Credit Squeeze: How Will You Fill the Liquidity Gap?
Intrinsically, the term ‘credit cycle’ implies that restrictions on the supply of credit will come and go over time; that the wheel of fortune will eventually turn full circle. Since 2001, a combination of geo-political uncertainty, corporate scandals and internet boom hangovers has led to a circumspect attitude among borrowers and lenders alike. Forecasts vary, but many predict that the global economy will regain momentum in the next 2-3 years, confidence and profits will seep back, bringing more relaxed credit terms in tow.
But will the good times really roll back? Signs are that, for corporates, the credit market is changing fundamentally, with short-term bank borrowing going the way of the dodo. Predicted for some time, regulatory and market factors are now snowballing to make corporate lending an increasingly unattractive use of capital by banks. Given such structural changes, treasurers should not try to hibernate until the harsh winter is over, especially if what looked like winter turns out to be the beginning of a new Ice Age. Indeed, aren’t treasurers better off trying to adapt to the harsh new environment, releasing hidden stores of liquidity and providing the CFO with the information required by the guardians of that ever more scarce resource, credit?
This article looks at whether banks’ approach to credit is undergoing a fundamental shift and examines the treasurers’ response to the current credit squeeze, i.e. a renewed focus on internal sources of liquidity. In addition, it will underline the importance of achieving more accurate cash flow forecasts in order to give lenders comfort that their investment of faith and funds is well placed.
The 1990s saw a plethora of attempts to prove that modern life was so different as to spell the end of familiar concepts such as history and inflation. But in a world where even flared trousers can make a comeback, we must be careful before sounding the death knell for the credit cycle. The following issues might prove permanent or temporary, but in combination they could represent a structural shift in the corporate credit market:
Scheduled for introduction in 2007, the revised capital adequacy regime will introduce a new framework for assessing credit risk across banks’ retail, wholesale and trading books. Many larger lending institutions already employ rigorous credit risk analysis, but more consistent use of risk-based pricing by banks will make lending “more profitable” under Basel II, according to Boston Consulting Group – and more scarce for the corporate borrower. New risk weightings will inevitably force banks to make tough choices in the corporate credit market.
Although retail franchises are contributing between a fifth and a quarter of some global banks’ revenues, suggesting that low interest rates do not necessarily equal low credit revenues, the prevailing interest rate environment has led banks to redouble efforts to diversify their product range to reduce their reliance on credit income. According to US treasury and banking consultancy Treasury Strategies Inc, this trend has grown steadily for the last two decades and non-credit services fee income already makes a significant contribution to the P&L of large banks. “Banks have extended their services across the commercial trading value chain and into working capital management. The result for the banking sector has been a stable source of income that is not dependent on risk assets or interest cycles,” the consultancy asserts. “Banks have diversified their income streams, reduced P&L volatility, and increased shareholder value.” Macro-economic factors may be cyclical but, in this case, they are merely accelerating a well-established trend.
According to The Boston Consulting Group’s 2003 review of global corporate banking, loan losses “contributed significantly” to the destruction of value by 75 per cent of participants in its survey of 40 of the world’s leading banks, and to a EUR40bn decline in corporate banking revenues between 2000 and 2002. The report blamed loan losses for dragging European banks’ ROE down from 13 per cent in 2000 to 10 per cent in 2002, and even larger falls in North America. Although plain vanilla lending accounts for around 40 per cent of global corporate banking revenues, BCG suggests the cost to banks has been high: “Too many players consistently underestimated the hazards of lending to large companies and took too many risks with respect to their portfolios’ size and structure. This led to underpriced loans and a reluctance to shed clients that repeatedly destroyed value … Many underperformers will need to consider narrowing their focus by serving only selected client segments, partnering with competitors or exiting the business.”
The public capital markets have already disintermediated credit banks from long-term borrowing by global corporates. In the US, where the commercial paper market is more established than in Europe, up to two-thirds of debt finance needs are satisfied by the capital markets. Many Asian countries also have well-established domestic markets. According to Fitch Ratings, the US has 2,500 rated non-financial corporates, compared with 650 in Europe. Moreover, the introduction of the euro has not only accelerated bank consolidation but also provided an impetus for a larger European capital market. Consolidation and disintermediation are well-entrenched features of the banking sector that will continue to reduce the capacity of banks to lend to corporates.
It is too early to judge whether these trends will lead to a permanent change, but the impact on corporates is already clear. Anecdotal soundings and survey evidence suggest a greater level of importance is being attached to managing internal sources of liquidity and accuracy of cash flow forecasts. Not so long ago, banks and analysts relied on cash flow generation because P&L was considered too unpredictable; the number of inputs left the headline figure open to interpretation. Comparison of any firm’s quarter-on-quarter P&L and cash flow charts would invariably show the former to be the more volatile. During the 1990s, profits were too strong to ignore and the economic outlook sufficiently benign for banks to take a relaxed view. But this complacency has been replaced in the last 2-3 years by a perception that profit figures do not tell the whole story. Profits – and belief in profit statements – have deteriorated. Banks have rediscovered the virtue of cash flow analysis in credit assessments; accounting scandals have reminded them that free cash flow analysis is a relatively quick and easy way to establish a firm’s financial health, as only debt and equity are other, relatively transparent, inputs.
