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Cash is king again!

A steady cash-flow is more important for survival, especially in a recession, than profits. Photo: Darrin Zammit Lupi.

A steady cash-flow is more important for survival, especially in a recession, than profits. Photo: Darrin Zammit Lupi.

A recent BCG report claims that many businesses can cut overall costs by 15 per cent or more without undermining their core business strength - and all within a matter of weeks. As the global downturn impacts the Maltese economy, companies will undoubtedly need to start thinking of how to improve their working capital.

It is, for instance, no coincidence that in recent months strong companies like Midi, Gasan and BOV have all issued bonds. These companies have recognised that the economic and business landscape has changed dramatically and that cash - the lifeblood of any business - is a priority. In the case of most local SMEs the issuance of bonds is not an option and they must rely on less sophisticated methods of raising cash.

Our area of specialisation is strategy (with a focus on competitive advantage) rather than finance but given the current (tough) business climate it is appropriate to dedicate an article to this topical subject.

Incidentally, I am assuming throughout this article that external sources of financing, at least in the immediate short-term, such as bank overdrafts, debt factoring, invoice discounting or issuing of shares are either limited or not available, hence the need to look inside your business for cash.

The first step for any business needing to improve its working capital in a recession should be to immediately set up an internal task force team, preferably led by the CEO. This high-powered team should immediately proceed to build a series of recession scenarios and establish a cost-reduction target for each scenario based on their cost structure.

In the consulting world this is what we refer to as scenario planning and what accountants call sensitivity analysis. The point being that you contemplate say four scenarios, from moderate to worse case, so as to understand better how your business will be hit by the recession and what costs might need to be cut and how.

The second step is to implement the relevant scenario plan in response to the economic reality your company finds itself in at the time and to be prepared to escalate your cost-cutting exercise if the situation worsens. The motivation is to find cash from within the company quickly, so as to improve your working capital (which is here defined as current assets less current liabilities).

The third and final step is to monitor the situation on a weekly basis so as to ensure that results are being reached without affecting the company's competitive position. It might help to use a three-by-three matrix in which one axis represents the "escalation level" (minimal, moderate, major) and the other axis the "time to impact" (one month, three months, one to three years). To be able to visualise the cost-savings measures in this manner really helps all concerned, from top management to front-line employees, to understand what the task force team is trying to achieve and how.

Your accountant would probably advise you that the three ways of raising cash internally and quickly, are by reducing inventory, delaying payments of trade payables and/or tightening credit control. A management consultant, on the other hand, might be tempted to approach the issue differently. Why?

Well, because cost-cutting exercises in a recession have a habit of focusing too much and too aggressively on the short term and at the expense of the medium-to-long-term competitive position of the company. Thus a management consultant might instead or in tandem, depending on the circumstances, suggest any of the following:

• Recalibrate your management's focus from the income statement (sales and profit) to the balance sheet (inventories and trade receivables/payables) and cash-flow statement (working capital). There clearly is a trade-off between sales and receivables. I was recently speaking to one of the largest local food and beverage suppliers to catering outlets, who exclaimed that if they were not "flexible" (generous) with their credit terms, customers would simply buy from their competitors. Yes, this may be true in some instances but it pays to reward those who pay on time or within your (recession) revised "X" days credit-window.

You must also appreciate that the savings, for example, made in financing your own overdraft (because more clients pay-up ontime) or from not having to invest so much time/energy to collect debts, can offset any dip in total sales revenue and more importantly improve your cash position in the process.

• Educate your sales people that there is more to sales than just making the sale. Put another way, empower your sales people to segment customers according to their ability to pay. Thus a customer with a higher probability to default should only be offered cash-on-delivery terms (even if it means potentially losing his custom) whereas a customer with a low propensity to default or make a late payment should be given appropriate credit terms with a reasonable incentive to pay early. It sounds simple but how many businesses, for the sake of not losing a sale, allow their trade receivables to balloon, not appreciating that bad debts can be very expensive and time-corrosive. It is better (especially in a recessionary environment) to collect a greater portion of your trade-receivables but from lower sales than to collect less from higher sales.

• Update your trade-receivables-and-trade-payables relationships. So if your business enjoys bargaining power with its suppliers or even its customers, and this can be ascertained by conducting an industry analysis, it should re-negotiate separate sets of relationships which improve its working capital position. For example, I can't understand why the mobile phone industry segments its customers into "post-pay" (contract customers) and "pre-pay" (non-contract customers). Surely a company such as Vodafone or Go would improve their working capital levels by rewarding customers that opt for pre-pay on a contract basis. Or even better scrapping post-pay altogether in favour of pre-pay (contract) and pre-pay (no contract) and rewarding customers accordingly. This simple (hypothetical) renegotiation of the receivables-payables relationship(s) would instantaneously improve working capital. Look at MacDonald's, the global fast food chain, they receive cash for their product but take 30+ days to pay their suppliers;

• Bankers and accountants love their current/quick ratios but these ratios can be very misleading. The current ratio is simply a company's current assets divided by its current liabilities whereas the quick ratio subtracts inventory from current assets before dividing the result by current liabilities. In practice, the closer you watch your current/quick ratios the greater the chance of facing a liquidity crisis. That's because a higher current ratio value encourages businesses to build up its trade receivables indiscriminately and in a credit crunch this may not necessarily be the best working-capital policy. Research by business academics from Insead in Fontainebleau (Kaiser &Young: 2009), when considering this very subject, quote a French consumer goods company which in 2001 announced with pride that its working capital had increased four-fold, with a current ratio rising from 110 per cent to 200 per cent and the quick ratio from 35 per cent to 100 per cent, yet six months later the company declared insolvency.

My advice is that indiscriminate cost-cutting can hurt your business even if your primary concern is to improve your immediate cash-flow. Think strategic when contemplating a cost-cutting exercise. Remember that a profitable company can still become insolvent. That is correct. A steady cash-flow is more important for survival, especially in a recession, than profits. Just imagine a starving man on a desert island having access to all the food and drink in the world but only in six months' time. If he doesn't eat quickly he will surely starve to death and well before the six months. "Cash is King" again!

Mr Fenech is a partner at FenciConsulting Ltd.

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