Managing working capital in times of disruption
Treasurers need to reassess their firms’ liquidity and funding needs and prepare for a wide range of potential outcomes
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The disruption to the global economy through the first quarter of 2020, caused by the COVID-19 outbreak, presents a unique challenge for finance and treasury teams. Unlike previous episodes of market stress or disruption, the impact of the coronavirus is heading into uncharted territory and may continue for some months, with implications for how organizations manage working capital and supply chains.
As the contagion manifests and intensifies worldwide, corporates increasingly face the reality of disruptions across their value chain – from procurement through to manufacturing and distribution. Moreover, certain industries are witnesses to reduced customer demand, which has a knock-on effect on cash flows and broader working capital.
Contending with the immediate implications
Restrictions on labor mobility or shortages in input components have led to the scaling back or suspension of manufacturing. To address the possibility of shortages in input materials and components, companies have sought to diversify their supplier base, while some are actively reviewing their inventory levels. Cancellation or delays in ocean shipments and cargo clearance may also amplify the disruption to manufacturing and distribution activities.
In the near term, a confluence of one or more of these factors may create a strain on working capital and necessitate higher liquidity buffers to cushion the impact. Furthermore, given the tightening liquidity situation, customers and suppliers, particularly those that are strategic or those with weaker financing capacity could also seek to re-negotiate contractual terms. This intensifies the need for treasury to focus on working capital. Achieving sales or revenue growth in this environment could very well entail longer credit terms and heightened customer and supplier credit risks.
Beyond the challenges in the physical value chain, uncertainties in the financial value chain also create funding implications. For example, the recent instances of unanticipated closures of financial markets and restricted operating hours for clearing systems, such as those witnessed in the Philippines, Indonesia and Sri Lanka, may impact the ability of corporations to make and receive payments as well as to fund and de-fund accounts.
Envisaging the imminent repercussions
When considering the medium to long term effects, the following three key aspects of the corporate value chain might potentially be revisited as an outcome of the contagion:
1. One can envisage corporates placing a greater emphasis on diversification and broadening of the supplier base to shield against the impact of disruptive events, compared to the traditional cost and efficiency considerations. Diversification or rebalancing of manufacturing capacity is another likely outcome. Companies with existing plans to relocate some of their manufacturing capacity to ASEAN as result of the US-China trade war may attempt to accelerate their relocation plans as an outcome of the contagion.
2. Another possible consequence of the recent events is that some companies may reevaluate their approach to lean inventory or the 'just-in-time' model, leading to higher working capital requirements and potentially increased capital spending on warehouses and localized supply chains to support increased inventory. Within some industries, we may also see an acceleration in technological development and adoption designed to de-risk the business model, such as through the use of 3D printing and lights-out manufacturing.
3. For some companies within sectors of strategic national importance, such as healthcare, the prospect of new regulatory actions needs to be considered, such as production quotas or stipulations on inventory levels, for example. These may also eventually contribute to an increase in working capital requirements.
Empty street in Singapore's Chinatown, due to the COVID-19 outbreak (source: asherkohyl / Shutterstock.com)
Focal role of treasury is to improve resiliency
For every organization venturing through such turbulent times, financial resilience is critical. Treasury is at the heart of this imperative and is vital to the process of identifying the projected liquidity and funding needs across an organization, liaising with financial institutions and markets to shore up external funding, and enabling subsidiaries access to intercompany funding.
Treasury can also be more actively involved in supporting commercial teams with critical decisions that have implications on working capital and risk. This could include reviewing customer credit risks, revising customer credit limits and payment terms, or adjusting supplier scoring criteria to derive better outcomes from sourcing decisions and revised procurement terms with suppliers.
To enable a diversification of the supplier base in procurement decisions, for instance, the weight assigned to various criteria used in supplier scoring may need to be adjusted, allowing for relatively greater emphasis on aspects such as responsiveness, proximity, and lead time to delivery as opposed to aspects such as price competitiveness or credit terms. The scoring of buyers may also need to be adjusted, to prioritize confirmed revenue or larger contracts over several smaller contracts. Treasury can support ongoing reviews of customer credit risks and supplier financial stability as tighter liquidity conditions pose a significantly higher risk to small- and mid-cap firms compared to their large-cap counterpart, as evident from the table below.
Figure 1: Liquidity, Working Capital and Leverage by Company Size * Includes public financial data for FY2019 of over 1300 companies in Citi’s key client base globally. Source: Factset.
Data can serve as a crucial input for treasury as it seeks to optimize both the commercial and financial outcomes for the firm through the available financial resources. Treasury should closely monitor net working capital and its underlying drivers such as days sales outstanding (DSO), days payable outstanding (DPO) and days inventory outstanding (DIO), both at the group as well as the individual subsidiary and business unit levels, to generate more working capital discipline.
