I can’t resist: “Cash is King!” There, I’ve said it (again)! Of course, everyone knows that, but with the economic clouds on the horizon looking uncertain, we might as well use this tired old cliché to tee up a conversation about cash.
In recent months, more companies have experienced a “TMI” problem — namely, too much inventory. The issue stems from a combination of economic uncertainty, overly optimistic sales projections, fear of dissatisfied customers, a flight to “safety stock” resulting from supply chain disruption, and previous organizational responses to persistently high inflation. Couple an inflationary environment with rising interest rates, reduced customer demand in a slowing economy, higher labor costs in a tightening market, and mismatches between days sales outstanding and how the company manages its accounts payable, it is no wonder that operating and cash flow margins are getting squeezed and liquidity conversations are becoming more important. The question is, what can the CFO do to address the impact of these issues on cash flow?
These developments highlight the need for a more dynamic approach to cash flow management, an effort that CFOs must orchestrate among a broad range of organizational stakeholders, internal and external data sources, and information systems and advanced technology tools.
As I noted earlier this year, many businesses have opted to pass along higher costs of manufacturing, logistics and talent to customers by raising prices. That strategy works well until it doesn’t, and many customers have reached that breaking point as they are delaying and/or reducing purchasing activity.
Leading CFOs are responding to demand-side challenges by making cash flow management, which encompasses planning and forecasting, more sensitive to external and internal factors. Doing so requires an understanding of the causes and risks of ineffective demand planning as well as knowledge of what enables successful cash flow planning.
In response to disruptions and shortcomings that pre-date the global pandemic, many companies and finance groups have invested significant time, thought and effort into overhauling outdated approaches to supply chain risk management. Ongoing economic volatility and uncertainty requires similar overhauls on the demand side as higher prices and rising interest rates affect buying behavior, pose customer credit risks, and boost the cost of capital, while also giving rise to new debt implications and impediments to capital expenditure planning and strategic investments.
Dynamic cash flow management equips finance groups with deeper, more timely insights into the trends and drivers affecting cash flow. This visibility helps CFOs ensure that business partners throughout the enterprise expand their focus beyond the P&L statement and capital planning to address cash flow in a way that bolsters organizational resilience amid uncertainty. Such cash flow planning approaches include:
- Working capital analytics: These insights extend beyond traditional DSO, DPO and DIO analyses to pinpoint trends affecting receivables, payables and inventory that help drive actionable insights to improve working capital and cash conversion. Finance groups can calculate the collection effectiveness index (CEI) to assess opportunities to improve customer collections. Analyzing the percentage of high-risk accounts provides additional visibility into receivable performance drivers as well as the composition of the customer base, which should facilitate credit risk management. Analyzing discounts taken versus offered may enable the business to take advantage of early-pay discounts or provide additional context related to missed opportunities.
- Scenario-based planning: By using only a few key variables related to the macroeconomic environment (e.g., interest rates) and company-specific drivers (e.g., fluctuations in customer demand), finance groups can mitigate financial risks and optimize cash management. Effective scenario planning identifies links to defined outcomes, such as seeking or reducing external financing or applying cost reduction initiatives that affect fixed or variable costs. Analyzing and comparing different cash flow scenarios helps CFOs and business leaders make more informed investment, financial and operating decisions. Of note, according to my firm’s latest global survey of CFOs and finance leaders, one in three organizations are refining and/or increasing scenario planning to address concerns stemming from inflationary trends in the market.
- Stress testing: Running “what-if” scenarios sheds light on best case/worst case prospects while enabling organizations to adapt quickly to changing market conditions. CFOs typically deploy a scenario-driven approach to test the impact of various economic assumptions on the business or on an investment portfolio. Beginning with a baseline forecast for the most likely outcome, finance groups run multiple simulations for alternative plausible and extreme scenarios to develop a probability distribution of economic outcomes. These analyses can also support capital planning by identifying the potential changes to the cost of capital and shedding light on which investments should be reduced based on a specified increase in interest rates.
Leading finance groups also incorporate product profitability data, inflation-adjusted information, debt and equity strategies, currency exposures (and mitigation strategies), and workplace planning strategies — among other economic, supply chain and ESG-related considerations — into cash flow planning. Such efforts yield more actionable results. As just one example, product profitability analyses may lead to SKU product rationalization that frees up inventory, reduces costs, and may even identify entirely unprofitable customer relationships.
A dynamic cash flow management capability requires new collaborations, new supporting technologies and, oftentimes, a new mindset. Sales partners and other finance customers tend to operate from a P&L mindset. Through a cash flow lens, excess inventory and the business decisions that caused the surplus likely do not have a cost associated with them. A cash flow mindset helps business partners understand how their decisions ultimately affect the funding of operations and even the fate of strategic investments.
As CFOs expand and deepen their cash flow management-related collaborations with more business stakeholders, they should request access to more data sources throughout the organization. Finance groups should enhance their communication with sales and marketing and demand planning groups who have a bead on changing customer needs. Treasury groups should keep CFOs informed of their work with banking partners regarding changes to short- and long-term strategies to manage cash, investments, debt and foreign currency exposures. Finance and treasury also should work closely to monitor debt parameters and covenant calculations, as well as understand the cash flow impacts of planned capital projects and strategic initiatives. The finance group’s collaboration with data analytics teams and the IT function can help ensure that the right tools and insights are available to deploy new cash flow planning models.
The annual planning and budgeting exercises now underway in many companies offer CFOs a timely opportunity. They should make the case for dynamic cash flow management while enlisting business partners in the finance group’s ongoing quest to access and analyze more data that resides outside of the CFO’s direct control. By making a compelling case for the importance of a cash flow mindset, CFOs will avoid having too little information to preempt deteriorating margins, emerging liquidity issues and related challenges from creating a drag on corporate performance in the months to come.
This article originally appeared on Forbes CFO Network.
