Published: March 01, 2008
Helen SandersIf we compare the experience of corporate treasurers today compared with this time last year, concepts of liquidity, credit and funding are now very different. Not only that, but the market itself has a different view of its participants. What does this mean in practice from a corporate perspective? What does the new world look like? What are the challenges and how we go about addressing them so that we still add value to our organisations?
The first question for a corporate treasurer is why the market has changed so dramatically, as we all have seen in our day-to-day jobs? Furthermore, how should we understand the consequences of these changes? We can then tackle these one by one and see if we can influence or eliminate each factor to allow us to access the market in the same way as we did before.
We have seen that clients have begun to tighten up their financial activities in many ways. Many issues which, while they have always been important to treasurers, have come to the fore as we come to the end of a cycle in which corporations have built up enormous cash amounts. If you look at the statistics on this, this sort of activity comes in waves. After 9/11, for example, corporate clients started to clean up their balance sheets and became far leaner in their borrowings and their cash holdings. Since that time, we have seen an enormous build-up of cash and we are now entering a new phase in which corporations are being more disciplined about their balance sheets again as the external credit markets tighten. Potentially, this becomes more expensive depending on the volatility of your base currency but risk is becoming more highly prized. Therefore, with credit becoming relatively more expensive, companies are making greater use of internal sources of funding. [[[PAGE]]]
Twelve months ago, we found that corporates were sourcing perhaps 50% of their funding externally and 50% internally. While this balance might differ according to the industry and the company, we are now seeing companies increasingly forced to move away from external financing options in favour of internal funding opportunities. In some cases, the financing simply isn’t available, in others it may be too expensive. So where can companies find cash internally - where is it and how can they get hold of it? Companies are working in a variety of ways to address this - perhaps looking at integrating their internal and external systems and information flows more effectively, to find a way to look across their global cash position. Once they have done this, then they can take steps to use that money more efficiently. So we see companies focusing on technology and management reporting and then looking at what they do with their cash.
Another problem is that many corporates only focus on relatively small, operational savings when they embark on working capital projects. For example, they might look at improving their payables or receivables processing and achieve a few ‘00,000 in operational benefits - while it is extremely worthwhile to optimise these processes, they should not be considered in isolation. Rather, companies need to look at the whole finance and liquidity picture which may be distorted by focusing on a single area.
Increasing predictability and reducing volatility are key to effective financial management. But how are companies going about this?
Although measurements are very different from one industry to another, cashflow forecasting is an exercise which is crucial to an efficient treasury. For companies with a long-term cash cycle, you would probably focus less on day-to-day balances. In an industry with a very short-term cycle, working capital is the key issue. In this situation, you tend to put in place systems that repatriate and centralise your cash as quickly as possible. Such tools are available from banks and software providers. Corporate access to the SWIFT network is a key element in making these things available and lowering the technology barrier, and there are a number of corporates moving in that direction. Something we tend to forget is identifying the return - what do you expect to gain from centralising cash and improving your decision making capability? This is a key factor when looking to improve the cash management strategy.
Let me just pick up on one point there - while we’re coming to the end of a phase, nonetheless we are still benefiting from the phase. There is an enormous amount of cash around. Companies may have difficulties finding it, but the reality is that it is out there although it may not be evenly dispersed across all corporations. In theory, the corporate world doesn’t need to borrow any more, it needs to find ways to recycle what it already has.
Corporations have done a very good job in improving their performance against the traditional measures of working capital such as days sales outstanding, inventory and days payables outstanding. When it comes to managing their cash assets, companies have not been quite so lean, encouraged by cheap credit. Many companies are sitting on piles of cash in the hope of buying other companies, share buybacks, etc. - cash which is out there and available to them. So I would underline Luc’s point about forecasting. One of the key measures or rather, one of the key determinants of your cash predictability is how well you’re forecasting. If you can forecast with 100% accuracy, you have no unpredictability of cash flow; however, while you may be able to predict cash flow, you may still be experiencing volatility. [[[PAGE]]]
One thing that has been very plain to us over the last 12 - 15 months, particularly the last six months, is that companies are very keen to find out where their money is, which is one of the things that people are most keen to find out about our MyTreasury platform. They want to know in which centres their cash resides, and the nature of the investments they are holding. At a glance, they want to look across the whole organisation and see what cash they have and where it is. Then they can realise and derive value from that cash.
