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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.

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