Much has been made of a “wall of refinancing” in 2013–15, when a huge volume of debt issued in the pre-crisis years, often on favorable terms, will become due. According to the credit rating agency Standard & Poor’s, companies around the world will need to refinance existing debt of as much as US$46 trillion over the next five years.
And, although many banks are on a more secure footing than they were at the height of the crisis, there are doubts about the availability of sufficient funding to meet these demands. This suggests that there will be an abrupt rise in the number of restructurings, although the steady process of de-leveraging that has taken place in the corporate sector over the past few years has reduced this risk somewhat.
But cash can still be found, either from within or without.
Simple changes to internal processes can make a big difference in reducing cash requirements and improving working capital management. For example, a company may establish a more aggressive and systematic “follow-up process” for contacting customers who are late in settling payment
Despite the acute practical difficulties they face, there are several important steps that CFOs of cash-starved companies should take. Although many will already have spent the past years seeking out efficiency improvements and cost-cutting opportunities, there is potentially more that can be done.
Improvements to working capital management, increased tax efficiencies, and operational changes to the finance function can all be important sources of additional cash. And, to increase their chances of obtaining finance, CFOs must also ensure that they have strong relationships with finance providers and that they communicate regularly with them, even if the news is not always good.
Cash-poor companies may need to make more fundamental decisions about their business model, and adapt it for a low-growth, low-cash environment. We explore some of the options that are available for cash-poor companies, and examine the role of the CFO in enabling these changes.
Build trust with banks
Although overall credit conditions remain poor, particularly for SMEs, banks are still willing to lend to companies with the right management team, strategy and processes. CFOs of cash-poor companies may have to work harder than ever to convince banks to finance them, but the funding is there for companies that have the right story to tell.
For Caroline Ross, Director of Ernst & Young’s Key Executive Program, this starts with having a transparent, open relationship with banks. “You have to maintain a very close dialogue with banks and ensure that there are no surprises at any time,” she says. “It’s essential to have absolute clarity on the numbers and to be able to communicate that regularly to finance providers.”
If problems are looming, Ross advises CFOs to anticipate them and communicate the situation as early as possible to the banks. “Don’t just say ‘We’re going to run out of cash,’” she says. “Tell them you have a seven-month window, that you’ve done your numbers and set out what you plan to do to rectify the situation.”
By ensuring close dialogue with the bank when trouble flares up, a CFO can explore the possible options more clearly. For example, it may be possible to negotiate a covenant holiday, or explore whether there are some alternative financing arrangements, such as equity, private placements or mezzanine finance, that can be brought into play.
Move operational working-capital improvements
Very often, the steps that companies took in the immediate wake of the crisis were short term and tactical in nature, and often designed to ensure that the balance sheet looked strong at a particular point in time.
“Companies were in panic mode and, for many, the crucial thing was to ensure at particular crunch points — say, the end of the financial year — that they could manage their balance sheets to achieve the cash performance that they needed,” says Jon Morris, EMEIA leader of Ernst & Young’s Working Capital Services. “So they would pay suppliers late, run stocks low and do deals with customers to get money in early.”
Morris argues that companies now need to adopt a more strategic stance. “Companies have realized that these tactical changes to working capital take a huge amount of effort and often don’t actually lead to better earnings.”
Simple changes to internal processes can make a big difference in reducing cash requirements and improving working capital management. For example, a company may decide to establish a more aggressive and systematic “follow-up process” for contacting customers who are late in settling payment.
They may reduce the time lag between steps in the follow-up cycle, or make calls before a debt becomes due. More fundamentally, a company may decide to shift to a global procurement model or create a shared service center to manage the company’s entire payables requirements.
Companies should pay careful attention to the processes that they employ in the tax department, as this could unlock savings that have previously been ignored. Even a simple miscoding on an invoice or expense form can lead to significant tax inefficiencies
Turn to the tax department
Tax is no longer an island. There is a growing acceptance that stronger links need to be forged between the tax function and the business to optimize the company’s tax position and uncover inefficiencies.
“Although it is below the line, tax has an immediate impact on cash,” says Herwig Joosten, Managing Partner Tax at Ernst & Young, Belgium. “As a result, CFOs are increasingly pushing tax directors to manage cash taxes and generate up-front benefits, and many of their KPIs are being established around these goals. There are a range of possible approaches that may unleash some of these benefits, depending on the company’s specific circumstances.”
Cost of sales accounting. One approach that may yield benefits is to look at the way in which the company accounts for its cost of sales. Depending on the approach to pricing used, companies may be able to allocate their costs into the cost of sales, which will reduce the gross margin and therefore reduce tax costs.
