Helping the CEO to Sleep Soundly at Night

by Nigel Grey, Chairman, ACTSA

As the treasurer of your organisation how confident are you about its ability to survive and thrive? And how confident are you about its ability to survive a material unexpected business disruption event? By disruption event I am referring to an event that the business had not anticipated in its normal business planning.

We have all heard the phrase ‘Cash is King’ from time to time, usually after some business has got into some form of financial trouble. But surely it does not apply to your organisation, considering your business model, market position, product offering etc. Whatever could go wrong?

Ever had those thoughts? Ever known someone with those thoughts? Ever done something proactive to prevent such an event having a disastrous impact on your business?

When I was starting my treasury career, I learnt two important lessons from one of the CFOs I was fortunate to work with. The first was never say ‘NEVER’ and the second was that nothing is impossible. Of course those words and sayings can be taken either positively or negatively.

It is hard to believe that major businesses could and do go out of business even when times are good and they are being well managed. Regrettably, the impact of a negative unexpected business event may damage the company so badly that it never recovers. The reason for such failures is because the company simply runs out of money before it has been able to react to the situation it is facing. For example, take the case of the American energy firm Enron which during the 1990s, through the use of accounting loopholes, special purpose entities and poor financial reporting, was able to hide billions of dollars in debt from failed deals and projects [1]. It all went horribly wrong in 2001 when it filed for bankruptcy. At USD 63bn in assets it was the biggest corporate failure in US history until Worldcom went bankrupt the following year.

The Enron story is well documented and in essence, whilst the management knew just what game they were playing, the real losers from the Enron scandal were its auditors, Arthur Andersen. The fallout caused a massive loss of confidence which resulted in their customer base evaporating and the business eventually closing – in essence they ran out of cash before they could rebuild their business and restore confidence. Matters that can rapidly change a business’s liquidity are often not foreseen. It is highly unlikely that the senior managers at Arthur Andersen knew what they were exposed to until they were in the thick of it fighting a rearguard battle.

Act before it’s too late

Trying to secure liquidity funding after a major negative disruption event is too late. Ever known a financier who wants to provide finance when the perception of the business’s credit quality has taken a knock? I reiterate, by then it’s too late! Recent examples of disasters which have affected businesses through no fault of their own are the tsunami in Japan, the volcanic eruption in Iceland which disrupted air travel and severely impacted Kenyan flower producers, the downing of the Air Malaysia jet over Ukraine just months after the airline lost an aircraft en route to China and the labour strikes in the South African platinum belt that dragged on for five months, impacting not only the mining sector but the many support industries in the Rustenburg area.

In today’s world, product cycles are shorter, the competitors who may make your products and services (and perhaps you yourself) obsolete may not even be in existence now, but could impact your business within years.

In the past two decades it has been the development of the internet, personal computers, mobile phones, tablets, and related automation which have made many products and processes obsolete. The development of electronic sensors is improving production processes and even moving into autonomous vehicle automation. These products are affecting consumer preferences which can and do change rapidly depending on the latest development. In the modern electronic and App era it seems as if the pace of change is becoming ever faster.

This means that having a liquidity buffer is becoming more and more of a necessity for businesses rather than just a ‘nice to have’. Having access to a considered amount of liquidity, especially when the business is experiencing a financially stressful period, is becoming harder to secure as the assessment of credit risk by financial institutions becomes more sophisticated and increased regulatory costs make the cost of finance expensive.

Focus on cash management

Determining a level of liquidity is based on many factors. Cash management is probably more important today than it was in decades past, yet in today’s frenetic pace of business I often get the impression that many people merely give the concept of cash management occasional lip service. I was recently involved with a business which went through a period of business rescue. The business recovered and a positive consequence of this process was an extremely high focus on cash management. This focus on cash management is one of the reasons the business has extremely low levels of debt today.[[[PAGE]]]

That business was eventually taken over and it was interesting to hear someone from the acquiring company say nonchalantly that there was no need for such a focus on cash management given the size of their business, as banks would always lend to them! I immediately thought of that phrase I had heard so many years ago about never saying ‘NEVER’!

Let’s get one thing straight at this point. Liquidity is not cash generation and if the business is not generating cash, no amount of liquidity management is going to help it in the long run. To generate cash you need sales, which you must collect in a timely fashion and which need to exceed the operating, capital and financing costs of generating the sales. Generating cash is the responsibility of the stewards of the company as they direct the various components of the business in implementing their business strategy and ensuring that their shareholders benefit from the investment that they have made.

Warning signs

So, before you can attempt to determine the amount of liquidity that’s needed, you need to have a viable business. If your business is showing some or all of the signs below, your primary focus needs to be on assisting management get the business model right first.

Examples of warning signs for broken business models are:

• Constant erosion of profit margins reflecting an inability to maintain market share
• Expansion beyond a business’s final plans, resulting in over-borrowing
• Over-reliance on borrowed funds resulting in significant proportion of the gross profits being directed towards servicing debt
• Inadequate capital base, creating problems in financing ongoing operations
• The lack of a cash flow forecast
• Difficulty in meeting operational obligations
• Continual capital injections resulting in increasing debt servicing costs
• The current account is never positive i.e., the business has a constant overdraft.