The idea of centralising treasuries is very familiar to most of us in some shape or form, whether for certain elements of treasury, such as FX or financing, or treasuries which have evolved into financial shared service centres. Many treasuries are now taking a broader view of cash, including payments and collections, one of the outcomes of which is to improve forecasting and cash flow decision making. However, we all know that centralising treasury and cash related activities can be very difficult and for some regions and activities, treasurers can only hope to gain visibility and control as opposed to achieving centralisation.
With credit becoming relatively more expensive, companies are making greater use of internal sources of funding.
Going back to the point about corporates having a great deal of cash, there seems to be a more aggressive focus in companies than simply knowing where the cash is, and there is more attention on what you are doing with it. For example, in the past each treasury centre might have managed its own cash requirements- e.g. if Europe had cash, they would keep it, the US might go and borrow. Companies don’t want to do this any more and prefer to leverage the group’s cash flow. But even with the most sophisticated systems and reporting, the question of tax always recurs, the difficulties of moving cash across borders and the implications of intercompany lending.
Tax is an issue, but whether it is seen as an insurmountable obstacle depends on the anticipated outcome of being able to move that cash. We’ve tended to undervalue cash and how much it costs a corporation. e.g. there is an assumption that if I have cash to invest in one region, and am short in another, the net cost to the corporation is the spread between the borrowing and lending cost. This amount is probably a relatively small and finite number. In reality, the cost to the corporation is a) the effect of inflating the balance sheet and b) the real cost of any corporate asset is what shareholders are paying for.
The true cost of capital to a corporation is the weighted average cost of capital, which is probably in the 10-12% range for most corporations. When you compare the cost of idle cash in one region versus borrowing in another, let’s say between 3% and 5% versus the weighted average cost of 12%, then suddenly the hundreds of millions of dollars you may be holding in cash can be seen to be an enormous drag on the earning capacity of your corporation. So the real cost measured from a corporate finance perspective is significantly greater than the nickels and dimes that we see moving backwards and forwards on the bank statement each day. While these are a visible cost, like an iceberg, the real cost is nine-tenths below the surface and we don’t see it.
I agree! It also depends on the corporate attitude to risk, which has changed in many companies. A company which was highly risk averse in the past is often now willing to be more aggressive. It can be far more interesting to use the cash that you have internally rather than going externally.
...which now becomes a necessity rather than a nice to have. Looking again at the issue of tax. If you now think of the difference between holding cash versus not holding cash, which is probably more like 6% instead of simply the spread on the borrowing cost, then you can see how you can overcome some withholding tax concerns and justify the effort on recovering these costs when they occur. [[[PAGE]]]
We talked earlier about corporate attitude to risk. Have corporate investment activities, for example, changed over the past year or so?
We have focused, in the initial stages of the company’s development, on money market funds (MMFs), which have been particularly in the news recently following the ‘credit crunch’. There have been substantial amounts of money being pulled out of funds, even the AAA-rated funds. What companies have noted though, is that a triple-A rated fund is not the same in all markets. In some cases, these have invested in nothing other than time deposits, or CDs without any asset-backed instruments. Others are much more diversified, and investors are starting to understand more clearly now the importance of visibility of the investments which underlie a money market fund. We have focused on providing more information on MMFs about the underlying asset portfolios. Investors are not only interested in the percentage of the portfolio in each instrument, but also the investments at an individual asset level. This is particularly the case on the banking side, because they can use their internal risk models to ensure a lower risk weighting, but a number of corporates are also seeking this level of analysis. For example, using our portal, you can actually drill down and look behind the MMF and compare it with other funds through a single channel.
Most funds are now at levels substantially above where they were when the credit crunch hit, but the underlying portfolio of investments and the percentage split across the different asset types may be substantially different to what it was nine months ago.
I would echo that. We have seen our clients analysing fund fact sheets more, but also diversifying across funds, even though in itself a MMF is a diversified instrument.
One of the key determinants of your cash predictability is how well you're forecasting.
Effectively, corporates are looking to diversify more, but they have become more risk-aware and have accepted that risk might be broader than they had previously assessed. Take the example of securitisation. We know that almost all the banks use a commercial paper (CP) vehicle for that. Now that the market is drying up, we do not have access to a CP market any more which has closed off one source of funding - this then leads to more pressure on other sources of funding which then itself dries up. This domino effect is risky for a corporate making its funding decisions.
