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.

On forex risk, Stebbings cautions against finance functions developing too much of a trader mentality. Keep things simple, he advises and hedge only when you fully understand why you are hedging. “Do not think about which rates are going to be moving up or down in ways that might be advantageous or disadvantageous. Think in terms of what your payments need to be made in and what your underlying exposures are, then, if the business need dictates, use straightforward instruments.

Ask the question: why hedge if, for example, you have a dollar exposure resulting from imports into the UK? There may be sound operational reasons to hedge. These might be to protect a covenant or the fact that you have an ability to change prices with, say, a six-month lag, or you can change your source of supply within the hedge period. But hedging costs money and it is not a “no brainer”, he says.

“The name of the game for FDs and treasurers today is capital preservation. This is about survival, not about making a few basis points on a deal,” he warns.

Stebbings points out, too, that FDs should also think long-term and include foreign exchange in the bigger picture when they are looking at operational decisions. A classic example, he points out, was outsourcing manufacturing to China. “That is a play, ultimately, not just on labour costs, but also on the US dollar against the pound. With the pound weakening heavily against the dollar, the cost of outsourcing to China has gone up very significantly. This was potentially foreseeable and may not alter the decision, but how many companies took it into account when making their decision?” he asks.

Alan Flower, a director in restructuring at KPMG, agrees. But he points out that FDs need to take into account shareholder expectations as well. Some transport companies, he notes, were heavily criticised for trying to hedge out the price of oil by taking forward contracts. When the price of oil fell dramatically, those deals no longer looked smart. But the companies were right to look to take commodity price risk out of the equation. They are in the business of haulage, not in the business of commodity trading ­ and their shareholders should not want to see commodity price risks playing a huge role in the share price.

Inoperative
“Working capital risk management is at the top of most boards’ agendas in the current climate,” says Grant Thornton’s Best, “with the majority making considerable efforts to understand their cost, debt and cash flow positions and looking to ensure that their working capital is being deployed in the most effective way. They are taking stock of their funding and renewal positions and considering a range of tightening scenarios and the associated contingency plans and funding options.”

He points out that management needs to understand and manage any operational commitments or outflows which may impact or breach banking covenants and pledges.

Operational line managers, for example, could sign contracts which make eminent sense in terms of their own projects and remit, but which inadvertently breach undertakings the company has made with its bankers.

Both Best and Sage agree that it is essential for corporate treasures and FDs to reach out into the operational side of the business in times like this if they want to fully understand and manage cash movements and commitments.

There may also be situations in which the company has price contracts with suppliers which contain contingent elements and clawbacks related to market variables ­ commodity prices for example. The recent market turbulence has created situations where trade creditors have moved into a receivable position and created doubtful debts as a result of market price movements. All this means the finance function has to be involved in the transactional aspects of the business and ensure that operational managers understand the financial obli gations which may impact upon their activities and decisions.

E&Y’s Sage says that of all the companies he works with, there are very few that he comes across where the treasury system is closely and robustly managed to the operational cash system. “Treasurers measure their major cash requirements, inbound and outbound, of course, but they miss the swings that occur in operational cash flows.

This side of things is just not as actively managed as one finds with major capital and investment flows.” He points out that some private equity houses are starting to raise the bar on cash management and are looking to put all their operations on rolling 13-week cash flow forecasts. “At a time like this, organisations benefit hugely from getting cash fit.

You have to have visibility and you have to get the management team engaged and operating to deliver the best possible visibility and predictability,” he says. The upshot of this is that operational risk remains something that organisations need to focus on as far as cash is concerned.

PwC’s Stebbings is another who warns that there is huge pressure on FDs to get much more accurate cash flow forecasting in place. Basically, the fundamentals are simple: understand where your cash is coming from and when you have it, manage it as effectively as possible, while mitigating risks before you spend it. Easy to say, fiendishly complex to execute.