Tactical financial management: cash flow and budgetary variance analysis.

• Author: Kavanagh, Shayne C.

Most discussion of financial planning centers on a budgetary perspective--the revenues and expenditures that occur annually Also, much attention has been focused on strategic financial management methods such as long-term financial planning and priority-based budgeting. A tactical perspective is especially important during times of uncertainty: the incidence and behavior of revenues and expenditures during the course of the year. In the current environment, public officials can't wait until the end of the year to get an accurate picture of financial position, and the choppy seas of the economy require constant course corrections. The ability to make these timely alterations guards against having to make more draconian adjustments later.

Two related techniques can help keep the financial ship of state on course: cash flow analysis and monthly budget variance analysis. Cash flow analysis tracks actual income against outflows of cash to discern patterns, providing insight into a government's ability to meet expenditure obligations without resorting to the use of reserves or short-term debt. Cash flow can also highlight patterns that might affect long-range financial position. Variance analysis compares monthly budgets against actual numbers to highlight deviations between strategy and execution. Variance analysis can illuminate the beginnings of unsustainable trends and help the organization manage its budget in a way that is better aligned with its strategic goals. Variance analysis also helps track cash by comparing what was expected to happen versus what actually did. (1) Together, cash flow and variance analysis provide unique tactical insight.

This article describes some of the most useful applications for cash flow and variance analysis, what a good cash flow and variance analysis model looks like, and specific modeling techniques. The following organizations contributed to the Government Finance Officers Association's research on cash flow and variance analysis: Prince George's County, Maryland; the City of Irvine, California; and the City of Scottsdale, Arizona.

VALUABLE APPLICATIONS

Investment Management. Investment management is the most common use of cash flow modeling for local governments. Cash flow modeling can determine the dollar amount that the portfolio needs to remain liquid and meet disbursement obligations (generally within a six-month period), thereby revealing the amount available for investment. Prince George's County has found that its cash flow management practices have provided comfort that liquidity needs can be met, thereby providing the confidence to invest over a longer timeframe than it otherwise might. In 2001, the county started making investments with maturities that were greater than one year. This change in tactics added $10 million in investment income (government-wide) on an average $750 million investment portfolio (of course, going long might not offer the same advantages today).

Sizing Fund Balance. Cash flow and variance analysis can be used to demonstrate the need for working capital. The City of Irvine has found that getting a better handle on volatility informs reserves requirements. If cash flow analysis reveals that revenues are very volatile such that cash reserves may become dangerously low for a period of time (during revenue low points), this suggests the need for a higher working capital reserve. At least one rating agency apparently agrees with the city, advocating that a government's formal operating reserve policy take into account the government's cash flow requirements and volatility of revenues and expenditures. (2)

Managing Financial Stress. As far as most people are concerned, the primary use of cash flow and variance analysis for managing financial stress is making sure the bills can be paid. It describes where income and disbursements are coming from and where they are going. For example, during a recession in the early 1990s, Prince George's County found that summer is traditionally a lean time for revenues and that short-term borrowing would be needed to bridge those months. The county's elected officials did not generally look favorably on the prospect of short-term borrowing, but management was able to demonstrate, using its cash flow models, that bridge financing could be a responsible solution for the summer cash shortage because revenues would return in the fall. The county's cash flow model also served as the basis for communication with rating agencies. The county was able to maintain its bond rating, despite short-term borrowing, by illustrating how the borrowing fit into a cogent financial strategy and by using the model to...