Funding discipline is the key when credit is tight

by Andre Pottas: Deloitte partner and leader of its debt advisory and securitisation services division.
A number of measures will ensure access to adequate funding through the current recession, which some forecasters predict could last for 18 to 24 months.

The days of easy credit are over and chief financial officers (CFOs) can expect to operate in a tough environment when it comes to raising new credit facilities. Required ratios of debt to equity and interest cover have become tighter, while loan covenants and reporting requirements have become more onerous.

In these volatile times, CFOs need to focus on their short-term funding requirements while positioning their organisations for a long-term financing strategy that can adapt to changing financial market conditions and enable their organisations to take advantage of the eventual upswing.

There are seven fundamental financing disciplines that are often relaxed or even forgotten in periods of extended growth, such as we have experienced in South Africa over the past seven years.

A cornerstone of sound asset and liability management and a basic tenet of banking is matching funding terms to asset maturities. UK mortgage lender Northern Rock got into trouble by funding all its long-term assets short term in the commercial paper market. The bank benefited from lower short-term funding rates, but exposed itself to high levels of liquidity risk that were not properly understood in the environment of plentiful liquidity that characterised the previous economic boom.

This resulted in a maturity mismatch, so it kept having to roll its funding, as the assets being funded were long-term residential mortgages that were not generating repayments quickly enough to meet maturing short-term funding obligations.

When liquidity dried due to nervousness over the US subprime crisis, Northern Rock could suddenly no longer raise sufficient new funds to repay its maturing funding liabilities. There were no marked credit problems or losses in its asset pool - it just got its funding profile wrong.

This is a timely reminder to South African corporates. Too many fund themselves with overnight or overdraft facilities that can be withdrawn by their bankers at short notice. Where the facilities are funding longer-term assets, such as machinery or inventory that cannot be converted to cash at short notice, this could result in the company being unable to repay the funding on demand.

The corporate will then be forced to sell its operating assets at well below market value to generate cash at short notice, or it could be forced into liquidation.

A realistic financial forecasting model, with a five-year integrated balance sheet, income statement and cash flow statement, is a necessity for every business.

Combining the model with a comprehensive ratio analysis allows management to predict trends and identify potential problem areas early on. Most importantly, a good financial model can be used to run stress tests and scenario analyses to identify the potential impact of various economic events on the business's cash resources and key performance indicators.

In the current market uncertainty, the ability to run scenarios on a number of different and inter-related assumptions is a vital tool for successful management.

It is important to ensure that the business has sufficient credit lines to provide a liquidity buffer against unexpected cash flow volatility. This allows instant access to liquidity at short notice to bridge a temporary cash shortage should a big debtor default or a large contract be cancelled.

The old adage of "don't put all your eggs (assets) in one basket" applies to liabilities as well, because a lender in a liquidity squeeze can demand repayment on call or overnight facilities and cancel unused facilities at short notice. This happened recently: an international bank closed its South African operations and withdrew all its approved unutilised facilities, leaving its clients potentially exposed.

Businesses should maintain reserve funding lines with a range of financial institutions to address this risk. This does carry some cost, as banks charge a facility fee to cover their statutory capital charge against unutilised irrevocable facilities, but it is worthwhile insurance right now.

Raising new credit facilities in this environment will require a concerted effort to work with banks and other funders to provide the additional information they require to approve revolving credit facilities. Companies should also explore alternatives to bank funding, such as private equity, institutional or private investors.

An inventory should be taken of all loan covenants in funding agreements across the organisation and a central schedule maintained, reflecting the key triggers.

Triggers should be monitored monthly against the latest year-to-date results and reported in the monthly management accounts. Graphing the trigger levels over the past 12 months will highlight deteriorating trends, which can be proactively managed well before the agreements are breached.

At the same time, the agreements and triggers should be built into the forecast cash flow model to provide early warning of any potential issues. Transparency is the new finance buzzword; early communication to lenders of forecast covenant breaches will enable a mutually acceptable solution to be negotiated before a breach.

Companies are well advised to focus on their core competencies and leave interest rate and currency speculation to the professionals. While it is tempting to leave interest rate exposures on funding open in the expectation of falling interest rates, the cash flow certainty of hedged transactions can give peace of mind in turbulent times.

Locking in foreign currency exchange rates and fixing interest rates enables accurate and predictable cash flow forecasting.

CFOs should not be nervous to use derivatives where appropriate. If used wisely to hedge existing currency or interest rate exposures, they can achieve cash flow certainty. A vanilla interest rate swap, converting variable interest rate payments to fixed payments, is a cheap, simple and risk-free tool for removing cash flow volatility.

Offshore exposures or assets should be funded in the currency of the exposure, providing a natural hedge and avoiding exposure to volatile currency fluctuations. Local banks are also hesitant to lend against the security of foreign assets, as it is difficult for them to enforce their security. Funding is thus easier to obtain in the jurisdiction where the asset is located.

Companies must cut costs and conserve cash to reduce their short- to medium-term cash burn rate, thus limiting their external funding needs. Cost reduction initiatives, starting with reducing corporate travel and other discretionary expenses, will be vital to retain sufficient cash reserves until demand returns. Controlling working capital and ensuring that inventory levels do not rise to unsustainable levels from a sudden drop in demand will be key.

Useful resources:
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