By Laura Glenn, CFA®, Senior Director of Investment Services – Public Trust Advisors, LLC
Thomas Tight, Managing Director – Public Trust Advisors, LLC
Cash flow analysis, also known as cash flow forecasting, is an estimate of receipts and disbursements during a given period. When executed properly, it can lead to the optimization of investment choices while aiming to ensure that liquidity needs are properly met. Monitoring cash flow, through the use of both historical data and forecasting tools, can assist a municipality in determining that it has adequate cash on hand to meet daily liquidity needs and allow the municipality to take funds that are not needed in the near future and invest them out longer term to seek a potentially higher yield (assuming a steep yield curve).
Municipalities that do not understand their internal cash flows - and have therefore been sitting merely in cash and cash-like products over the past two years - have experienced a welcome advantage of higher yields on the front end of the curve due to the Federal Reserve’s aggressive rate hike campaign to battle stubbornly high inflation. As we say in the south, “even a blind squirrel finds a nut once in a while.” A lack of attention to cash flows and maintaining more than ample liquidity has been advantageous to a municipality while cash is king but that is not always going to be the case.
On the flip side, investing funds further out on the yield curve simply to “lock in higher yields” can be costly when not considering future cash flows. Those municipalities that had to sell longer-dated securities in 2022 and 2023, due to a lack of cash, were often forced to realize significant losses as rates had risen dramatically from when those securities were first purchased. A misunderstanding of cashflows has proven to be costly in these last few years - as opposed to the time after the Great Financial Crisis.
As GFOA states in their best practices, “Cash forecasting helps governments recognize structural issues that might have a negative impact on their cash positions. When looking at the entire organization, governments use cash forecasting to coordinate spending patterns and mitigate potential shortfalls by using this information to improve revenue collection practices and align revenues and expense cycles. Cash forecasting is therefore an essential tool for informed management decision making.”
The old adage “history repeats itself” applies to some extent when it comes to cash flows. For those entities where the primary source of revenue is property tax collections, the seasonality of these cash flows is known but will change based on assessed values. Historical cash flows, if adequately tracked, can be used to forecast the next fiscal year’s cash flows. Sales tax history can be used as well but may differ dramatically from previous years based on current economic conditions or other factors. Historical information can certainly be used as a starting point for cash flow projections and in conjunction with national and regional economic forecasts.
"GFOA recommends that governments perform ongoing cash forecasting to ensure that they have sufficient cash liquidity to meet disbursement requirements and limit idle cash. The cash forecast period should be at least a 12-month rolling period, as opposed to a fiscal year basis. The forecast within this rolling period should be divided up in at least monthly sections for most governments, or weekly or daily for larger and more complex governments.”
The cash forecast should be updated at least monthly to ensure revenue collections and expenditures are trending as expected. This careful eye on the cash allows for wise decision making when it comes to cash and investments. Revenue projections that come in lower than expected or an increase in expenditures due to unforeseen circumstances can provide valuable information suggesting a municipality allow investments to mature and roll the proceeds into cash to provide additional liquidity. Conversely, revenue projections that come in higher than expected or reduced cash outflows can provide a municipality with opportunities to invest longer term, seeking higher returns in a steep yield curve environment.
Whether managing funds internally or outsourcing to an investment manager, having a solid understanding of an entity’s cash flows is crucial to ensure proper liquidity that meets short-term cash needs thereby reducing the need for short-term borrowing and/or prematurely liquidating long-term investments to provide the requisite liquidity.
Disclaimer: All comments and discussions presented are purely based on opinion and assumptions, not fact. These assumptions may or may not be correct based on foreseen and unforeseen events. The information presented should not be used in making any investment decisions. This material is not a recommendation to buy, sell, implement, or change any securities or investment strategy, function, or process. Any financial and/or investment decision should be made only after considerable research, consideration, and involvement with an experienced professional engaged for the specific purpose. Past performance is not an indication of future performance. Any financial and/or investment decision may incur losses.