Another issue is that corporates should be cautious about the balance between shareholders’ funds and bank funding or external funding. As well as taking into account the cash cycle, we also need to be aware of day to day volatility, potentially being cash-rich one day and short the next. More corporations are now looking at working capital and reinforcing their credit management policy, in order to address a wider scope of risk. [[[PAGE]]]
We’ve spent a bit of time talking about how to invest cash to get a good return and make sure it’s safe. These are the primary concerns of the corporation. What I don’t think corporations have a good handle on is knowing what the right amount of cash is for them. Notwithstanding the cyclicality of the business, or even seasonality, what is the right amount of cash for your business? Secondly, what factors determine the right amount of cash you need? The answers to both of these questions elude most treasurers and CFOs. They know how to invest it, they know how to lend it, they know how to borrow it, but they don’t know how much cash they actually need.
Companies are interested not only in the percentage of the portfolio in each instrument, but also the investments at an individual asset level.
Typically, companies have no objective measure of whether it needs more cash than a company in the same industry. We find significant variations in the amount of cash that corporates are holding. Bearing in mind that cash is a very expensive asset, and also perhaps a risky thing to invest, a company is most competitive if the treasurer and CFO know how much they need and keep that amount. There have been models available to us since the 1950s to determine the right amount of cash that a corporation exhibiting certain characteristics should be holding. Added to these models are modern liquidity techniques such as cash pooling, zero-balancing, multi-currency, multi-entity pooling, all of which can be used to drive down the amount of cash that a corporation needs.
In terms of predicting your cash, forecasting is extremely important. In terms of minimising or reducing the amount of cash we rely on, focusing on the volatility of your cash is the next most important thing you can do.
It would appear that in many companies, treasurers are compensated or recognised based on the return on their investment and the cost of debt. They’re not necessarily being recognised for holding the level of cash that the company needs. This must create a problem, because if your performance is being measured on something which may not ultimately be in the best interests of the company.
An important consideration is the company’s view of treasury’s role. I think if you look at treasury as a service provider to the group, responsibility for cash remains with the business operations and treasury acts as a service provider to maximise this. If the treasurer ultimately has responsibility for cash, of course he would put in place techniques to centralise cash as far as possible. This could potentially be detrimental to the business. However, before you implement that kind of approach, treasurers have to know their corporate business model very well. That being said, the cash exercise should not only take place in treasury - it should be a focus of all departments and an essential role of the treasurer should be to educate and assist people in understanding cash management.
Do you think it could harm the business to centralise cash in some cases?
In some cases, yes. For example, if the treasurer is rewarded on minimising cash levels, they may take inappropriate action for the business, because there is a direct incentive to do so. My approach would be to look at the cash impact of a business decision and ensure that the decision makes sense from an economic standpoint. Then we can look at how to maximize the value of that cash.
My experience as a corporate treasurer is that the hardest job for treasurers is prising cash away from the business operations. The business always wants to maintain a cash cushion and depending on how they’re measured, the interest on this might even accrue to their P&L. To give an example of how cash build-up can really get out of hand, a corporation expecting to make an acquisition may build up a large war-chest of cash to finance it - this can stay there for a number of years. After a few years, when compared to peers in the same industry, the cost of that cash to the company could easily be 10% of their market capitalisation. In other words, there is a 10% drag on the company’s value; the company that was supposed to be worth 100% is actually being valued at 90%.
Going back to why a company may have cash sitting around for three years, e.g. for an acquisition, an acquisition does not achieve as much as 10% increase in value, and a lot of research has indicated that most mergers are value depleting. So while a company is looking at an acquisition to achieve some synergies, it may be paying a heavy price in terms of market capitalisation to make that acquisition. [[[PAGE]]]
In addition to looking at the cost of cash relating to the cost of capital and how can we use that cash efficiently in order to make sure we’re creating economic value, shouldn’t treasurers be working more with the risk management teams to look at the business risks of the company in order to reduce the cost of capital - the amount of cash and the amount of own funds?
That’s exactly the point. How do you find the right equilibrium between internal funds and external funding? While it depends on the activity, I think you’re right to say that the biggest risk is where the biggest return is expected. We talked earlier about companies having a weighted average cost of capital of 10-12%. In some sectors, this can be 15-20%, because companies are taking on substantial risks, such as industrial risk.
A company is most competitive if the treasurer and CFO know how much they need and keep that amount.
