Introduction: Cash is King, Cash is also Risk
No other phrase has encapsulated the business environment more in the last decade than the mantra “Cash is King,” and for good reason; without cash, companies cannot pay their employees, suppliers or investors. The corporate roles of treasurer and cash manager have specifically developed to manage cash and to ensure that companies can meet their obligations as they fall due.
But that’s only half of the story. Cash is certainly a critical corporate asset, but it also creates risks. These risks have to be managed. This is nothing new to corporate treasurers, where the need to manage the operational risks around cash drive every cash process or bank selection.
Managing liquidity is clearly a critical part of a treasurer’s role. The question is therefore whether it is possible to perform this role better by focusing more on risk. After all, if it is best practice to align risk and return when setting the broad business strategy, isn’t it appropriate to do so within the treasury department too?
Focus on Risk to Achieve Treasury Objectives
The key is to focus on group risk rather than the operational cash. By prioritizing risk, treasurers can analyze the requirements needed to help deliver the business strategy, identify the exposures that may hinder that, and take measures to mitigate or eliminate any risks.
Support Growth
For growing companies, a strategic risk focus is very beneficial. A simple company (one with few entities within a group, operating primarily in its home market) might find its liquidity management structure is easy to operate. Its liquidity management policy and procedures should protect against operational risks, such as error and fraud, and ensure cash is captured and reconciled effectively. If this is the case, information will be easy to collate and risks relatively straightforward to identify.
However, once a company grows beyond this, by operating via multiple legal entities, or in different countries and currencies, then the risks associated with each cash flow or bank account balance can escalate quickly. Two critical variables are introduced in this situation. First, multiple bank accounts mean it becomes more difficult to collate group cash positions and to use group cash to support the wider business. Second, volatility in foreign currency means it is no longer possible to firmly calculate the value of all balances in the operating currency, representing a risk to the company’s ability to meet its obligations. It is clear that there are risks associated with expansion.
The problem for growing companies becomes the inadequate ability to analyze, and therefore manage, these risks. In effect, the operational focus on cash management (rather than a focus on group risk) can act as a constraint on expansion.
Get Control over Data
The task then is to identify how a treasurer can achieve control over risk while the company’s liquidity management structure changes. Broadly speaking, the treasurer needs an understanding of three interrelated factors to operate effectively. These apply no matter how complex the organization becomes:
- Daily group cash position
Automation of data feeds from multiple banks has made this task much less challenging than it used to be. However, treasury still needs a tool to collate the various data feeds. This also assumes that treasury knows where all group bank accounts are held, which is not always the case, especially in complex organizations that have grown through acquisition. - Future cash requirements
The cash position needs to be joined with the group’s forecasts and estimates of both cash inflows and outflows to identify future cash requirements. Does the company have, or have access to, sufficient cash to meet these requirements? Is there sufficient headroom in the company’s credit facilities to meet any shortfalls? Is invested surplus cash available (i.e. not locked in a fixed-term instrument)? How accurate are these forecasts and estimates? - Exposure to market risk
Finally, the treasurer also needs to know how sensitive both these calculations are to market changes, keeping in mind that some positions may naturally offset each other. How will a change in an exchange or interest rate affect group cash flow? Is invested cash readily available and protected against counterparty failure? The treasurer will want to ensure that they understand the risks to be able to take any necessary action.
Analyze Data
To do this as accurately as possible, companies need a centralized view of cash, ideally in real time. Without that, it is impossible to get a full appreciation of the company’s risk profile.
Once data is centralized, there are many different ways it can be interrogated, as long as the company has a tool to do so. From a liquidity management perspective, three elements are particularly useful:
- Cash forecasts and estimates
One of the challenges for any treasurer is gaining a clear view of the anticipated cash positions, both immediately and for the foreseeable future. This requires data feeds from partner banks and subsidiaries so that the treasurer can develop forecast cash flows and positions and transition them into firmer estimates (as the timing and value of these forecasts become more certain). - Stress tests
Centralized data also allows treasurers to perform more meaningful stress tests. These enable the company to assess the implications of a wide range of market factors (not limited to changes in interest rates or exchange rates) on the company’s cash positions. Such tests help treasurers identify where natural internal hedges exist and where they may need to hedge unmatched exposures. - Facility room
These tests will also help to identify when and where the company has surplus capacity within its credit facilities. No company wants to find out it does not have room in any of its facilities in times when it urgently needs more liquidity. A centralized view will help the treasurer rationalize the use of facilities in two key ways. First, it will highlight how the group can use internal liquidity more efficiently, cutting down on excess simultaneous investing and borrowing of cash. Second, greater information about future cash positions will help the treasurer plan the use of facilities, reducing associated fees and interest at the same time.
Use Risk Analysis to be Strategic
The analysis allows the treasurer to answer two key questions:
- Does the company have, or have access to, sufficient cash to meet current and future obligations?
- How can liquidity management processes be made more efficient? As long as the treasurer is confident obligations can be met, the analysis also provides an opportunity for the treasurer to consider how to use resources more effectively, in order to reduce costs and to generate a better return on capital.
Optimize Liquidity Management
With the ability to take a strategic approach to liquidity management, treasurers can focus on a range of issues, all of which have potential benefits. A centralized view of cash across the business will help treasury understand the relationship between cash flow and risk. Treasurers will be able to fund intercompany loans from surplus cash and to use the identification of natural hedges to minimize the use of external hedges. They can also plan more efficiently for any external borrowing or investing.
The centralized cash and risk position allows the treasurer to be more proactive and to standardize processes. Developing tools to assess the risk impact of different types of cash flow to ensure that any hedging activity is effective is key. For example, treasurers will not want to hedge contingent liabilities (such as foreign currency cash flows arising from a yet-to-be-awarded tender) via a forward. Similarly, advance knowledge of future cash positions will help the company make funding or investment decision more quickly and more efficiently.
Support the Wider Business
The final benefit from a focus on risk is that it enables the treasurer to add value to the wider business.
Treasury always has to report up to the CFO and the board. Access to consolidated data ensures compliance with corporate governance regulation and provides confidence to the board that they have oversight and control. More detailed consolidated views of cash and risk can also help management and the board develop business strategy, such as by giving early identification of downturns in a core market.
This centralized data will also help treasurers support the business units. On one level, while business unit requirements tend to determine the liquidity management structure (except in the most centrally controlled organizations), treasurers can in turn help the business units rationalize their bank accounts to make it more effective.
More importantly, treasurers can use the insights from their centralized analysis to help the business units understand their exposures and risk factors more clearly. The analysis can help business units track customer payment practices to help them manage their credit policies. It can also help business units with local pricing, perhaps by helping them to understand their sensitivity to exchange rate movements.
Conclusion
Treasury technology provides the tools for treasurers to obtain a centralized view of cash and risk in order to manage these positions efficiently. With a primary focus on risk, treasury can be strategic, supporting company growth as liquidity management structures change and the development and implementation of overall business strategy.