Liquid Gold - Frank Wendt, KPMG

A recent KPMG study has revealed that after net profit growth, liquidity generation is the key performance indicator for investors. However, corporate management is failing to measure liquidity generation on an operational level.

Liquidity generation is a key value driver used in discounted cash flow models and strategic management tools. In practice, however, corporate management is often orientated around profit and loss and economic profit. These frameworks are not suitable for measuring, planning, controlling and steering liquidity in the short and mid-term because the key to cash generation is in organisational and process chain optimisation.

MANAGING YOUR LIQUIDITY

Liquidity Based Management (LBM) provides a direct approach to liquidity generation management. LBM follows the typical management cycle of planning/forecasting, controlling and steering, and can be embedded in current management and controlling structures.

The methodology is based on forecasted transactions such as sales and purchases, firm commitments, such as contracted orders, and assets within debtor, creditor and inventory sub-ledgers. These are used to deterministically and stochastically generate cash flows.

Actual/plan deviations can be traced back to changes in assets, firm commitments and forecasted transactions, enabling fine-tuning and counter-measure allocation as well as the detection of changes in disposition methodologies in procurement or production.

LIQUIDITY DRIVERS

With LBM’s steering element it is possible to determine concrete liquidity drivers and liquidity risk factors, derived and integrated from the planning/ forecasting and controlling activities, allowing early warning indicators of potential deviation from plan/forecast figures to be defined.

Typical liquidity drivers can include:

• Changes in margin
• Changes in cycle times due to more frequent production set-ups
• Changes in payment behaviour
• Changes in payment term negotiations
• New factoring/leasing programmes
• Mergers and acquisitions
• Delays in investment realisation
• Delays in projects

KEY LIQUIDITY RISKS

Through the adequate derivation of ratios, the drivers can be turned into targets and incentives assigned to functions, business units and departments. Risk reporting on key liquidity risks can also detect where risk mitigating measures should be taken.

Typical risks can include:

• Financial (currency, interest rate and commodity)
• Customer/supplier (default and delinquency)
• Competitive
• Country
• Operational

To get the most out of LBM, a good conceptual design along the value chain is essential. It is also necessary to incorporate tax, payroll, facility payments, corporate finance and treasury.

The design can be implemented on modern system platforms, such as business warehouses, in combination with specialised LBM software. With adjusted targets and incentives, the payback can be significant.

THE LBM PROCESS

The LBM process involves converting actual assets into cash flows via a deterministic approach by analysing vendors, customers and Stock Keeping Units (SKUs) and by taking payment behaviour and disposition rules into account.

Actual firm commitments are converted into accounts payable and receivable via a deterministic and stochastic approach by analysing lead times between order inception and invoice generation. These forecasted assets are then turned into cash flows, as described above.

Forecasted transactions are converted into firm commitments via a stochastic approach by analysing replenishment strategies and disposition rules per planning group.

ADVANTAGES OF LBM

LBM ensures that:

• Planning/forecasting accuracy is more precise and is value-date based, allowing the seamless aggregation and disaggregation of planning intervals, for instance, daily, monthly and quarterly
• Profit and loss and assets are directly planned and can be reconciled with other planning tools
• Planning groups are driven by liquidity criteria and not by the firm’s organisation, although an aggregation on organisation unit level is facilitated