Cash & Liquidity Management

Striking a balance

Published: Feb 2013
Photo of stones stacked on top of each other to represent team work balance

The financial crisis means businesses should take a more holistic view of their balance sheets – and must do so in a timely manner. What does this mean and how is it best achieved?

It would seem prudent in any economic environment to understand exactly how much money you have coming in and how much you have going out. This is nothing new: Charles Dickens’ fictional character, Wilkins Micawber (from ‘David Copperfield’), dispensed the following words of wisdom:

“Annual income twenty pounds; annual expenditure nineteen pounds nineteen and six: result happiness. Annual income twenty pounds; annual expenditure twenty pounds ought and six: result misery.”

Back to basics

So what is balance sheet management all about? Starting from the top, a balance sheet is an accounting report designed to give a snapshot of a business’ financial health at any point in time. It includes its assets, such as cash and debtor liabilities; liabilities, in the form of creditors such as banks and bond holders; and total or net worth, which is assets minus liabilities. Whilst asset and liability management are typically viewed as separate elements within the financial function, they necessarily come together under the balance sheet management regime.

Finding focus

The process of balance sheet management is equally applicable to private individuals and global corporations and yet, for many corporates, before the current financial crisis, few corporations were giving much thought to the issues that were impacting their balance sheets. “But as the downturn hit and businesses got caught up in bank insolvencies, there was a much greater focus on balance sheet management generally,” says Martin Hutchings, Finance Partner in the London-based banking team of international law firm, Freshfields Bruckhaus Deringer. Now many more companies are grasping the nettle “and taking it much more seriously”.

In the corporate sector, balance sheet management is closely aligned with working capital management. This focuses on controlling current assets and current liabilities to ensure a business remains a going concern and can meet its short-term debt obligations and operating expenses.

Daniel Windaus, Head of REL Consultancy in the UK, points out that before 2008, when funding was cheap and readily available, most businesses would question the need for sourcing more cash. But as the crash came and liquidity started to freeze up, the focus of corporates in many regions shifted towards working capital, at least in the short term. This rather changed the face of many operations: “During the slump, many companies realised their revenue line had disappeared and that all the materials to feed their supply chains were now going to have to sit idle as they didn’t have the revenue to soak it up. Suboptimal supply chains always get exposed in a downturn.”

Spotting problems

One obvious need for a thorough understanding of the balance sheet is that it can help reveal financial issues before they become major problems. In the current climate this is a must, but even when times are good, solid balance sheet management can help companies put their capital to better use. In any case, managing asset and liability mismatch and maximising returns on assets is necessary to be able to keep the business running smoothly.

In addition to monitoring and anticipating actual and potential value differences between a company’s assets and liabilities, the process of balance sheet management calls upon company policy and procedure to control, or at least limit, the various financial risks a business’s liquidity may be exposed to. As such, it is also closely bound up with risk management. According to PwC, there are four main areas of balance sheet management:

  1. Interest rate risk management.
  2. Liquidity risk management.
  3. Capital management.
  4. Discretionary investment portfolios management.

Cash first, ask later?

Of course, from a working capital perspective, Windaus notes that it depends on organisational type as to whether liabilities or assets take precedence, although he argues that both should be managed with equal vigilance. A manufacturing business, for example, will have a heavier demand for assets and thus cash consumption will be higher. A pure service organisation, with very little inventory (if any), will most likely see a higher concentration on liabilities. In terms of building up working capital, he believes that less is better, to the point where negative working capital – when current liabilities exceed current assets – can actually be a good thing. To achieve this, trade-offs need to be well considered and managed so that the overall business is not negatively impacted.

Turning a net asset into a net liability in this way sounds counter-intuitive and in most cases it is a warning that trouble lies ahead. But when a supplier delivers products to a buyer, and it then sells those products to its own customers, cash up-front, before it has to pay the supplier (as with fast food restaurants or supermarkets), its low inventory married to low accounts receivable equates to efficiency. If it can maintain this model it will have no problem raising cash. So, rather than having cash stuck in everyday business processes, it is in-hand and can be used with purpose for activities such as debt reduction, M&A and capex investments.

In Europe, working capital levels did improve post-credit crunch, but in the past couple of years it has deteriorated once more, notes Windaus. “Companies focused on it when they needed to because cash was not readily available, but now there are other priorities, management attention has probably wavered away from maintaining any improvements on a structural basis.”

Notwithstanding the discussion around the importance of cash, Hutchings believes that many companies have become much more focused on liability management over the past few years. These businesses may have a profile of debts maturing – such as bank loans or bond facilities – but have found themselves struggling to finance their repayments because the liquidity in the market has tightened. In response, when previously treasurers were rarely invited to board meetings, he says now they have become “quite central to that function” because senior executives are concerned how their business is being financed and what risks exist within that process.

Look to the future

Clearly there is a need to look beyond the immediate financial needs of a business. At a bare minimum, says Hutchings, there should be a view some 15 to 18 months out, simply because a business will need its auditors to give it ‘going concern’ status when signing off the annual accounts with a buffer that indicates it can continue to pay its debts, at least in the near term. “But any good company will look out longer than that, possibly to the next two to four years, identifying what needs to be refinanced and how best to do it.”

There is good reason for this. A notable problem with the market at the moment is that it can take much longer to raise money. Companies cannot automatically assume they can go to the same sources each time, as banks are more reluctant to make funds available.

Asset or liability?

The degree of importance attached to either asset or liability management does depend on the nature of the business. A company favouring debt should naturally err in favour of liabilities management, but whilst a cash-rich operation still needs to keep a watching brief over its liabilities, asset management becomes more pressing.

