Detection and Resolution of Cash Crises:- Detecting and resolving and preventing cash flow crises is a priority for the Chief Financial Officer, one of whose missions is to ensure the medium and long-term sustainability of the company. It detects the deterioration from the financial analysis of the annual and interim financial statements, the reporting on the cash position.
Detection and Resolution of Cash Crises in Business
The functional balance sheet model (FR – BFR = TN) identifies 5 scenarios of cash flow crisis, either from the decrease in the FR or the increase in the WCR.
The Functional Balance Model
The financial equilibrium analysis model called functional balance was designed by the financial analysts of the Banque de France, during the 1980s after the two oil crises of the 1970s. Their objective was to detect cash flow crises that they are prolonged and lead the enterprise more or less rapidly to the cessation of payments.
After a period of 30 years of uninterrupted growth after the end of the Second World War called the “Thirty Glorious Years”, a sudden increase in oil prices led to waves of business failure.
The functional assessment describes the following financial balance:
Working Capital (FR) – Working Capital Requirement (WCR) = Net Cash (TN)
The net cash position is determined in two different ways:
FR – BFR = TN
Or Active Cash – Passive Treasury
The formula of financial equilibrium clearly shows that the net cash position is the result of the two previous aggregates: the cash position is the result of all cash flows.
Cash flow crises can also be diagnosed from the cash flow statement as this table shows the change in the WCR.
Among the 5 cash crises, two of them have their origin in the deterioration of working capital: the loss of profitability and the financing error, which we address in this post.
Loss of Profitability
In this scenario, cash flow deterioration results from a negative net result that decreases equity and therefore permanent capital and working capital. A negative net result means that expenses for the period were greater than revenues (accounting income). As a result, in the balance sheet, expense disbursements are likely higher than revenue receipts.
The analysis of the financial equilibrium makes it possible to detect that the cash flow deterioration comes from accounting losses. However, it is the previous stage of the analysis process, the profitability analysis, which makes it possible to diagnose the origin of these losses.
Of course, it is important to understand the origin of the losses in the income statement and to try to remedy them. The loss of profitability is probably most often the cause of deterioration of the most delicate cash to solve. Losses are sometimes due to exceptional events that are not intended to be renewed. In other situations, measures of economy or rationalization, of modification of the economic model are enough to return to profits. Conversely, in other circumstances, the very basis of competitiveness and the chances of survival of the company are compromised.
Where shareholders’ equity and working capital have been excessively degraded by losses, shareholders should be asked to make additional contributions in the form of capital contributions (recapitalization) or, for the time being, current accounts of shareholders ( associates’ current accounts are often reclassified as equity in the financial analysis balance sheet). The diagnosis of the origin of the losses, the definition and the beginning of the implementation of a profit-return action plan are likely to win the confidence of existing shareholders or new investors.
The deterioration of the cash flow originates from financing choices leading to a shortage of permanent capital; three distinct errors can be distinguished: excessive self-financing, a short repayment term for MLT loans, and an excessive distribution of dividends.
- Excessive self-financing
The CFO self-finances the acquisition of fixed assets thinking that cash flow will be sufficient to absorb disbursements related to the investment. In reality, a lower cash flow than the one provided in the business plan degrades the cash position.
Curative way, the CFO can firstly negotiate a posteriori processing out on loan to MT (consolidate the overdraft loan MT). This operation is an opportunity for the bank to obtain a guarantee on the financed property it did not have when it lent to CT.
It can also finance an asset a posteriori by lease-back. This operation involves selling an asset with a credit institution to become a tenant under a lease transaction. On disposal, the company improves its cash position. At the end of the financing, it can become owner again by exercising its option of purchase.
In a preventive way, the CFO finances the investments with funding to MLT fairly systematically so as to strengthen the FR and preserve the cash flow. It is obviously easier to negotiate financing when the company’s situation is favorable than to renegotiate a loan in a crisis situation. It thus contributes to one of its missions which are to ensure the long-term success of MLT. It constantly updates its vision of the forward RF and the financing plan to MLT which is the central tool of financial forecasting at MLT.
- Repayment period of a loan to MLT too short compared to the profitability of the company
Illustration: a raw material processing company must make extremely high investments to ensure its activity. For several years of high profitability, the CFO financed the acquisition of production equipment with a useful life of 15 years with loans repaid over 5 years: high cash flow (CAF) allowed a quick repayment. Later, it continued to finance itself in this way, while profitability had declined significantly due to stronger competition. The CAF had become insufficient to ensure a repayment over 5 years and consequently the cash flow deteriorated. From this realization, he subscribes his new loans for longer periods,
- Excessive distribution of dividends
High dividend distributions degrade equity and the FR. This situation is likely to arise particularly in the context of a business acquisition with a high leverage effect (leveraged buy-out LBO). Investors favor the return of dividends from the target company to the acquisition holding company to repay the acquisition debt.
