influence of a company’s business model should not be underestimated, either. Examples of this are series versus contract manufacturers, seasonal effects or even business models that change as a result of digitalisation. It is quite obvious here that direct liquidity planning that is tightly oriented around what will come to pass and not what should come to pass (business planning) is a tool that will permit the treasury to respond sooner.
The indirect method has its raison d’être, too, however, because hybrid model approaches are encountered very often in practice. With these, the indirect planned cash flow statement with predefined methods is adjusted based on the direct method to at least enrich the last projection by controlling with current developments and findings.
In the era of predictive analytics, however, these discussions may soon come to an end.
Source: KPMG Corporate Treasury News, Edition 73, November 2017
Author: Börries Többens, Senior Manager, Finance Advisory, firstname.lastname@example.org
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