When you think about business risk, the market values continuity and steadiness of earnings. So companies which are not in high risk businesses that exhibit wild swings, low volatility of earnings reduces your cost of capital. Just as all markets value instruments on the basis of their volatility, we are now valuing cash and the cash assets of the corporation based on the volatility of that cash.
We also need to bear in mind that volatility is based on the past, but the future is never the reflection of the past. Therefore, volatility cannot be the only measure in the assessment of risk to find out what level of funds or cash you need. According to one of François Masquelier’s (ATEL) articles, around 90% of a corporation’s risk is non-financial. Therefore, an important consideration is the likely business risks the company is likely to run in the future and the potential impact of this risk.
I would say that volatility is predominantly a predictor of the future, although not an absolute predictor. One discipline we rarely see in treasuries is the acceptance that as business risks are inherent, why we as treasurers do not charge business units different rates on investments that we make to them. During my time in corporate treasury, every investment that we made to any part of the business always had to achieve the same hurdle rate, despite the fact that some activities which we were financing were inherently more risky such as breaking into a new market versus buying a replacement piece of equipment.
An important element here is transfer pricing. Large corporations which have centralised treasury are not neutral when it comes to transfer pricing risk, so they have to charge different rates according to the different types of risk they’re taking.
What seems ironic is that the tax man is the person who is driving good corporate behaviour, because transfer pricing tends to be a tax.
I would say that this is a side effect of the introduction of Sarbanes-Oxley and similar compliance rules in Europe so yes, I think corporates have become aware of it quite recently and are addressing it now because they are forced to. I would say it’s less of a tax issue than one of co-operation between tax and treasury.
Going back to what you were saying about enterprise risk, there are a number of issues to take into account, apart from the logistical issues of identifying a risk model which works at an enterprise level. For example, there’s the need to put in place incentives for people to behave in a way that is directed at addressing risk at an enterprise level rather than at a departmental or individual risk level, which does not exist in many organisations. [[[PAGE]]]
One important element we have discussed is volatility - I’d like to ask the panel about what aspects of the business most affect volatility and how should we go about managing them?
The inherent operating model of the company is going to affect the volatility of cash flow. Generally for most corporations, incoming cash flows are unpredictable. If you know you can use a credit card 100% of the time, or perhaps you are a large utility with the majority of inflows through direct debits, then incoming flows may be smoothed out. But for most companies, the operational activities of the business create unpredictability. However, there are also some things that we do as treasurers that contribute to unpredictability (and I use the terms unpredictability and volatility interchangeably - volatility is just the mathematical measure of unpredictability).
The hardest job for treasurers is prising cash away from the business operations.
Some things we do as treasurers make sense when we look at our cost structures, efficiency and automation, but which nevertheless damage the predictability of our cash flow. As an example, when corporations create shared service centres, they often centralise their payables, and in doing so, they often concentrate payments into particular payment cycles. In a decentralised organisation, cash flow cycles might be different across the business, making payments on different days etc. When bringing everything together and creating a batch payments process every week or every month, you create enormous spikes in terms of unpredictability.
On the face of it, weekly or monthly payment cycles might seem to create predictability, but I would argue that if you pay out on a particular day, you’ve held cash throughout the period to be able to make those payments and so you are holding more cash than you need. So anything that contributes to one-time events that cause large inward or outward spikes of cash flow, are increasing volatility and therefore increasing the amount of cash that you need to hold.
As an example, many corporations in the United States pay by cheque to hold on to the value created by cheque float, which creates the same problem of unpredictability. They may earn a few cents on every payment but cash outflows become highly unpredictable as they don’t know when those cheques will be cashed. The effect of this is to keep cash on the balance sheet to deal with unpredictability, so the few cents that saved on cheque float is grossly outweighed by the amount of cash they have to hold. Focusing on increasing predictability can have substantial benefits - one corporation we’ve worked with expects to save $300 million on the balance sheet this year, $450 million the following year, and $500 million after that by centralising cash and reducing volatility.
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I agree completely. I think many corporate treasurers are now looking at their cash and seeing what they can do to reduce it on a permanent basis not just on a cyclical basis. They might not be able to influence inventory, but they can have a significant impact on payments and collections - another driver, of course, is SEPA. I think SEPA will probably help treasurers to reduce the cash cycle, as with greater standardisation and common payment products, we’ll be in much better position to measure sales outstanding across countries. For example, today we see big differences between payment cultures in northern and southern Europe, which can be detrimental to the whole cash cycle. Secondly, with additional services linked to SEPA, treasuries will be able to obtain information much earlier in the cycle and be more proactive in forecasting in order to reduce the cash that’s left in the operations.
