The advantages of a good quality cash forecasting system are well appreciated. They include the ability to plan better for financing levels, identify surplus cash for investment and keep pressure on management to improve working capital. In practice, however, implementing a top quality cash forecasting system in a big organisation is onerous and expensive.
Treasury techniques such as money market funds, netting and pooling, and, for major companies, the very small difference (possibly only 50 basis points) between their borrowing and deposit rates can cast doubt on the need to implement the perfect cash forecasting system.
While basic forecasts are essential, an 80/20 approach is increasingly being adopted at group level in major international companies as CFOs realise that aiming for highly accurate forecasts is only marginally beneficial compared with "good enough" forecasts. However, CFOs appreciate the need to enforce the highest quality cashflow disciplines on the operating companies because they place an important pressure on local management to control working capital.
There is a clear trade-off between the quality, and therefore usually cost, of the cash forecasting system with the likely cost of forecast variance. Consider the effect of forecast variances in relation to other treasury techniques. One of the most common cash management techniques is the pooling of bank accounts. Most major companies pool all the accounts in one currency - the domestic sterling accounts for a UK company and euro accounts for the eurozone. US dollars will also typically be zero-balanced into one location. It is also now possible to pool across different currencies, though at a cost of direct expense and management effort.
When cash flows are pooled, not only are balances netted off, but so are forecast variances. The calculation to assess the incremental value of pooling both within and across currencies should therefore incorporate this effect.
Element of error
All cashflow forecasts have an element of error, so the more bank accounts pooled the better because the forecast errors will begin to offset each other. Few companies bother to make the connection between the number of accounts, and possibly currencies, that go into the pool with the effect this will have on total forecast error and the cost of implementing forecasting systems at the potential levels of precision. The worse the forecast, the greater the benefit from having a cash pool. Conversely, the bigger the pool, the larger are the compromises over cash forecasting accuracy that are acceptable.
It is not necessary to have a huge number of accounts in the pool to give a significant benefit in terms of minimising cash forecasting error.
The cost of forecasting error can be computed from the size of unforecast debt or cash and the relevant interest rates compared with the rates at which forecast debt or cash could have been borrowed or invested respectively.
In our experience, with a large number of accounts in a cash pool, the natural offsetting of the forecast errors can eliminate between 80% and 90% of the cost.
However, the most rapid improvement in terms of savings comes when just a few accounts are pooled. After about five, which typically produces about half of the maximum potential savings, the number of accounts in the pool has to be tripled to about 15 to get savings up to 60%-70% of potential. Once more than 20-25 accounts are in the pool, about 70%-80% of the savings will be achieved and the advantage of including more becomes relatively small.
It is indisputable that cash forecasts are a key financial management process. However, a wise treasurer should not launch any grand and sophisticated forecasting implementations without a hardnosed assessment of the benefits compared with a rudimentary system.