A Brave New Investment World

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By Chris Dark, Advisor, former President International at C2FO

Working Capital, DPO, and other liquidity indicators are vital tools for measuring the effectiveness of a treasury department when focusing on liquidity risk. Invariably a company will set targets in each of these areas at the beginning of the year and personal incentives will be delivered based on how the department performs in relation to each target.

But what happens if achieving those goals becomes counterproductive to overall company performance? As the overall economic and financial climates change, is it enough to adjust objectives or is there a need to investigate more creative solutions?

A good example is a recent shift in the banking world where banks are now charging interest rates on deposits. The cumulative effects of regulation (Basel III & liquidity coverage ratios), Quantitative Easing (FED, BoE and ECB), and negative base rates (ECB & Swiss Central Bank) have created an environment where it is too costly for a growing number of banks to hold deposits. The consequence has been that these costs have been passed down to the major corporations in the form of negative interest rates on deposits.

This has created an unusual situation in treasury departments: the normal rules of managing investment risk are based on a positive correlation of risk versus return. You would not expect the inverse: to have to pay your bank to accept the risk of your deposit. This is counterintuitive to the very fundamentals of finance and investing, although every day it is becoming more and more of a reality.

The knock-on effect of this conundrum, when applied to the bigger picture of internal finance initiatives like working capital optimization, is worth noting.

Difficult economic environments have placed a squeeze on top line revenue growth which has invariably focused equity analysts not just on their top indicator of earnings growth but on more intricate and complex metrics such as cash and working capital management to ensure a business can stay healthy during these challenging times. The consequence has been an internal focus on these indicators led by initiatives such as extending payment terms, reducing DSO, and increased efforts on controlling inventory levels. All worthy initiatives that generate improved cash flow. However, when the new reality of paying for deposits is factored into the equation, the benefits of cash generation start to erode. Questions should be asked as to the effectiveness of the overall initiative: what is the benefit of increasing cash levels if a bank is going to charge a company to deposit that cash? Are treasury departments potentially in a situation where they are incentivized to improve working capital, even if negative interest rates remove any benefit in doing so?

Some treasurers have decided that paying a bank to hold a deposit does not make sense, and as a result they have been driven into investing short-term liquidity in riskier assets. This situation is not ideal, as the exceptionally modest returns found in these riskier investments do not offset the increased liquidity risk on a company’s cash holdings.

However, there is another, rapidly emerging solution called C2FO which flips the current situation on its head and allows for significantly higher returns with no risk and still allows a treasury department to meet its objectives and personal incentives. Innovative treasurers and open-minded leadership have implemented a disruptive approach to maximizing cash returns and improving gross margins while justifying working capital initiatives. The groups that have adopted this forward thinking option have earned themselves plaudits at a board level and provided a huge benefit to their companies and shareholders. They have recognized that a significant portion of their supply chain is suffering from the rising costs of funding. By leveraging their excess short-term liquidity, these innovative and forward thinking treasurers have opened up their supply chain as a new form of risk-free investment and helped their suppliers by offering affordable liquidity that would otherwise not be available.

“Not many people get the chance to make a fundamental change in the way business is conducted. Our partnership [with C2FO] is a great example of what can be accomplished when thoughtful, ethical people are willing to challenge the status quo,” said Joe Grachek, VP Merchandise Accounting Controller for Costco Wholesale.

Naturally, there are multiple acceleration platforms that have appeared to help companies accomplish this from reverse factoring to dynamic discounting. The key to the success of any solution needs to be the long-term sustainability of the concept: in this paradigm acceptance of the model by the suppliers is vital for success. If solutions are dictated to suppliers, the acceptance will be low and narrow, and invariably the model will fail. Models with a ‘supplier pull’ structure will engage the suppliers in a long-term partnership that will consistently produce business benefits for both parties. Disruptive companies like C2FO have taken the lead with their innovative marketplace model, which has been driving the rapid expansion of their working capital market.

In the end, the key to introducing these working capital solutions is for executives to allow their teams to be open-minded and creative so innovative new solutions can be put to use and will also solve a funding problem for their suppliers.

Read The Liquidity Paradox, to see an expanded point of view on this topic.