Companies should also determine whether indirect expenses, such as research and development (R&D), need to be capitalized, and accounted for as an intangible or an up-front cost. “By looking at these types of choices, you can bring forward cash inflows based on the tax treatment of these expenditures,” says Joosten.
“It is essential, however, to discuss this with your auditor and tax advisor to determine the positions that are appropriate to take.”
Sale and leaseback of assets. A second approach that cash-poor companies may be able to take is the use of a sale and leaseback transaction. Gains generated from these types of transactions may be able to be offset by net operating loss carry-forwards (NOLs).
Specifically, a company that has NOLs might be able to sell its assets (usually movable rather than immovable) to a related party in the group that is currently subject to tax, which then leases them back.
“Cross-border leasing becomes particularly interesting if the qualification of the lease as a finance or operating lease differs between the lessee and lessor jurisdictions,” says Joosten. “For many years, cross-border leasing has been a way to accelerate positive tax cash flows or defer negative ones.”
Tax credits and incentives. Companies involved in R&D, or that have large intellectual property assets, will probably already be aware that many countries provide tax credits or incentives that encourage investments in innovation.
There are now so many programs available that it can be difficult for even the largest companies to keep up and ensure that their tax position on these investments is optimized.
“The savings that are possible from the use of these regimes are considerable but very few companies know about all the possibilities, particularly when you include subsidies as well as credits,” says Joosten. “We see a considerable amount of interest among our clients to explore the available options and take advantage of them appropriately.”
Going back to basics. Companies should pay careful attention to the processes that they employ in the tax department, as this could unlock savings that have previously been ignored. Even a simple miscoding on an invoice or expense form can lead to significant tax inefficiencies, particularly if it is repeated many times.
A review of these processes to spot mistakes or incorrectly followed processes can help to uncover problems and eradicate inefficiencies.
Customs duties are a good example of this. A common problem is that the responsibility for these duties may fall between the cracks — tax directors may not know how much duties are paid because they do not see it in their account, while the business units do not see tax affairs as their responsibility.
The result is that major inefficiencies can quickly creep in, particularly when measured over a long period of time.
“Looking at customs duties is a quick win because you often find that there is no one in the company looking at this,” says Joosten. “Simple changes, such as changing the importer of record, or revising the way in which products are categorized when they are imported, may make a big difference to the amount of customs duties that you pay.”
Explore non-bank sources of debt
Put simply, the banking sector will struggle increasingly to meet the demand for credit in the economy. This is because it needs to de-leverage and because it faces more stringent regulation, which is aimed at strengthening the capital position of the sector as a whole.
“Under the new Basel rules, banks will be unable to lend profitably relative to the amount of capital that they have to hold against certain categories of loans and risk weighted assets,” says David Barker, Head of Transaction Advisory Services for Financial Services, EMEIA at Ernst & Young.
“If you’re having to pay 7% or 8% for your credit, plus putting a bit of equity on top, then you’re getting to a weighted cost of capital that is significantly higher than 10%. There are not many investment cases around that show a return of greater than 10%"
So who will step in to fill this funding gap? In the past couple of years, a number of different non-bank sources of finance have started to emerge, including private equity, asset managers, pension funds and even sovereign wealth funds.
These institutions are establishing a range of different business models, including setting up their own lending operations, or establishing new collective investment vehicles and other platforms that can make lending decisions on their behalf.
Private equity in a new form. Many large private equity firms, including Blackstone, Bain Capital and KKR, have also set up credit businesses over the past few years to provide lending to companies in need of greater financial flexibility.
Rather than simply replacing the role of the banks, however, private equity firms will seek to use their deep industry and financial expertise to have an influence on the business and place it on a stronger operational and financial footing.
“These firms have seen a gap in the market and believe that they can do a better job than what is currently offered,” says Sachin Date, Ernst & Young’s EMEIA Private Equity Leader. “This is part of a broader trend whereby the biggest firms are transforming themselves from pure play private equity funds to multi-asset managers.
Peer-to-peer lending for micro-businesses. A range of internet-based, peer-to-peer lending services aimed at the very smallest companies have also sprung up, along with innovative services for advancing cash against invoices, and crowd-funding” initiatives that enable money raising from multiple small investors using online channels.
Taken together, these may not fill the funding gap outright, but they do represent an important shift in the provision of credit and an increasing disintermediation of the banking sector.
Private placement market. In Europe, “the private placements market is booming at the moment,” says Barker. “A lot of European companies have dollar needs and this is one way in which they can fulfill those requirements at a time when European banks have been reluctant to extend credit as dollar lenders.
