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Finance discipline for optimized performance
Part III: The journey to instituting more agile capital
The current environment has exposed the need for enhanced financial disciplines to enable more flexible real-time management and better decision making against an unpredictable future. Creating an operating finance discipline that optimizes performance now and empowers more agile capital allocation and improved future planning is vital for the finance function.
May 15, 2021
A blog post by David Cutbill, principal, Deloitte & Touche LLP
With increased marketplace volatility in varying degrees across all industries, organizations may struggle to plan for the future with an inability to account for different predictions in forecasting future performance.
Recent events have exposed the need for enhanced financial disciplines to enable more flexible real-time management and better decision making against an unpredictable future. Creating an operating finance discipline that optimizes performance now and empowers improved future planning is vital for the finance function.
In Part I of our series on finance discipline, we discussed steps to develop new finance disciplines to optimize performance. Part II took a deep dive into the methodology for developing resilient scenarios, the first step to optimizing finance discipline. The next step to creating more finance discipline is creating capital agility now and more capital resilience for the future with a better understanding of capital and cash needs across the business.
To do this, the journey to instituting more agile capital allocation can follow three phases:an initial focus on near-term liquidity, then a move to identify excess and available capital, and lastly instituting fully agile capital.
Creating capital resilience in the current environment
Focus on liquidity: The immediate response to uncertainty
Many companies are still grappling with the effects of the first months of the pandemic or struggling with the current environment after more than a year of uncertainty—so in the near term, it is important to focus on liquidity as the global marketplace and most industries continue to evolve amid the pandemic and on the road to recovery.
When the pandemic first started, many professionals observed limited real-time transparency onto liquidity across businesses and globally. In this type of crisis environment, it is vital to focus efforts on responding quickly and immediately to understand cash impacts and availability. During the early days of the pandemic, this was often done with brute force (by necessity) as many organizations instituted almost daily reporting of cash positions and adjusted cash forecasting to more immediate and near-term timelines. Capital expenditure reductions were introduced, and additional liquidity was also sought through financing as safety nets for the unknown, both being blunt instruments in trying to ensure adequate liquidity for the business amid rapidly evolving marketplace impacts.
Once an organization shores up its short-term working capital, the next focus should be on identifying the excess capital available to improve strategic advantage.
Understanding capital needs: Recovering against uncertainty
As we discussed in Part II of this series, to better manage against the uncertainties, companies should develop more robust scenario planning. Developing potential scenarios can help you look to and understand capital needs in three primary tranches:
First, what capital is (or was) needed to maintain ongoing normal operations in the most likely scenarios? Whether in the middle of the crisis or coming out of it, a full assessment of the bottom line is a vital first step. This includes defining the key issues, understanding what the crisis means to the business model, and identifying the most likely disruptions of the operating plan and impacts on capital needs.
Second, what capital is needed in reserve for potential impacts from the more damaging scenarios? As the different detailed scenarios are created, and predictive forecasting is employed for each scenario to understand the potential impact on capital needs (more detail on these capabilities will be provided in the next blog), capital should be held in reserve for the most capital-intensive scenarios, even though some may be of lower likelihood.
Finally, is there any “excess” capital after identifying maintenance and reserves that the organization can use to invest?
Even in challenging times, after allowing for the reserve capital, management can feel confident that there is still additional excess capital that is available to them to improve their strategic advantage either by continuing to invest in the business (especially those likely to fare well in the most likely scenario) or identifying those long-term assets that may be available at reduced prices because of short-term distress.
Agile capital optimization: Thrive by increasing future returns
After first responding to uncertainty and optimizing capital in the short term, it is time to reimagine business in the future and implement more agile working capital models, effectively building a new finance discipline. What does this mean? It means incorporating lessons learned and turning them into a sustainable capital allocation approach that recognizes that the future is always unpredictable. It needs to reallocate capital on a real-time basis as you sense that factors have changed.
Overcoming bias in the capital planning process: With uncertainty comes inherent management bias in the capital planning process, commonly in optimism bias, expert bias, and narrow framing. Individuals may be overly optimistic about certain courses of action, rely too much on specific pieces of information, or simply interpret the objective through too narrow a lens. In one study1, 60% of finance executives say they are not confident in their organization’s ability to optimally allocate capital. Overcoming biases in the planning process may increase confidence and, therefore, support the allocation of working capital.