Consulting in financial management

14.3 Working capital and liquidity management

In order to survive, an organization must be able to meet all its commitments as they fall due, i.e. to pay its bills on time. The efficient management of working capital, therefore, and particularly the provision of adequate levels of liquidity at all times, are crucial.

Definitions

Accountants define working capital in accounting terms as the difference between current assets and current liabilities. This is a static approach, and not a very useful one. Liquidity – the ability to meet commitments and to pay bills – comes from the availability of cash. A company could have considerable working capital in the accounting sense (because of very large inventories) but no cash, and thus be on the point of insolvency. The approach taken here will be based on cash flows rather than on accounting concepts. One of the most useful services the consultant can perform is to educate the client to think, and to plan, in cash-flow terms.

Working capital and the operating cycle

Every manufacturing business has an intrinsic operating cycle, in which materials are purchased, stocked, converted into finished products and finally sold. Even service industries have such a cycle, though its duration is shorter. Cash flows out of the organization when purchases are made, and returns when accounts receivable are collected. Consultants can help clients to understand their organization’s own unique operating cycle, and to find ways of increasing operating efficiency so that the cycle is shortened and cash is conserved. In most organizations, improvements of 25 to 40 per cent in cash utilization may often be made simply by careful analysis and the application of common sense.

One of the factors that the consultant should remember (and one of the advantages he or she has over the banker or the accountant) is that the changes leading to improvements in cash utilization are as likely to be in production or other operating areas as in purely financial ones. Improvements in inventory control leading to a reduction in average stock levels, and improvements in quality control that reduce wastage and scrap, will reduce the cash tied up in the operating cycle just as effectively as an improvement in collection of accounts receivable, or an acceleration in the transfer of funds from remote locations to a central concentration account. The very fact that most managers working in non-financial areas do not fully

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Managing cash

While the entire operating cycle has cash-flow implications, the management of cash itself should not be overlooked. Here, the banks are indeed the experts, and most major banks have actively developed and marketed cash management systems in recent years. The consultant can play a useful role, however, by assisting the client in evaluating the bewildering array of different packages, in which the banks offer combinations of concentration banking, lock-box collection systems, remote disbursement, zero-balance accounts, intra-group payments netting, and so forth, and in finding a solution appropriate to the client’s needs.

14.4 Capital structure and the financial markets

Every business organization needs an adequate capital base to support its operations. It has been repeatedly demonstrated that operating a business with inadequate capital – which in British financial circles is called “overtrading” – is one of the most widespread causes of business failure. In addition to having adequate capital, the business must have an appropriate capital structure: the right mix of equity funds and debt. All of this is easily said, but difficult to achieve in practice.

Determining an effective capital structure

A major portion of current financial theory is concerned with the capital structure of companies and with the effect of long-term financing decisions on the cost of capital to the organization. Most of the theory is based upon assumptions that do not reflect reality, however. In addition, the theory is usually expressed in a highly quantitative form. Once again, a consultant who is conversant with the current financial literature can play an invaluable role in helping clients to identify the usable and useful concepts that are now beginning to emerge from this mass of theory.

The management of an organization’s capital structure actually involves a twostage decision process. The first task, when any new financing operation is proposed, is to review the organization’s current capital structure in the light of management’s policies, accepted debt/equity ratios, market conditions and, most important of all, expected cash generation and use over a period of some years. The consultant’s help can be invaluable here. On the basis of this analysis a decision can be made whether to seek new equity funds or additional debt. Once this is complete, the second stage involves the determination of the exact type of security to be issued, the selection of underwriters, the pricing and timing of the issue, and so forth. These second-stage decision areas are the distinct professional field of the investment or merchant banker, and the general consultant should ensure that the client seeks such specialist services at the appropriate time.

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Consulting in financial management

Using debt funds

There are great advantages to using debt funds: judicious amounts of debt increase the earnings per common (ordinary) share through the leverage effect, and the fact that interest charges are tax-deductible makes the net cost of borrowed funds relatively low. In general, debt financing will be the first choice if the company can safely add the proposed new borrowing to its existing debt. The key task in capital structure management, then, is to determine the company’s debt capacity. There are many possible approaches to this question, but few of them are fully satisfactory. Policies that allow some external standard or institution to determine the decision (for example, keeping a debt/equity ratio more or less equal to the average for the industry, or limiting borrowing to what can be done without lowering the rating of the company’s debt securities by the rating agencies) are unlikely to produce optimal results.