Dougald Middleton, Ernst & Young’s Head of Lead Advisory Services, UK & Ireland agrees. “Private placements have become an important source of longer-term debt capital. We have helped clients in a range of sectors raise over US$2 billion in the private placement market.”
Private capital fund. In recent years, a number of large institutional investors, including Axa, M&G and Alliance Bernstein, has set up private capital funds that lend directly to corporates. Other pension funds and insurance companies, whose business models have suffered as a result of record low interest rates, are also stepping into the market in search of yield.
This market represents a good opportunity for these institutional investors to secure a good return, which may be in the region of 8% to 10%. For borrowers, the market offers a lifeline at a time when many find it extremely difficult to access bank finance.
Shadow banking. Middleton emphasizes that the high costs of tapping the non-bank market for credit mean that any company choosing that route needs to be confident that it can achieve a significant rate of return.
“If you’re having to pay 7% or 8% for your credit, plus putting a bit of equity on top, then you’re getting to a weighted cost of capital that is significantly higher than 10%,” he says. “There are not many investment cases around that show a return of greater than 10%.
Taking matters into your own hands. In recent years, a number of small private companies, including the UK’s King of Shaves and Hotel Chocolat, have launched their own retail bond issues that primarily target customers. Hotel Chocolat has raised £3.7 million from a three-year “chocolate bond,” which pays a return in chocolate to members of its tasting club.
Rethink the supply chain and business model
Uncertain patterns of demand and a volatile economic environment have increased the need for close collaboration between suppliers and their customers. Traditionally, suppliers have been unable to get a clear picture of demand, because the end customer will not deal directly with them.
To address this lack of visibility, many suppliers and customers are now working more closely together in order to understand when peaks and troughs of demand might occur. Suppliers to a supermarket, for example, may request point-of-sale data on the products that are being sold, so that they have a better picture of demand and how it is changing.
Companies can make structural changes to the way in which they conduct business with suppliers and customers. This might include changing customer and supplier commercial frameworks
“If companies can think of themselves as being part of an overall supply chain rather than focusing on their own internal issues, they will be much more efficient at predicting and managing demand,” says Morris. “Visibility and collaboration are very important drivers of improvement.
Review business model. At the most fundamental level, companies should look at their business model to determine whether it could be changed in such a way that it improves their working capital position permanently.
Consider the difference between a manufacturer that sources all its products from China, and one that sources them closer to home in Continental Europe. The company that sources from China may benefit from lower input costs, but the physical distance usually means that inventory holdings are high due to longer lead times, higher minimum order quantities and the low order flexibility, which leads to buffer stocks.
By contrast, the company that sources from Continental Europe may pay slightly more on its input costs, but can get its goods to market more quickly, with more flexible ordering systems and hence lower levels of working capital. “Thinking through different fulfillment models can completely change the amount of cash that you need in the business at any one time,” says Morris.
Improve commercial frameworks and processes. Companies can also make structural changes to the way in which they conduct business with suppliers and customers. This might include changing customer and supplier commercial frameworks so that, rather than billing on delivery of goods or services, the supplier stipulates part-payment up front.
It also includes fundamental changes in the way that key working processes operate. “By changing your operating processes to be more effective from a cash perspective, you carry out structural changes, which reduce the need for working capital,” says Morris.
Review asset performance regularly. Cash-poor companies may need to take a close look at their portfolio to determine whether there are any assets that could be offloaded to free up cash and improve performance.
Robin Jowitt, Partner for Telecoms, Media and Technology and Pharmaceuticals M&A, Ernst & Young, advises that companies should put in place a structured, systematic approach to reviewing the portfolio to determine which assets are working and which are not.
“Raising cash in order to be able to use it in more effective areas ought to be at the heart of everybody’s agenda, and therefore selling subsidiaries makes sense,” he says. “Every company ought to have a process for reviewing the returns from each area of the business, to make sure that each asset continues to be consistent with overall strategic goals.”
“If it’s not, or if it’s not performing in the way that it should, then companies should consider churning it and using the money more effectively elsewhere.”
Manage your timing to manage perceptions. Companies that leave it too late to sell an asset, and that do so only for liquidity purposes, may create a perception that they are selling a distressed asset. This can lead to a negative reaction in the markets and also make it difficult to realize an expected valuation.
“Selling out of distress is too late and companies ought to be thinking about their portfolios and planning disposals well in advance,” says Jowitt.
About the Author
Ernst & Young is a global leader in assurance, tax, transaction and advisory services. This article is an excerpt from “Drought or Drowning? Cash Challenges for CFOs at Both Ends of the Liquidity Spectrum,” which is Volume 4 of The Master CFO Series. It has been re-edited for clarity and conciseness. © 2015 EYGM Limited. All Rights Reserved.
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