Accurate cash flow forecasting is vital to treasury in its planning and management of liquidity and funding in times of turbulence. The assumptions underlying corporate cash flow forecasts should be reviewed and revised to reflect prevailing conditions, with the notion that all parties along the value chain will also aim to conserve cash. The impact of issues such as bottlenecks around shipments, vessel inspections, and customs clearance on working capital needs and cash flows should also be taken into account. As commercial and market conditions evolve, treasury should increase the frequency of its stress tests and scenario analysis to assess the impact to cash flows and estimate the headroom available using metrics relevant to credit ratings and/or financial covenants.
Figure 2: Four Components of the Cash Flow Forecasting Cycle
In cases where corporate activities such as procurement, production planning, supply chain, logistics, collections and payments, have been centralized into a shared service center (SSC), treasury can work with the SSC team to get more in-depth and proactive analytics and visibility around the order-to-cash and procure-to-pay cycle as an input to its forecasting and funding activities. Data could be used towards predicting customer payment behavior, for example. This could incorporate macroeconomic indicators (e.g. GDP growth, unemployment indices), market-specific variables (e.g. market closures, currency volatility), industry-specific factors (e.g. demand drivers) as well as company-specific variables (e.g. liquidity, working capital and leverage ratios).
Treasury should also review the available sources of financing, including credit facilities with banks at the headquarters level, along with allocations to subsidiaries. Where possible, it may facilitate a ramp-up of initiatives such as supply chain finance (SCF), in order to release cash from the working capital cycle, while extending support to strategic suppliers. In cases where the suspension of manufacturing activities and supply chain disruptions lead to a drop in the quantum of trade financing, funding through general working capital loans may be required.
While most treasuries have moved forward on initiatives to automate and streamline their processes, the digitization and automation of every working capital process, where possible, will likely be the new normal. Paper collections have created challenges given the restrictions on the physical movement of people and have lengthened the time taken to convert receivables to cash. For many, the manual processes currently in use to apply and reconcile funds received to open invoices also pose a challenge, potentially further lengthening DSO. This is an opportune moment for treasury to advance its agenda for digitizing collections in collaboration with business partners. Solutions provided by banks and treasury technology vendors that can support more automated cash application and receivables reconciliation processes should also be considered.
Furthermore, treasury should prioritize digitization and automation in the end-to-end trade financing process. For companies that are substituting suppliers or diversifying their supply chains, the speed and ease of on-boarding new suppliers onto existing SCF programs could be a key consideration. This is particularly so when market closures make the movement of signed documents challenging. Where paper documents are still in use, treasury needs to work in close collaboration with its advisors and banking partners to immediately identify and implement digital alternatives through digital banking channels to initiate financing requests, submit trade documents and take advantage of status reporting.
Transitioning into the new normal of the future
Whether the present situation drives a more sustained trend towards the decentralization or localization of supply chains and working capital needs remains to be seen. The ensuing complexity will have implications for treasury in terms of its organizational construct and in its management of associated processes. Such a scenario may drive the need for more regional or local treasury teams and resources.
If there is a counter movement from globalization towards more regionalization, corporate treasury needs to ensure visibility. The use of systems will become more important to keep an overview on cash flows, FX exposures, liquidity and funding. This can still be achieved if one treasury management system (TMS) is in place to aggregate all data at a company-wide level. When it comes to data, it is important to avoid inconsistencies resulting in incorrect decision making. Implementing and enhancing your TMS will help you get there.
Whatever the case, greater complexity will require organizations to be more agile than ever. Treasury technology and improved data will support the transition to the new normal. Speeding up the process of digitizing the treasury organization should be a top priority as it will allow the treasurer to not only react but, in some cases, even proactively change course to mitigate the impact disruptions have on their organizations. Treasury technology incorporates data with digitization to improve visibility and agility – the ingredients required to weather the storm and the storms to come in the new normal. Citi and Zanders are well equipped to provide you and your organization with the experience and expertise required to successfully fortify your treasury department.
These materials are provided for informational purposes only and are intended for institutional clients only and not as a solicitation by Citi for any products or services. The materials may include market commentary, views and/or opinions of the Citi Treasury Advisory Group, based on reasonable analysis of information available to the group. Although the content herein is believed to be reliable, these materials and the information herein do not constitute legal, accounting, tax, or investment advice and Citi makes no representation or warranty whatsoever as to the accuracy or completeness of any information contained herein or otherwise provided.
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This article is a co-production of Citi and Zanders
The authors of this article are (from left to right): Anton Abraham and Anahita Shah (Treasury Advisory Group, Treasury and Trade Solutions, Citi), Michiel Putman Cramer and Mitchell Ponder (both Zanders).