Thursday, April 15, 2010

How To Succeed In A Brave New World

THE worst may be over. Growth opportunities are now emerging again but the environment remains volatile and the prospects for a deep and sustained recovery are still uncertain.

Capital injections by governments around the world have maintained liquidity in some key areas, but not necessarily assured us greater stability.

In this climate, some companies will succeed, but others will continue to fail. We are at a point in the economic cycle where chief executives need to consider a few key questions, one of which is – how do I fund my new business model?

Where previously there was ample capital available, now it is critical to consider whether capital is being allocated appropriately, efficiently and competently. In the new environment, the CEO cannot just rely on the CFO to answer this question and should seek to understand capital management issues more thoroughly.

It is ironic that as many companies fail on the way out of a downturn as do on the down slope. It is when things start picking up and their order books fill up that addressing working capital requirements is critical.

Typically, businesses with high volumes, low margins, high fixed costs, high costs for premises and staff, high operating gearing and highly volatile cash flows have been hit fastest in the recent crisis. At the other end of the spectrum, companies with low volumes and high margins have been better placed as they have more capacity to cut margins and continue selling.

Right capital structure
The CEO should be challenging whether the organisation has the right capital structure to match its business model. This may seem obvious, but there are many painful examples of crisis-hit companies that have failed to realise just how fundamentally their business environment has changed and how that has affected their overall capital structure and accompanying risks.

Many companies operating in Asia have complex corporate and debt structures due to the use of offshore holding companies as listing vehicles, and many debt instruments may actually have risk characteristics akin to traditional equity.

Good housekeeping on the company’s debt and equity structure is absolutely necessary. This enables the corporate executives to understand how continued weakness in business activities will affect their business revenues and potentially risk the breach of a covenant.

When bank funding was freely available, many organisations became overly reliant on cheaper uncommitted funding, relative to longer term debt, as a way to fund long-term assets.

This mismatch created problems when banks withdrew their short term lines. CEOs should be looking at their cost of funds and their net (not gross) operating margins to match pre interest earnings to meet their debt obligations.

Risk detection
While there are signs of a recovery, executives must continue to ask how continued weak performance could affect their financial positions. In cases where debt covenants risk being breached, they need to know how close they are to the thresholds.

This is another reason why executives must understand what activity drives what line in the company’s profits and loss (P&L) and to make a realistic estimate as to how this might lead to a “cash crunch”.

Financial risk detection should start with the long-term forecasting of a company’s pre-tax earnings.

This means examining the company’s back-end to understand a company’s business activities and sales records to realistically assess the firm’s P&L accounts.

This allows companies to set achievable targets, rather than relying solely on the “nice-to-have” predictions that CFOs may have derived from past data alone.

In these uncertain times, it is more critical than ever to conduct a critical or independent review of the reasonableness of the assumptions behind P&L forecasts.

To gain the maximum visibility, the cash forecasting process should involve all key business managers who are most able to influence those business activities and outcomes, such as the heads of sales and procurement, or the general managers of particular operating units.

Funding thresholds should be established, and well in advance, to enable companies to tap into various funding sources well before credit bottlenecks occur.

While there is liquidity available in the current market environment, banks are no longer prepared to lend until they have completed their due diligence.

They need to be convinced that their borrowers are able to service their principal and interest obligations and can withstand a level of continued market deterioration in case the current market optimism proves to be premature.

The notion that “success breeds success” certainly holds true in Asia’s funding world.

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