In most cases, the consultant will face a difficult task in this area. He or she will have to re-educate clients away from rules of thumb, and convince them that nothing can replace a systematic analysis. The ability of a company to use debt depends upon its ability to service that debt, i.e. to meet all interest charges and repayments of principal as they fall due. This in turn depends upon cash flows.

The importance of debt management was brought into sharper focus by the experiences of many companies during the recession of the early 1990s. The period of rapid growth in the countries of the Organisation for Economic Cooperation and Development (OECD) during the period from 1985 to 1989 was characterized by an unprecedented increase in both corporate and consumer debt, particularly in Japan, the United Kingdom and the United States. The reasons for this were complex. Although strong growth in output (over 4 per cent in 1988) gave rise to an upsurge in capital investment, conditions in the capital markets made many companies reluctant to issue equity. A particular factor in the United Kingdom was that the large privatization issues, all of them somewhat underpriced, tended to squeeze corporate issuers out of the equity market. In consequence, the average “gearing” or leverage of the British corporate sector doubled between 1987 and 1989. The economic slowdown after 1990 therefore caught many United Kingdom companies with unprecedented levels of debt. Interest rates were kept high by the Government’s exchange rate mechanism (ERM) policy. Companies quickly found that cash flow fell below their debt-servicing commitments, and a high rate of corporate failures and liquidations was the result.

Could such problems have been foreseen and avoided? Yes: but in times of high growth the attention of line management is understandably concentrated on expanding output to meet demand rather than thinking about the next downturn. Yet we know that a GDP growth rate of 4 per cent is not sustainable for long in mature economies, and by 1989 there were clear warning signals from the commodities markets as well as from the financial world. Both consultants and outside directors should have been looking ahead and advising caution.

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One of the consultant’s tasks, then, is to persuade the client company to undertake a long-term projection of the cash likely to be generated by its operations, not only under normal economic conditions, but also during periods of economic uncertainty and recession. This is likely to require the use of simulation techniques, and the development of a computer-based model of the company’s financial dynamics. Few companies can undertake such projects without outside assistance. Effective consulting work in this area depends upon the availability of a consulting team that combines financial expertise with electronic data processing (EDP), systems analysis, and programming skills. Consulting organizations that are willing to develop such teams can expect growing needs for their services as more and more companies realize the fundamental importance of such an analytical approach to financial decisions.

Dividend policy and share repurchases

The determination of an optimal dividend policy is a particularly complicated issue, in that it has implications for management of working capital, decisions on capital structure and maximization of shareholder value. Payment of a large and stable cash dividend pleases most shareholders, and facilitates subsequent new equity financing. On the other hand, the payment of a cash dividend is an obvious drain on the company’s liquidity, and management has to be careful not to establish the dividend at a level that cannot be supported. This is another reason for the careful simulation of the company’s cash flows under various economic conditions. Management is usually reluctant to increase dividend payouts, even in periods of exceptionally high earnings, in case they have to reduce them again when profits decline and cash is scarce. Any decrease in a dividend once established is believed to send a very negative signal to the market.

At times, however, some companies find themselves with large amounts of cash, possibly as the result of a divestment. What should be done with it? Again, the criterion should be shareholder wealth. If the directors believe that they have adequate internal investment opportunities that promise a rate of return higher than the shareholders could achieve for themselves, the funds should be invested. If not, they should be returned to the shareholders. Rather than disrupt the established dividend policy, the distribution should be treated as a non-recurring event and accomplished by repurchasing shares. There are a number of ways in which this can be done. One is simply to buy shares in the open market, which tends to be a rather slow process. Another is to make a tender offer to all shareholders at a fixed price and for a limited time. The most popular, however, is the “Dutch auction”, in which shareholders are invited to offer shares for sale and to state what price they will accept, with the company selecting the lowest price that provides the required number of shares. The one thing that all of the methods have in common is that they will increase the share price, so that all shareholders, whether they sell or retain their shares, gain value.

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