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April 13, 2020

Managing Liquidity in a Potential Global Credit Crunch

By Robert Haas  – Manager at The Hackett Group

Although the Fed’s interest rate is currently at zero and a $2tr U.S. stimulus package was recently passed, companies might still need to prepare for a worldwide credit crunch potentially more severe than one from the 2008 financial crisis. Liquidity management will be key in the next few months as companies see a major hits in revenue while accurate predictions as to when the crisis will end remain elusive.

Companies that have accumulated debt thanks to the historically low interest rates over the past decade may now find themselves heading toward insolvency as they struggle to pay it down. Based on 2019 FactSet data, 24% of the top 1,000 US companies are already having difficulties servicing all their financial obligations, evident by their negative free cash flow. 11% of companies even had negative levered free cash flows over the last 3 years.

The COVID-19  pandemic has led to a sudden change in the market conditions, severely affecting companies’ creditworthiness. This has caused corporate borrowing costs to surge, as seen by the ICE BofA US Corporate Index Effective Yield, which tracks the performance of investment grade, publicly issued corporate debt. The most affected industries up to this point include travel/hospitality and oil & gas, because they’ve experienced  the strongest revenue declines, followed by the automotive industry, which has  the largest percentage of debt due for refinancing this year. According to S&P Global Ratings, a total of around $1tr of global corporate debt needs to be to be rolled over in 2020,and as lenders’ confidence in future revenues is shaken, borrowing costs will continue to increase.

Companies will need to prepare for continued economic volatility and ensure they exhaust all their means to stay financially afloat amid rising borrowing costs and declining revenues. According to The Hackett Group research, In 2019, US companies had about $1.3tr tied up in excess working capital, which companies should now release to help offset external funding shortages. Tactical working capital activities are a proven and effective method to rapidly drive cash flow from internal sources. These need to be coordinated across all three major functions: accounts receivable, inventory and accounts payable. Bellow are some concrete actions companies can take quickly to mitigate their working capital exposure:

Overall

  • Accelerate ongoing process improvement initiatives to minimize the potential of working capital buildup in the new volatile economy environment
  • Create a cash taskforce to monitor key cash metrics on daily basis
  • Cascade dollar value associated to key working capital metrics (DSO, DIO, and DPO among others) to raise cash awareness among relevant stakeholders in the organization

Accounts receivable (customer-to-cash process)

  • Sales & contract management
    • Eliminate discount terms for early payment when the cost of the discount is higher than the benefit of the accelerated cash flow
  • Credit and risk management
    • Tighten credit-risk evaluation and monitoring process to ensure the appropriate trade-off between risk and sales and take appropriate and timely measures to reduce bad debt write-offs
  • Collections
    • Set weekly collection targets and prioritize efforts based on value, not volume
    • Use proactive collections on high-risk and high-value accounts
    • Promote electronic payment methods vs. checks
    • Reduce the cost of third-party collection agency fees and bad debt write-offs through improved collections effectiveness
  • Dispute management
    • Improve dispute resolutions and reduce invoice disputes to collect payments quicker

Inventory (forecast-to-fulfill process)

  • Product range management
    • Rationalize portfolio and stock keeping units to lower storage (warehousing) costs
    • Optimize product mix to increase sales, with a view to overall reduction in inventory
    • Lower inventory write-offs through improved product lifecycle management and prevention of slow and obsolete inventory
  • Inventory management
    • Improve revenue from customer service level via inventory targets that are differentiated by product segment and increase accuracy of demand-and-supply forecast
  • Sales order processing
    • Standardize order cancellation and returns policy to reduce inventory write-offs
    • Implement standardized processes to improve internal order processing times

Accounts payable (procure-to-pay process)

  • Sourcing and supplier management
    • Introduce financing mechanisms where possible to support weaker supply chain elements
    • Consolidate supplier and spend, increasing leverage to improve both payment term and pricing discount agreements
    • Establish a trade-off model to determine when discount terms are more favorable than extended payment terms
  • Requisitioning and ordering
    • Improve purchasing effectiveness through demand management, supplier rationalization and the close collaboration between the budget holders and purchasing
  • Invoice processing
    • Optimize the number of payment runs to streamline processes while reducing transaction costs and effort
    • Improve supplier invoice validation and processing practices to eliminate duplicate payments
  • Payment
    • Prioritize payments to strategic vendors/suppliers

Although the U.S. government has provided some relief with its recent $2 tr stimulus package, companies need to continue preparing for a potentially prolonged period of depressed revenues and higher funding costs. . Strengthening the working capital processes will prevent cash leakage in a time where it might count more than ever before.