Tuesday, August 18, 2015

Unlocking resources through better corporate cash management

Companies call on the full resources of their cash management, as they need to grow, execute CapEx or acquisitions.

But going an extra step gives financial managers a chance to help benefit their organization in a less-than-usual way.

The financial manager has an excellent opportunity to contribute strategically to a company's growth, by demonstrating how working capital can be leveraged to serve as a financing and risk management tool in conjunction with, or in addition to, traditional funding methods. This can help strengthen the capital plan and help improve the debt structure.

The benefits of freeing up cash to grow a company:

Reduced financing requirements
  • Existing cash is typically the cheapest form of financing. Using it to finance growth, including for CapEx or acquisitions, can reduce the external financing expense of stock or bond issuance. 
  • The cash released from
    working capital in this instance, should be valued at a weighted average cost of capital (WACC) or, alternatively, the cost of financing the growth should be included in the capital plan typically developed by the financial management team. 
  • In the example above, established working capital standards, can guide a company to release a sizable amount of cash, which applied at a well structured WACC can generate benefit for the company.

Look out for financial ratios and credit ratings
  • Credit rating agencies like D&B review company balance sheets. 
  • Rating agencies usually look upon increases in free cash flow as a positive factor during this process; however, it’s important to note that agencies may penalize companies that ineffectively manage their working capital compared to their peers.
A positive impact on company strength and valuation
  • When looking at a discounted cash flow valuation, the release of working capital that can be achieved by the company would translate as an increase in cash, ultimately improving the valuation of the company.
  • This needs to be looked at carefully and conservatively to ensure that all improvements can indeed be achieved; the finance team is in a prime position to evaluate this.
  • When using weighted average cost of capital, including working capital release in the calculation may boost a company's financials through a one-off increase in free cash flow.
  • Although working capital is priced into a corporate acquisition, the full potential of the synergies often go unrealized when the treasury team, which handles working capital daily, isn’t involved early in negotiations.
  • Working capital is often looked at with more detail in private equity deals, as it is the goal of financial sponsors to maximize asset allocation and drive quick shareholder returns.
More funds for growth
  • Cash unlocked from working capital may help a company grow more quickly, facilitating integration and reducing the execution risk from a cash flow requirement perspective.
  • Strategic events such as mergers, acquisitions, sales, reorganization, etc. provide the perfect opportunity to review the working capital position of the company. 
  • Although the review of working capital and improved management of cash may require some efforts, (improve processes, deploy new banking solutions, and change policies), uncovering these funds can sometimes can release sizable cash to the company's balance sheet.

Released cash can add up quickly

Even a one-day improvement in working capital management parameters can have a profound impact and the finance management leadership plays an important role in this.

Working capital release techniques could be bank-led solutions such as factoring, supply chain finance and card solution, or internal re-engineering such as supplier and customer payment terms standardization. A centralized liquidity structure automated at an in-house bank level can also move the needle in terms of the funding mix of long-term versus short-term debt structures.

As another internal example, larger companies execute ‘payment runs’ on a weekly or fortnightly basis. As these payment files usually are designed to have all payments processed on that same day, the company often ends up paying invoices earlier than their due date (invoices due in the following
week or two) to avoid the cost of executing daily payment runs. Changing this process so that payments are ‘warehoused’ at the bank level until the invoice due date can be a quick and easy way to release working capital, often resulting in a three-day extension of Days Payables Outstanding.

The example above illustrates how the finance manager’s knowledge of the organization’s cash flow can help establish what the achievable extension of company's days payable outstanding is, and therefore, what the subsequent reduction in the cash conversion cycle would be.

Best practices to consider
  • Involve finance staff as often as possible in to decision-making process.
  • In M&A situations finance team can propose the use of cash from working capital as a funding option.
  • Identify the focus areas for working capital release.
  • Prioritize the deployment of processes and policies, which can quickly release cash from the working capital to accelerate the funding growth.
  • Centralize treasury operations: consider using shared service centers to standardize payments flows and leverage funding from an in-house bank with automated cash concentration structures.
  • Hand off functions to banks, such as the financing of some of the strategic suppliers through a supply chain finance program, or the management of some local processes (such as payment file translations).

Note: Calculations of Working Capital used for the examples in this document follow the bellow formulas:

Days Payable Outstanding [DPO] = (Trade Accounts Payable / Cost of Goods Sold) * 365
Days Receivable Outstanding [DSO] = (Trade Accounts Receivable / Revenue) *365
Days Inventory Outstanding [DIO] = (Inventory / Revenue) * 365
Cash Conversion Cycle [CCC] = DSO – DPO + DIO

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