There was an interesting case study in the September 2007 edition of TMI of Monster Corporation, the on-line recruitment company. Monster’s US shared service centre had taken great pains to reduce unpredictability. One of the methods they used was to use payment cards for as many payments as possible. According to their bank, the best in class benchmark was 18-20% of payments using corporate cards, but Monster achieved 32% of payments using cards. The rebate alone pays all their fixed costs, with the exception of payroll. Not only is the predictability of the cash cycle greatly increased, but there’s a very tangible benefit. One problem I have noticed among companies, often those with highly efficient shared service centres, is the lack of systematic communication with treasury. Often there seems to be substantial business intelligence built up in part of the group which is not being used effectively elsewhere, for example to assist with forecasting etc. Different systems, different departments, different ownership of the process, so the potential outcomes are not always realised.
For most companies the operational activites of the business create unpredictability.
Shared service centres are, of course, valuable to many companies, and corporations which have centralised financial activities have created significant benefits to the organisation. However, when we centralise financial activities, we need to be very careful to ensure that we are not adopting behaviours that could be harmful or counter-productive to the business. We so often miss the cash on a balance sheet, ignoring it as though it is a good thing to have and comes at no cost.
Although my company is involved in a slightly different area, we are trying to maximise the efficiency of cashflow, either surplus cash or when there is a need for cash, to give access to investments or to bring cash back into the business again. This is why we are trying to increase the range of instruments available to treasurers through a single gateway rather than having to source them from different places. We focus particularly on operational cash and aim to provide as much information to treasurers as possible to inform their decision making. For example, if high liquidity is the main criteria and the yield is less important, what’s the best investment? The other thing we are trying to do over the long term is to link the portal to back-office systems so is can fulfil a decision support role, so cash forecasts can being built into investment strategies and then even trigger trading.
The way we use technology within our organisations is clearly vital to facilitate decision-making and the visibility over cash flow, trends and volatility. I think an important development in treasury technology is the increasing integration between treasury, payments and collections - more of an enterprise view of cash, so by integrating processes, it also allows integration of strategic decision-making.
Finally, I’d like to ask the panel for their advice to an organisation looking to improve the predictability of their cashflow. [[[PAGE]]]
It’s unlikely that a treasurer will be able to fundamentally change the predictability of cash flow at the operating level of the corporation, so visibility, mobility and optimisation are key. Firstly, you need visibility over what is happening at the operating level, making sure that you’re not doing anything yourself to contribute to volatility, such as concentrating payments on one day a month, as we discussed earlier. True visibility needs to encompass cash flow activities across all of your banks, all of your currencies, your geographies, your divisions. Ideally, you need a system that allows you to look at these things in the way you manage the business, not which only gives you a view of bank accounts which banks so often provide. This will help with the next important aspect, which is to forecast your cash and align your historical cash flows to help with future predictions of cash flow.
The way we use technology within our organisations is clearly vital to facilitate decision - making and the visibility over cash flow, trends and volatility.
To achieve cash flow mobility, centralise your cash as much as possible, and with multi-currency pooling, this can be done across multiple currencies and geographies. There are some countries which cannot be incorporated into a multi-currency pool, but these should be the only countries where there is any trapped cash at all, so this should then be the only cash on your balance sheet.
To optimise is about how to reduce the cash assets to a sensible level and then make use of them. What is a sensible level? That’s where the bank can help. Once you understand this, you can use instruments such as MMFs to achieve the optimum yield with the minimum risk. So that’s my message: Visualise or forecast, mobilise or centralise and then optimise your cash.
I fully agree with Mark. I would first recommend to develop an in-depth knowledge of the business operation, to understand the processes and be as efficient as possible in areas that you can influence. Secondly, we should not forget that cash has a cost so the target should always be zero cash on the balance sheet.
It’s difficult to add to that. It seems clear to me that there are currently incentives in organisations for people to engage in non-collaborative behaviours - if we are to achieve the best result for the company, those barriers have to be addressed.
I would like to pick up on one word you said - ‘collaborative’. My view is that the financial management needs to be as collaborative as possible: internally with business units; externally with the banks; between shared service centres and treasury. Treasury is not an island and the whole process needs to be as collaborative as possible.
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