Despite the downturn, cash-rich corporates are on the increase. In early 2012, reported that in the US non-financial corporate sector “profit margins are at record levels thanks to savage labour shedding and companies are awash with cash”. It added that a similar “accumulation of cash has occurred in Europe”, and cited McKinsey’s estimate that European and US companies “hold about $2 trillion of surplus cash” (the amount outstanding over and above operating cash, defined as 2% of revenue). With such large surpluses, these companies need to consider the best place to deposit their cash, not just to generate the best return, but also to minimise counterparty risk.

The aim of a company is to assure its own success. Cash-rich is generally a good thing, but if there are liquidity issues because asset management is poor, a business may soon find itself in a position of actual or technical insolvency.

Getting better

Improvements in balance sheet management are founded in improving operational processes, states Windaus. Where most would see it as a pure finance issue, he sees it firmly embedded in operational matters. Working capital management, for example, is all about how a company procures from its suppliers, how it contracts with its customers, how these processes are run and how the supply chain and demand forecasting are managed. “Very quickly you get out of the realms of finance, where a CFO or treasurer can influence, and into the daily operational processes,” he notes. It then becomes a matter of how efficiently the business is running, turning to decisions around inventory and production line downtime.

“The challenge for the treasurer or CFO,” says Windaus, “is to try and bring that cash awareness into the overall business, to make people aware of what they can do to influence the balance sheet and what that means for the business.” However, he warns, stepping outside of the finance realm to speak with supply chain managers, for example, often requires time and patience to explain the impact that the balance sheet has on the overall business.

But in building that bigger picture, Hutchings advises the need to consider a number of external risks as well. Counterparty risk information, for example, can be sourced from various business units regarding contracts with suppliers and customers. There is also a need, he says, to understand what sort of business is being carried out and with whom. “If there is a breakdown in your supply chain because a supplier has become insolvent, it could have a major impact on your business.” It therefore becomes another ongoing task to assess the health of these relationships and the financial wherewithal of the parties involved and the market risks they may be facing.

How it’s done

Effective balance sheet management starts with an understanding of what it is that is required of the process; not knowing some of the issues and consequences, and therefore not being sufficiently prepared to take advantage of opportunities at the right time, is a quick route to being caught out, says Hutchings.

Accessing and gathering financial data is a key function too. Whilst a treasury team should know its own debt maturity profile, if those debts are executed on a group-wide basis, it won’t necessarily know about some of the supply chain or credit collection issues, for example, making it more difficult to pull in the right data, in the right format, at the right time. In response to this potential issue, Hutchings says a centralised function “can give a full and proper understanding of the business needs”.

Clearly then operational processes must be optimised. Windaus suggests one of the duties of the finance professional (treasurer included) is to increase awareness of the power of the balance sheet by establishing clear key performance indicators (KPIs). These must be communicated across the business. And rather than just having a KPI at a corporate or business unit level, it should be cascaded down to the people who can influence processes, where the processes are carried out. All the measurements can then be brought together “to enable the levers to be pulled at an operational level, and at the same time deliver visibility and transparency across the organisation”.

Additionally, Windaus believes that CFOs have a key role to play in the introduction of incentives around the management of liquidity at board level. But one other important aspect – one that he feels is often underestimated – is how to communicate and manage the cash flow forecast of the organisation.

Predicting liquidity requirements can be an insular, desktop-based activity for a treasurer, but involving other business and process stakeholders in creating a cash flow forecast can be a means of changing organisational behaviour. If, for example, the cash requirement for a specific unit looks like it may unexpectedly and significantly increase over a short period – based on figures supplied to treasury by that unit – questions can be raised immediately. A solution may then be found to head off this demand by perhaps changing the way the unit’s business processes are conducted, for example by revising the collections process or credit terms.

With different operational stakeholders involved, Windaus argues that treasurers have the opportunity to turn a habitual set piece regarding liquidity, into “proactively doing something about the processes that generate cash in the first place”.

Preparation, preparation, preparation

Preparing the ground for that coherent view follows Hutchings’ belief that reporting systems should be created centrally and pushed out to the local business units, requiring them to report in a standardised format as required. Reporting may be carried out electronically into a central system but this is a rare occurrence. Standardised reporting of the different elements using spreadsheets will suffice as it at least enables treasury to form an overview and open dialogue as necessary with the various stakeholders.

Technology is often cited as the panacea for all process issues, but not in this case Windaus believes. “It can help and might make your job easier, but it will not solve a problem by itself,” he states, adding that it is “an illusion” to believe that if a business simply applies technology to a certain set of functions, all will be fine.

Indeed, at the centre of the process, in the treasury department, the need is for experience, professionalism and judgement. “Treasurers will know their business and their own markets better than anyone. Many will have been through similar cycles and will know some of the mitigants to use,” comments Hutchings.

At the highest level, balance sheet management requires a firm purchase on what the wider risks to the business are including, for example, the economic, political, geographic and social. Hutchings says: “It’s about trying to understand the potential issues. From there you can work back to the risks these present to the business, the exposure you have to these, and then deciding how to mitigate against them, making it less painful if and when those issues arise.”

For Windaus, effective balance sheet management centres on transparency, communication and process optimisation. Implementing these concepts in a cohesive way that will work on a day-to-day basis can often overwhelm the finance division “when they realise what it really means to change behaviour in their own company”. For financial minds, it may be quite straightforward, but opening up the mysteries of the balance sheet to the rest of the organisation on both a structural and process basis is not a “plug-and-play” exercise. Indeed, he notes, “managing mind-sets and behavioural changes will take some time and hand-holding. Do not underestimate the effort required here.”

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