It is generally accepted that more companies fail due to lack of cash flow than for want of profit. This is an inevitable position because while profit is a vital indicator of performance, its generation does not necessarily guarantee an organisation’s growth, development, or even survival. For the C-level executive, cash flow also has a particular impact in the planning of short- or long-term investment strategies, where decisions are more often focused on anticipated funding requirements rather than projecting levels of profitability.
Capital budgeting is the process for managing cash flow, where the basic unit of analysis is the investment project. From a finance perspective, projects and program represent a series of contingent cash flows over time, whose amount and timing are only partially under the control of the executive. The amount of expenditure these consume directly influences the level of available working capital, which is the primary benchmark for measuring a company’s operational liquidity. The eternal challenge for organizations is keeping this liquidity in the positive position needed to support day-to-day operations – i.e., to service both maturing short-term debt and upcoming operational expenses – and for maintaining the flexibility to respond to emerging opportunities.
Corporations are currently sitting on significant cash reserves to alleviate the risks presented by market volatility. This serves to highlight a flawed approach to evaluating risk, which is denying them potentially lucrative opportunities. Such a position also emphasizes the importance of an effective governance framework for proposing, selecting and managing projects. Such a framework should be based on their perceived value and ability to provide maximum returns – balanced against risk across the portfolio.
The eternal challenge for organizations is keeping this liquidity in the positive position needed to support day-to-day operations.
In project-intensive industries, capital and operating spend remains high. For example, upstream oil and gas expenditures for 2012 are estimated to reach $1.23 trillion, for telecommunications, 2012 capex alone is expected to reach $320 billion, while capex spend in mining is likely to remain at a level similar to the $113 billion of 2011. However, one thing remains certain – the better capital can be managed, and the more of it that can be released from existing commitments, the greater the funds available for pursuing higher returns. Return on Capital Employed (ROCE) remains an important metric for organizations focused on capital projects. Examples of the ROCE rates for 2012 in key sectors including oil and gas (BP 17%, Shell 15%), construction (Saipem 15%, Balfour Beatty 12%), energy (RWE 20%, EDF 6%), and engineering (Lockheed Martin 17%, Larsen & Toubro 22%), highlight the value of directing operational cash reserves to the point of highest impact.
This paper will explore the ability of organizations to augment cash flow in their operations by addressing a key area of stagnant cash reserves – contingency budgets. It will argue that the collective pot of contingency monies is conservatively estimated at between 5–10% of total project operating costs across the portfolio. To free up even a small portion of these budgets can therefore help organizations expand their portfolios to decisive effect. Finally, it will also detail the way forward, and how a more flexible approach to setting contingency budgets requires the adoption of a portfolio approach to risk management.
