IFT Information Note: No Cash, Treasury and Working Capital Management. Treasury and Risk Management. 1. What is Treasury and Risk Management

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1 1. What is relates to the provision of sufficient, and appropriate, liquidity for a company to fund its anticipated business requirements and the identification, and controlled management of, the financial risks (eg. Foreign exchange rate (FX) fluctuations, interest rates, commodity prices) facing that company. In practice, the scope of Treasury within an organisation ranges upwards from the micromanagement of liquidity (cash and available debt facilities) to ensure its on-going survival. The other end of the spectrum is for Treasury to act as a showcase for a company to the international community through its professional dealings, and clearly communicated policies, with all stakeholders. Over time, and consistently applied, this will strengthen the company s name and reputation in the international financial markets. 2. Relevance to a turnaround practitioner Treasury activities, to a greater or lesser extent, are central to any financial restructuring, whatever the size of the company. Whilst the scale may be different for each company, the fundamental issues remain the same. The reason for this is that these Treasury activities include managing liquidity, negotiating and raising funding and, normally, being the main point of regular contact for the company s debt investors (banks or investors from the international capital markets). Treasury is tasked with communicating to the lenders the latest information about financial and other covenants, the financial results and other significant matters. It is also Treasury s responsibility to warn (preferably, in advance) the lenders of any possible breach of covenants and negotiate appropriate covenant waivers. In smaller companies, which may not have a full time Treasury, specific tasks may be allocated to others in the organisation (eg. lending relationships handled by the CFO; reporting to lenders and daily FX activity and cash management overseen by the Financial Controller). However, these are Treasury type activities where ever allocated within an organisation. What is essential to note, however, is that managing Treasury risk within a company is as much about exercising judgement and discipline on the many different issues that arise, as it is about analysing numbers. Turnaround practitioners are well used to exercising these attributes for the benefit of their client. 3. Approach to Treasury risk management For most manufacturing and commercial companies, the board s prime goal is to develop and grow the underlying commercial and core business areas in the best interests of their shareholders and other stakeholders. In pursuit of that aim, therefore, the board will decide the extent of risk, if any, it is prepared to accept on financial risk issues. This level of risk is normally driven by key sensitivities that the IFT Information Note - Page 1 of 7

2 company is facing from time to time (eg. the need to squeeze cash out of the operations to reduce debt; having to protect certain financial covenants; protect a certain level of earnings etc) and, indeed, the Board s own collective appetite for risk. Normally, however, the board will adopt a prudent approach to financial risk management. Treasury s role is to support the overall commercial objectives of the organisation. It will develop risk parameters for each key Treasury risk area, within the constraints set by the board. For example, this might set the maximum level of gearing/leverage that a board would be prepared to accept or the extent it would want foreign exchange exposures to be hedged. These parameters, which must be approved by the board, should be regularly reviewed and updated to reflect the changing nature of the business priorities and challenges. In some cases, however, the board will have to deviate from their previously agreed approach if, for example, a significant unexpected event arises. Under these circumstances, it is essential that they exercise their judgment and discipline by fully understanding both the risks, and possible repercussions, of their alternative actions and carefully weigh the matters accordingly. Unfortunately, boards can sometimes become complacent or greedy, perhaps in good times or during a period of self-denial, during some difficult situations, and they are tempted to take on risks that they do not fully understand or would not normally accept. These situations could possibly be aggravated by the ill-advised opinions of some external advisers. The consequences of such actions can result in damage to the company s reputation or, indeed, even prove fatal. The landscape is littered with debris of companies, along with their corporate tombstones, where basic disciplines have been ignored by the board. 4. Key risk areas The main key risk-areas are: Liquidity: - Cash and liquidity - Investments (surplus cash) - Funding Risk management - Currency (FX transaction and translation) - Interest rates Debt investor relationship management. Here the debt investor may be a bank or an institution acting in the international capital markets. In order to manage these risks effectively, it is essential that a robust control structure exists within the organisation, both at head office and in all operating subsidiaries. IFT Information Note - Page 2 of 7

3 Some companies will have other significant financial risks (eg. exposure to commodity prices) that they will include within the appropriate category. Each company will establish its own bespoke risk management structure which is applicable to its own specific commercial needs. The key risk areas are discussed briefly below. 4 (a) Cash and liquidity Turnaround practitioners are keenly aware that liquidity (being cash and available-to-use funding lines) are critical to the survival of any company. Treasury plays a central role in managing and forecasting group cash. To ensure cash is managed effectively, Treasury uses various techniques to mobilise cash throughout the group (domestic and international) such as implementing cash pooling arrangements. If structured effectively, cash can be made available at group level for the benefit of group companies, without disrupting the day-to-day business of the operating units. Cash forecasting is sometimes ignored by companies until it is too late. This is unfortunate as it takes time and patience to establish an effective and accurate forecasting process throughout the group. When disaster strikes, it is often difficult, if not too late, to implement. Forecasting of liquidity on a regular basis is an essential management tool as it gives management time to take pre-emptive corrective action should the forecast anticipate worrying cash shortfalls. 4 (b) Investment management This is associated with the investment of a company s surplus funds. From a Treasury perspective, the key drivers are: Capital preservation (will the company get back the full amount of its investment); Liquidity (how soon will that cash become available: overnight, 3 months etc); Counterparty risk (what is the chance of the deposit taker going into liquidation without government underwriting). 4 (c) Funding This covers the raising of finance to meet the on-going, and anticipated, business plans of the company. The typical sources are the banks and the international capital markets (which include pension funds, insurance companies and Sovereign Wealth Funds). A company that has an investment-grade rating has a great deal of flexibility as to where to source funding at competitive rates. However, a non-investment grade rated company is more restricted and will have to rely on more onerous terms and conditions (eg. a leveraged, or asset-backed, facility) from a lending institution or have to approach the high yield bond market. Typically, a non-investment grade rated company will have to provide security (by pledging physical assets, shares) for the finance and have to meet certain financial hurdles (known as financial covenants) in order to continue borrowing under the facility. These financial covenants IFT Information Note - Page 3 of 7