So, have you got your CEO covered against a massive unexpected loss of liquidity?

A treasurer’s responsibilities

In my opinion ensuring the business has enough liquidity to see itself through unexpected business disruption events is one of the most important activities of a treasurer.

Traditionally a treasurer will be involved in:

• Cash management including managing cash forecasts,
• Managing financial risks stemming from foreign currency, interest rate and commodity price exposures,
• Raising capital,
• Investing surplus funds,
• Managing bank relationships and running the treasury department with all the necessary control processes and operations. 

All of these activities play a role in managing liquidity, involve specialist skill sets and will be of varying importance within different organisations. However, whilst all the activities mentioned above are vitally important in their own right, it’s ensuring that the business has enough access to cash to weather any ‘100-year storm’ that’s of critical importance.

When unforeseen business events impact the business it’s the treasurer’s role to ensure a steady source of funding to draw on whilst the stewards of the business react and manage the situation. It is almost like being a sensor in a motor vehicle engine. The sensor may constantly test a situation for thousands of kilometers, even for years, always returning a negative condition. However, as soon as a part fails/wears out it signals the problem or in some cases adjusts the settings to optimise performance. Monitoring liquidity can be a bit like that, but importantly should never be down played or overlooked especially during the ‘good times’.

Assessing liquidity needs

How much liquidity do you need? Do you just suck an amount out of the air?

Pre 2008, banks were falling over themselves to provide uncommitted facilities that could be called upon, but those facilities were always at the discretion of the financial institutions providing them and were almost always repayable on demand, making them essentially useless in times of financial stress.

Post 2008, with increased banking regulation and a better understanding of credit risk by financial institutions, facilities now have costs attached to them which are not immaterial. Ever increasing banking regulation through Basel III and other regulations have also made all forms of bank borrowing more restrictive and costly.

Not all businesses can tap into the capital markets, leaving the majority with the stark alternatives of raising equity capital with all its issues or managing the business based on the balance sheet if the costs of bank finance is too onerous. The amount of liquidity availability now carries a significant cost and as such optimising the amount is more important than ever.

Those organisations that are already weak from a cash flow perspective need to focus on rectifying that situation before attempting to ensure adequate liquidity measures are in place to survive an unexpected disruption event, but they need to appreciate that they are extremely vulnerable, in any case, to such an event.[[[PAGE]]]

Ensuring adequate liquidity

A suggested methodology for ensuring adequate liquidity, to weather an unexpected business disruption event, involves doing the following:

• Establishing the cash position and being able to model how changes in the key variables of the business will impact the liquidity position. If you are fortunate to have a sophisticated cash flow system available to you, it probably is part of your processes already. My guess though, is that most treasurers don’t have such access, but the good news is that, with a little effort, an appropriate model can be developed using a spreadsheet application.
• Understanding the nature of the business’s existing financing facilities. The structure, quantum and term are all important aspects.
• Monitoring any covenants and the degree of leeway that the business has before covenants trigger default clauses. The last thing a treasurer wants is for a covenant to trigger causing financing facilities becoming due and payable.
• Understanding the business’s ‘burn rate’. The burn rate would be how much cash your business would be expending monthly on the basis that you have no sales or production taking place.

Typically these are the fixed overhead structures, financing costs and those operating expenses you would still incur even without any production; for example, if your business was subjected to a strike by a group of employees that shut down your production as well as all other activities. Salaries and wages of those not involved in the strike would have to continue to be paid. The total of these expenses would be part of the business’s burn rate.

• Understanding how long it would take to turn the business around is also an important part of the process.
• Access to liquidity, is expensive and accordingly needs to be ‘enough’ but not excessive. Determining what is enough requires the treasurer to be in touch with the business, understanding the business model, the issues that cause challenges, and requires consultation with senior managers in identifying what would constitute an adequate level of liquidity which would enable the business to recover from a disruption event.

Ultimately, the level of liquidity (‘headroom’) required is a matter of judgment after taking the above matters into account. The important criterion is that it should be large enough to enable the business time to develop a plan to recover from a disruption event in the first instance but not so large that it becomes a costly overhead. An example would be x months times your organisation’s burn rate.

Conclusion

Whilst businesses around the world strive to maximise returns for their shareholders they are faced with ever more strenuous conditions for sourcing debt facilities that are available on a committed basis.

The need for corporate treasurers to seriously consider the amount of liquidity that would be required to carry the business through a severe unexpected business disruption event is becoming more and more a necessity as the cost of having access to that liquidity is becoming a part of normal business overheads.

Optimising that level and monitoring the business liquidity situation will go a long way to ensuring that your CEO can sleep peacefully at night.

Note
[1] Excerpt from Wikipedia on Enron.