The technique of the “debt push down” consists of having the target company subscribe a loan to MT allowing it to pay the holding company an exceptional dividend. In 2015, PICARD borrowed 750 million loans to MT to pay to its shareholder, the Lion Capital investment fund, an exceptional dividend of 602 million Euros from large reserves and 4.5 times its annual profit.
Detecting and resolving and preventing cash flow crises is a priority for the Chief Financial Officer, one of whose missions is to ensure the medium and long-term sustainability of the company. It detects the deterioration from the financial analysis of the annual and interim financial statements, the reporting on the cash position. We have reviewed in the first part of this post the two cash-flow crises resulting from the decrease in working capital: the loss of profitability and the financing error. We are now interested in the cash crises resulting from the deterioration of the WCR.
Three scenarios of cash flow deterioration result from an increase in working capital requirements (WCR).
The Growth Crisis
The financing requirement of the operating cycle increases at the same rate as the turnover, even if in the short term, a restart of sales may allow a fall in inventories temporarily inflated by a commercial sub-activity. Vis-à-vis the BFR, the financial director has a dual mission:
- Finance its growth;
- Identify the courses of action to better manage it.
The “leap ahead” process describes the process of cash-flow degradation resulting from significant margin less growth: The need for operating cash increases due to activity while the RF stagnates due to the weakness of results, not counting the capital investments needed to support this growth in activity.
Suppliers and bankers do not necessarily increase their credit limits as this unprofitable and poorly funded growth exacerbates the risk of default.
In periods of strong growth, the probability also increases that the services of the company are disorganized and that stocks and customer credit are less well managed (management crisis, below).
- Financing growth by increasing stable resources
Financing a substantial part of the WCR by stable resources contributes to the sustainability of the company, knowing that the lines of credit loans can be denounced by the banks under a very short notice of 60 days. Not widely used by banks, the BFR’s coverage ratio by the FR guides the CFO in his financial decisions, especially when he adjusts his financial forecast to MLT.
Compared to a 50% RF financing objective for the WCR, he strives to increase stable resources during the growth period of the business: shareholder contributions, dividend reduction, financing of debt investments to MLT or asset financing.
- Suggest a change of Commercial Policy
In terms of commercial policy, the sales manager is given objectives that focus on improving margins, sales growth and market share. The choice to favor either margin or growth has implications for the financial balance.
Greater margining contributes doubly to improved cash flow: the FR improves with the result while the WCR increases to a lesser extent due to controlled growth. The company will implement this policy by only responding to calls for tender guaranteeing a minimum margin rate, limiting discounts, aware that sales growth is not an end in itself.
- Turn to Factoring
Factoring consists of short-term financing by selling its receivables to a specialized financial institution, the factor. Compared to bank cash loans, factoring offers a particularity that can be particularly advantageous for fast-growing companies.
For credits to CT, banks determine from the credit risk analysis, a credit limit that they will not necessarily increase in case of growth of the activity. The factor, meanwhile, does not determine an overall credit limit on the borrower but rather on each of the transferred debtors in relation to the risk analysis of each of them. A company with a solvent and sufficiently diversified clientele will therefore have a source of funding from the factor that is likely to exceed the standard bank credit limits.
The Management Crisis of the BFR
As the diagram below shows, this crisis scenario is detected by the fact that the WCR increases faster than sales. The BFR expressed in days of HT sales increases. It is then necessary to detect the BFR ratio or ratios that are degrading: customers, stocks, suppliers, down payment rate (down payments received / work in process and inventories).
Operational actions carried out on the WCR are one of the components of cash culture that aims to maximize the cash flow generated by the operation. In the short term, one-off actions help to rectify a situation marked by a lack of management more or less prolonged. When a portfolio of receivables has not been revived for several months, the operation “punch on the old balance” is to mobilize a team over a period of a week to a month to restore it afloat: obtaining payments, passing on losses, providing duplicate invoices lost by the customer. A similar action can be taken on stocks: storage, scrapping.
Beyond the implementation of an amicable recovery procedure, the monitoring of customer management indicators in a management dashboard, help to perpetuate the cash culture
In practice, the management crisis often occurs concomitantly with the growth crisis.
The Cyclical Reduction of Activity
The unanticipated drop in sales may lead to a cyclical downturn in the WCR, at least in industrial and distribution activities: sales are falling, production remains at the same level, and consequently inventories are increasing. In addition, the decline in sales may lead to losses to the extent that structural expenses are no longer fully covered.
To recover cash, the company will act both by reducing production, resorting if necessary to technical unemployment and increasing its commercial effort to sell overstock.
Following the economic crisis of 2008, the Manitou group saw its sales decrease by 35%, a significant part of its sales being made with construction equipment rental companies. Following ten years of growth, these renters having invested heavily, then reduced all the more brutally their orders for equipment.
The consequences of this reduction in activity on the cash position of the group were all the more important as the BFR represents around 90 days of turnover excluding taxes. The group managed to absorb this cash crisis, thanks in particular to high equity representing 50% of the consolidated liabilities.
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