Ensuring accurate cash flow forecasting across a multi-national corporate is no small undertaking. Process, people and technology must combine to release the data that allows the treasury to make accurate funding decisions and provide the CFO with the data by which lenders will assess the firm’s financial health. Typically, cash flow forecasts are broken into short- (1-3 days), medium- (30-90 days) and long-term (180 days-three years) horizons. Short-term forecasts need inputs from operating units, but also rely on transaction and balance data from banks and are supplemented by drawdowns from short-term loans and commercial paper. Long-term forecasts are used to help plan large funding and strategic questions. As such, they include a lot of underlying assumptions, but accuracy is less important than presenting a complete picture of the options open to the firm, e.g. how best to get the funding in place to make an acquisition in a new market in the next two years?
In the middle, the medium-term forecast can sometimes fall between the two approaches, especially if supporting data is not forthcoming. But it is precisely this forecast that the analysts and banks will swarm over for evidence of financial strength and good management. Often, the key problem is that what should be a transactional-based process becomes riddled with assumptions – simply because the data isn’t there. Not only is this simply too haphazard an approach to be sustainable in the post-SOX world, it is a recipe for disaster in terms of providing lenders with accurate forecasts. Human nature alone ensures that a controller in one unit will underestimate receipts to a slightly lesser or greater extent than colleagues within the same division.
A US-based manufacturer that supplies many Fortune 500 firms grows to $10bn+ annual turnover through acquisition and rapid expansion. The growth is impressive but it comes at a cost. Operationally, the firm is left with a plethora of A/R and A/P systems that would take many millions of dollars to integrate. Financially, the acquisition campaign has left the firm with a high debt-to-equity ratio. As such, any cash flow miscalculation could have serious consequences in terms of debt repayments and covenants. When highly geared, a firm only has to miss a forecast once for the market to take a more sceptical view of the management performance and a minor cash flow problem spirals into a full-blown credit crisis.
In any firm that has grown by acquisition, calculating an accurate free cash flow forecast across all divisions and operating units is very labour intensive. A first step taken by the company in question was to have senior finance staff meet on a monthly or even bi-weekly basis to create a consolidated cash flow position based on the data provided by finance teams across the organisation. Although an improvement on existing practice, clearly this approach was too time-consuming and error-prone to be anything more than an interim solution. Questions abound: Are figures from different divisions truly comparable? What factors have been taken into consideration at a lower level? Have all operating units been working on similar models or assumptions?
To improve reliability and accuracy of data and reduce management time, automation of the process was a logical next step. Today’s real-time cash positioning and data extraction tools make it possible to ‘suck in’ A/P and A/R records from across operating units into a cash position database on a daily basis. This active cash flow database can be accessed by users across business lines who look at the A/P and A/R entries for their business then make judgements on whether they will pay or collect. Moreover, the adjustments and assumptions made at operational level can be seen at divisional level. Whereas once, senior managers might not have known what the assumptions were, now they are able to either override or agree with the assumptions made at an earlier stage. The end result is much better visibility of the free cash position all the way up the chain. The CFO is able to compare free cash flow by division or track this year versus last, even obtain a global view of debtor days A/R performance down to operating level.
When profits are at a premium and external funding a scarce resource, a firm’s ‘stakeholders’ will target P&L and cash flow forecasting data as key performance indicators. Not only does a deeper level of detail help the company tell its credit story to banks, investors, shareholders, the media etc., it can lead to better marshalling of debt facility utilisation on a day-to-day basis. If it can be seen that A/R is down 10 per cent for the period, the treasurer can make the appropriate drawdown to bring the forecast back into line. Accurate and timely data allows firms to approach banks in a proactive manner, putting facilities in place to cope with emergencies rather than making an urgent call when the position becomes desperate. Moreover, at a time when banks are under pressure to re-examine their key lending relationships, there is little doubt that a complete and credible picture is required to satisfy banks’ credit committees. And as banks prepare for Basel II’s new, tighter credit risk framework, borrowing costs are increasingly likely to be tied to rigorous credit risk analysis.
Ultimately, accurate forecasting removes the need for an often over-inflated liquidity cushion (which, in addition, may distort the balance sheet) and underpins the firm’s liquidity position with an element of certainty. Whether or not the current credit squeeze turns into a more permanent feature of the banking landscape, this surely is to be welcomed.
1 Basel II: Trouble for Treasurers?’ by Treasury Strategies Inc. Published on gtnews October 2003
2 A gtnews survey conducted in September 2003 found that of 92 per cent of senior treasury and finance professionals attached a ‘high’ or ‘very high’ level of importance to accurate cash flow forecasting.