Impact Partner Content: Absa / by Justin Schmidt, Head of New Sector Development, Absa Retail and Business Bank
While COVID-19 is first and foremost a global health crisis, the brutal reality is that the measures to “flatten the curve” have had a devastating impact on many businesses already – and will continue to in the medium to long term. The need to quickly conserve cash and to alleviate inefficiencies that may have crept into business in the good times are more important than ever, with revenues being down substantially due to these shocks. Acting quickly to manage your liquidity is essential in these uncertain times.
This an unprecedented, 1 in a 100-year event.
Unfortunately, this means that textbooks can’t give us an indication of what the future holds and how quickly countries, economies, businesses and households will recover. While this is an emotionally draining and uncertain time, we have seen many businesses not get overwhelmed by the uncertainty by getting back to basics.
Businesses are planning and analyzing various scenarios.
In South Africa we are technically a month into this crisis. However, we were already seeing impacts on supply chains as well as our tourism sector before the lockdown was put in place. An important lesson has been for businesses to speak up and act quickly when faced with cash flow pressure.
Scenario planning is becoming common practice with businesses plotting best-case, base-case and worst-case scenarios. This will give them a stronger base to get through the crisis and enable them to adjust to shocks they may face over the coming months.
A strong focus on managing cash flows.
Understanding a business’s cash flow and what costs can be cut immediately is important as revenues come under severe pressure. Fortunately, a few external measures have already been put in place to ease this. Reserve banks have reduced lending rates and commercial banks are introducing payment relief programs. This frees up much-needed cash within businesses in the short-term but are only one component of remaining cash flow positive over the medium to long-term. Other essential levers that are being used to manage liquidity include delaying long-term capital projects, reducing monthly operational expenses, and potentially mothballing or even closing some operations. All these decisions are being made to strengthen business’s liquidity.
Analyzing the cash conversion cycle and understanding where to free up capital.
The cash conversion cycle is a measure of how long it takes a company to turn its investment in inventory into cash from sales of that inventory. Understanding the cash conversion cycle and it’s three components (this was unpacked in more detail by way of a lioness example here) is key to knowing where short-term capital is tied up. When stress testing each element of the cash conversion cycle, some questions should be top of mind:
1. Average Receivables Collection Period
Is there concentration risk in your customer base? In other words, does the business have many customers offering diversification of payment risk or are there only a few customers that the business relies on? In the latter case, any shock to the customer’s business puts your own business at far greater risk.
What risk should be assigned to each account receivable? Financial statement analysis is not just for investors and credit departments. If a business’s customer is given credit, financial analysis of this potential customer could be essential. If this is not a listed entity it is likely to be very difficult to get the financial statements but a way around this might be looking debtor’s insurance against that exposure. This insurance is also a measure to see the risk of extending credit through accounts receivable to that customer. Furthermore, if this is a risky customer, are you being paid a “risk premium” in the form of the gross profit margin, shorter payment terms or even cash sales for taking on this business?
2. Average Inventory Processing Period
Unfortunately, there are now examples of receivables under severe pressure and, in turn, accounts receivable is at risk. If any of the business’s customers fail, there would be the need to take inventory back. How this will impact inventory levels? How much will this increase inventory days? What is the impact on future sales? How will the company need to set prices and sales margins and, in turn, what will the impact on working capital be?
Another common scenario is that businesses will be sitting on inventory for longer, which will tie up capital. Many businesses have also been impacted by supply chain interruptions caused by COVID-19 before the South African lockdown. They will need to purchase more stock when markets open again, which will have an immediate funding requirement.
3. Payables Payment Period
What is the financial health of your payables (i.e. suppliers of goods and services)? If they are financially strong, will they allow you to extend your payment terms, which in turn frees up capital and liquidity for your business? If they are experiencing cash flow pressures and looking to get payment from you sooner, this will be a constraint on your liquidity and mean you need to find another source of funding for the stock and debtors’ books.
How businesses fund their cash conversion cycles.
Understanding the various scenarios of your cash conversion cycle gives you an understanding of the capital tied up in each scenario. You can then plan how you fund this. Traditionally, funding comes from your own cash balances or through short term funding, such as overdrafts, from banks. Businesses are facing the tough decision of whether to free up their long-term savings and investments to support their liquidity or to use portions of this along with their existing overdrafts.
In summary:
The COVID-19 crisis will likely fast track the conversation about global decoupling of supply chains, the need for greater localization as well as what are the more sustainable solutions for local economies to protect themselves from shock. ‘Thinking local’ and having a sense of community could become important in the long-term planning of business owners and potentially offer future growth opportunities.
If you are planning and running scenario analysis, acting quickly, getting closer to your stakeholders and, most importantly, managing your liquidity, this will equip you to take advantage of opportunities and be more efficient when the economy recovers.
Photo by William Iven on Unsplash