Originally published in the Credit Research Foundation 2Q 2019 CRF News
Balance sheets don’t simply add up; they reflect an intricate balancing effort.
Numerous ratios and key performance metrics must be individually managed. As quarter ends approach, managing the balance sheet combines proactive foresight with reactive moves that require all tools in your toolbox.
Treasury, FP&A, and Controller professionals have ever-increasing expectations placed on them to manage balance sheets for both the short-term and the long-term. Increased complexity in global trade, an intensely competitive environment, aggressive activist shareholders, and volatile markets set a “new normal” for tight management of the balance sheet in any year.
Add to this the political whiplash that happens when a tweet rocks markets, and the credit team now operates in an environment of volatility on an almost daily basis.
From this macro perspective, expectations are high. The credit team must have the foresight to synthesize trends, market movements, and competitive actions and plan accordingly, always balancing multiple causes and effects.
That said, the company’s needs raise the stakes even further. New product launches, increases in raw material prices, promotional inventory, raising (or falling) interest rates and cost of debt, and manufacturing snafus can have an impact on the entire supply chain. All of this has an impact on the balance sheet that requires fast reaction to maintain control.
And it doesn’t stop there: From an Accounts Receivables (A/R) perspective, global payment terms and customer receipts delays are lengthening, according to Atradius’ Payment Practices Barometer. These changes have led to an increase in the average payment duration by 13 days for U.S. businesses.
That’s a lot to keep steady.
The Need for Flexibility and Control
Given these external and internal forces, customer receipts remain a variable that is at times very challenging to accurately forecast and control.
This is often because customers are under the same pressures your company faces, thus creating a global economic environment of longer payment terms that become the cost of doing business.
This “cost” shows up on the balance sheet as increasing DSO and aging A/R values, causing businesses to wait longer for sales to convert to cash. Fortunately, there are tools to put the cash conversion cycle back in control.
Story of a Quarter End
The credit team is required to effectively manage the balance sheet on an ongoing basis, and KPIs are measured daily, monthly, quarterly, and annually. In a public company, however, there’s a “heartbeat” from quarter to quarter that requires consistent flexibility and control.
Consider Erik, a Controller of a global manufacturer based in Chicago. His role is tied to many facets of the company and he needs to make sure their financial performance is managed as smoothly as possible.
This means managing shareholder obligations, maintaining a conservative debt-to-asset ratio and improving their cash conversion cycle metric. As a global company, the impact of recent tariffs – with potential for more in other regions – continues to put him in a defensive position in cash management and forecasting.
Start of Quarter
Erik creates a forecast that includes A/R that will be realized as cash at quarter-end. He has multiple tools at his disposal, including asset-based lending, factoring, supply chain finance, and dynamic discounting.
Day 28: Tariff Threat
Recent U.S.-based political actions increase the threat of a new tariff on his company’s raw materials. Erik needs to increase inventory ahead of the cost increase to protect profitability. The tradeoff is a reduction in working capital and free cash flow balances are reduced. At this point, all tools remain available, but timing is tight.
Day 65: Shareholder Dividend
The company announces a shareholder dividend that is above Erik’s forecast. Asset-based lending and supply chain finance are unlikely tools to cover the additional cash needs to hit projections by quarter-end.
Day 86: Customer Receipts Risk
Key advance customers have requested terms extensions to manage their own cash flow. Risk is increased that A/R will not be converted to cash by quarter-end as planned. Tools are limited to address their needs. Erik’s key metrics are in jeopardy.
While this example is a microcosm of any large, complex organization, Erik’s story is all-too-common: impacts to working capital and cash metrics seem inevitable as the calendar rolls toward end-of-period financial reporting.
Working Capital Certainty in an Uncertain Climate
Flexible and convenient solutions for monetizing customer receivables should be a part of any finance professional’s toolkit. A toolkit enables the credit team to proactively manage the financial impacts of the evolving complexity of external economic factors.
Whether the objective is to support a range of strategic cash needs-driven off events like M&A, dividend hikes, share repurchases, or even debt repayments, the subsequent impacts of cash output can be offset through negotiated arrangements or on-demand acceleration of customer receivables.
If time allows, using tools with favorable rates such as asset-based lending, invoice discounting, and supply chain finance may be the optimal approach. While the dollar costs may be low, the tradeoffs are significant effort, time, and the potential for unfavorable impacts on debt ratios or covenants. Indeed, debt covenants may restrict these tools from the credit team altogether.
Factoring provides a greater degree of flexibility and it can be a useful tool to accelerate A/R without incurring debt. While the net working capital may be less than forecast, factoring may provide enough cash to cover obligations, such as Erik’s need to offset the increased inventory due to the tariff threat. The tradeoff here is a “one size fits all” discount across multiple receivables, potentially leaving profit on the table; plus the time involved in underwriting the receipts to arrive at – and negotiate – the right discount.
Dynamic discounting is a simple, technology-driven solution that provides the ability to offer discounts on invoices in exchange for early payments from customers, and access receivables finance for the rest. It requires no underwriting process or contracts, and no third-party financial intermediary. Because it’s a debt-free tool in an on-demand solution, it provides greater flexibility and control to convert outstanding receivables to cash on hand.
Simplicity, Complexity, and Balance
Just as a professional craftsman knows which tools to use for which job, the credit team must choose the right tool for the task at hand. This requires a deep understanding of each tool’s uses and tradeoffs, plus the team’s desire for flexibility and control when and where it’s needed.
For Erik, choosing one tool, say factoring, allows him to master the underwriting and negotiating process and ultimately streamline the overall factoring process. The payoff is greater simplicity and speed in that process.
Conversely, using a broad array of tools – especially in combination – may be best to address the complexity of global operations and a wide array of metrics. This requires a high degree of coordination and advanced modeling to finesse the relationships between tools and metrics.
In practice, Erik will likely look for a balance: He will choose tools that balance dollars with discounts; control with flexibility; terms with speed; and foresight with action. Simply put, he will choose the right tool for the job. And while an academic could model a slightly better way, Erik needs to get the job done now.
Early in Quarter (or Annual)
As macro trends such as interest rates, inflation, and sales forecasts tend to move slowly, Erik may deploy asset-based lending to secure the most favorable rates. In this juncture, he has the luxury of time to model and negotiate the terms that best meet his needs. That said, other tools such as factoring and dynamic discounting remain available if needed.
The tariff threat on Day 28 required Erik to increase inventory purchasing ahead of cost increases. Erik may choose to cover this cash need though supply chain finance (i.e., reverse factoring) that allows him to choose invoices he will allow to be paid earlier by the factor. Because it is Erik’s company’s liability that is engaged, he receives a more favorable discount than if the supplier had given it on their own.
As time gets tighter, Erik may move to dynamic discounting as it provides flexibility and control at the same time as speed. While dynamic discounting is not limited to late-quarter needs – indeed, the same benefits are available at any time – it’s ability to navigate exposure ratios and covenants, and help achieve critical key performance indicators and metrics, make it especially appealing.
From Markets to Microns
“Doing more with less” has been the mantra in business for years, and credit teams are no different. Managing balance sheets involve an understanding of global markets, macro-economic and macro-industry trends all the way down to the smallest units of manufacture.
A hyper-competitive environment and cross-functional internal demands mean credit teams must understand and deploy a host of tools to effectively manage ever-increasing metrics tied to their company’s performance.
And with greater shareholder transparency and scrutiny, higher expectations are part of the game: credit teams must deliver to survive.
Suneel Chirunomula is Managing Director of C2FO, a provider of working capital solutions, serving a broad array of global clients. You can contact Suneel at email@example.com.