FD Report: Go with the flow - getting to grips with cash flow forecasting

Cash is not by nature an orderly commodity for a large plc. It has much in common with the tide, washing in and out, gathering in pools here and there, running into the sand and draining back into the receding ocean of global liquidity.

“What is clear is that there has been a financial collapse and some overtrading of financial derivatives,” says David Sage, head of the global working capital group at Ernst & Young.

“Liquidity has been taken out of the market and smaller companies, where the FDs are closer to the real operational levers of the business, have reacted far faster than they did in the last recession,” he says. Everyone is now focused on cash flow. Analysts are looking for cash flow and anyone who is not impressing in their efforts at cash management is going to get marked down, he argues.

The two cash management risks at the top of the agenda today tend to be counterparty risk ­ an inevitability after the global banking meltdown ­ and foreign exchange risk. But there are other risks that are almost as important, with bank covenants and operational risk being right up there.

It’s my counterparty
Sage argues that counterparty risk, at least as far as the UK clearing banks are concerned, has settled down somewhat from the days when HBoS and Royal Bank of Scotland were both dead in the water. “The main assumption today is that the UK government, in common with the US government, cannot afford to let any major bank fail, so that means we are now looking steadier,” he says. However, since no one yet knows if this is going to be a double-dip recession, counterparty risk has to remain a serious consideration.

For Sage, the best advice to any treasurer or FD looking at a pool of cash that is going to be surplus for three to six months or longer, is to buy long-dated, inflation-proof government gilts. They are going to be expensive, but cash preservation, not yield, is the name of the game right now.

David Stebbings, director and head of treasury advisory at PricewaterhouseCoopers warns: “You certainly do not want cash collecting in subsidiary bank accounts with banks for days before you know it is there.” The Icelandic banking crash was a shot across the bows and a real wake up call for many FDs in both the public and the private sector.

“What we are seeing is companies going very short-term indeed when they put funds on deposit. The world can change dramatically in three to six months, so short-term deposits and government bonds are very much in vogue at present,” he says.

An obvious ploy to reduce bank counterparty risk is to go multi-bank. However, Stebbings points out that this is potentially counter to another good maxim, which is to avoid over-complicating, since that generates its own level of unnecessary operational complexity. “There are risks and rewards in going multi-bank. Two years ago, operational issues would have been the primary driver and that would have pushed corporates towards reducing the number of banks. Now people are not so sure,” he says.

Traditionally, counterparty risk related more to your trading partners than your bankers ­ and that risk hasn’t gone away, either. Eddie Best, a partner in Grant Thornton’s business risk services unit, says: “Understanding the financial health of those you are contracting with, or reliant upon for critical supplies, is crucial. Considering the financial position of potential suppliers and clients against this backdrop, often in the absence of timely published financial information makes management of counterparty risk very challenging for some.”

Stebbings notes corporates are increasingly referencing credit default swaps (CDSs), which are basically contracts that insure a particular counterparty against risk of loss from a bi-lateral contract with another ­ one of the instruments that proved so toxic for Lehman Brothers and the insurance giant AIG.

However, corporates are not investing in CDSs. Rather, they are using market ‘spreads’ ­ what a particular CDS contract is trading at in the market ­ to evaluate counterparty risk.

They can do this because the higher the perceived risk of default the higher the spread. So if company A, a supplier or a client, has debts that have CDSs written against them, and those CDSs start to shoot up in value, treasurers beware.

Forex rated
“Anyone who had a dollar, euro and sterling pool would have made a very significant exchange rate gain when sterling crashed, if their reporting currency was sterling. So managing your currency pool is also going to be key,” says Sage.

By the same token, companies interested in cash managing surplus millions would be well advised to invest not just in sterling index-linked government bonds, but in other sovereign debt as well. “Look for stronger economies, where the risks are minimal. You might want to consider a pool of US, German and UK debt, for example,” he says.