As we move into the first quarter of 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. This historic 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 organizations.
Revenues that were once fairly predictable are no longer stable or even present, and organizations trying to navigate the crisis face previously unforeseen costs.
COVID-19 and other 2020 crises have affected almost all aspects of most organizations, making it challenging to pinpoint all potential variables that might affect cash inflows and outflows simultaneously. In this environment, CFOs for both large and small companies should consider taking a number of steps and various planning scenarios to obtain a better, more comprehensive view of organizational cash flows.
As we think about sources of cash flow, it might help to think through these questions:
What are the core sources of cash for our organization? For most organizations, sales of products or services are the main sources of revenues (and ultimately cash inflows). Of course, working capital fluctuations related to Accounts Receivable (AR), Accounts Payable, and Inventory can also cause tremendous fluctuations in cash flow.
How is the current business environment 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 (i.e, AR) 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.” 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 organization? Compared to cash inflows, the number and variety of cash outflows can be significantly greater. Most organizations 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 categorized as fixed or variable? Some cash outflows are fixed, such as debt and interest payments, rent, and IT service 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 (e.g., investments in technologies to support a remote workforce) while there may be decreasing costs for others (e.g., lower interest expenditures). Variable expenses are likely affected the most, but there may also be opportunities to adjust or defer some fixed payments (e.g., 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.
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 various strategic scenarios 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 visualize 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.
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.
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 organizing 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 eight examples to consider (not necessarily in order of preference, given they likely vary across organizations):
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. Watch Accounts Receivable (AR) carefully. Carefully monitoring fluctuations of customer payments (e.g., DSO) and potential customer credit risk is absolutely mandatory during this economic crisis.
3. Rebalance inventory levels. 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.
4. 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. Organizations may find there is more willingness on the part of suppliers and vendors to renegotiate key terms on a more favorable basis.
5. Leverage benefits of financial markets. Interest rates are at all-time lows. These market conditions may provide organizations opportunities to refinance debt to more favorable terms. Organizations 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.
6. 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.
7. Evaluate payroll options. Compensation and related benefits are often one of the more significant cash expenditures for organizations. 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.
8. Consider government funding options. While there are often many strings attached, government funding may be an option for some organizations. Management should stay abreast of legislative developments at national and regional levels to ensure readiness to act if funds become available.
Thinking about liquidity isn’t a one-time activity. Keep in mind that these analyses are only estimates. As time passes, new facts and circumstances will arise. Assumptions used to prepare earlier cash flow analyses 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.
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