4 are intended to act as an early warning system for both the company and lenders, should the company fall behind in meeting its financial targets. It is essential for a company to forecast compliance with its anticipated covenants on a regular basis. This will give management time to take pre-emptive corrective action or, should the need arise, enter into an early dialogue with lenders. Other covenants, known as Positive and Negative covenants, are included to provide further security to the lender. These can cover, for example, limits on the sale of assets (negative pledge) or capital expenditure. However, carve-outs can be negotiated to ensure that the company can maintain operational flexibility whilst, at the same time, satisfying the lenders need for security. 4 (d) Risk management The key areas here are managing the fluctuations (volatility) of foreign exchange (FX) rates and interest rates. However, companies may include other risk areas (eg. commodity hedging) should these have an impact on the overall performance of the company. Normally, a company s exposure to its key sensitivities is identified and then a management decision will be taken to hedge some or all of the exposure, in line with constraints set by the board. Hedging (matching of currency, amount and timing) plays a critical role as it: reduces risk and ensures certainty of cash flows; helps protect business margins; gives management time to consider the impact on the business (pricing, manufacturing) and take appropriate corrective action. There are many hedging instruments which have been developed for different purposes. However, the main ones remain forward FX contracts, options or forward rate agreements (FRAs). Some loan documentation requires a company to hedge a certain proportion of its foreign currency debt, the exposure to interest rate fluctuations and, possibly, forecast cash flow. The purpose of this is to protect the lenders and the company from material adverse fluctuations in rates, particularly when compared with the underlying forecast supporting the debt. Transaction hedging may become ineffective, however, where there is a structural shift, leading to another country being able to manufacture similar products at substantially cheaper costs (eg. via currency depreciation, lower costs on raw materials, wages etc). In this case, management will have to make a strategic decision as to the action they will take (eg. restructure or outsource its manufacturing processes; relocate plants in another country). 4 (e) Debt investor relationships IFT Information Note - Page 4 of 7

5 It is essential to manage carefully the company s relationship with all of its lenders (banks or international capital markets). Timely and accurate information needs to be provided to the lenders as well as maintaining clear communication and an open dialogue. All this takes time and much effort on behalf of the company, particularly if there are many levels of debt investor (senior, mezzanine, bond holders) with competing priorities. It is also essential for the company to manage the expectations of the lenders, as they do not appreciate surprises. If something adverse happens, then this should be communicated promptly to the lenders. The return for all this effort is to help enhance the company s name and reputation in the financial markets, thus making it perhaps easier to raise funding in tight financial markets. This is particularly relevant (now, as at any time), given the many companies competing for a scarce supply of cost-effective funding. 4 (f) Treasury and risk management control framework The cornerstone of any Treasury and risk management control framework is the Treasury Objectives and Policies. These are prepared for each key risk area in line with the board s risk appetite and for their formal approval. The objectives define WHAT is to be achieved (eg. for funding: to ensure a consistent supply of funding at a reasonable cost). The policy will define HOW that will be achieved (eg. via committed debt facilities with an average maturity of 5 years). These objectives and policies are designed to support the underlying commercial ambitions of the group; they, therefore, must be regularly reviewed and updated to reflect changing circumstances which face the group. Treasury would then be responsible for developing appropriate control and reporting structures, as well as supporting documentation (eg. procedures manual). A key element of this would relate to the segregation of duties (identify, approve, transact, reconcile and report) in order to minimise loss through error or fraud. Another key element of control, often overlooked, is to ensure that treasury has a robust disaster recovery and back-up systems to enable it to operate whatever adverse circumstances might arise. Thus, it must be in a position to make and settle transactions on a daily basis (eg. third-party and intercompany payments, settle FX deals, manage the group s cash) even if company s IT systems are down. The management of this operational risk becomes increasingly important given the preponderance of hackers in cyber-space. Treasury would then be expected to clearly communicate these requirements to all operating companies; suitable and appropriate training would also have to be provided for personnel throughout the group. 5. Commercial considerations If the Treasury function is well managed, it is in a position to both: IFT Information Note - Page 5 of 7

6 enhance the competitive position of the company (eg. raising funding in tight financial markets, the use of effective hedging strategies and the mobilisation of cash); achieve cost savings (eg. cost competitive banking transaction services, improving value dating and establishing appropriate cash pooling arrangements). IFT Information Note - Page 6 of 7

7 6. Concluding remarks The Treasury area is probably the single largest risk area within a company. It represents financial risk in a non-financial (corporate) environment. Thus it must be appropriately structured and controlled at both group and operating company level. The Treasury objectives and polices, approved by the board, are the foundation of the risk management structure for the company and provides clarity of purpose in what it is trying to achieve. Discipline is required to keep to the agreed approach and the exercise of careful judgment is needed where it is necessary to deviate from that path. A well managed function is a significant asset for a company and its management team. It can manage sensitive financial risks, mobilise cash on an international basis, reduce costs of the treasury operations, ensure that tight controls exist at both group and operating company. It can also, by careful management of the company s debt investors, enhance the company s name and reputation in the international financial markets. Michael MacCallan MM Consultancy Ltd mmaccallan@mmaccallanconsultancy.co.uk mobile: +44 (0) web page: IFT Information Note - Page 7 of 7