DM Q2 2020 Surviving the liquidity

DealMakers - Q2 2020

Surviving the liquidity crunch

by Christo Roux, John Geel and Mickey Bove

When the COVID-19 lockdown regulations unexpectedly disrupted ‘receipts’, whilst leaving ‘disbursements’ unscathed, business focus rapidly shifted to ensuring healthy operating liquidity.

Why the sudden drive for Liquidity and how do we respond?
The government-imposed COVID-19 lockdown regulations impacted the lives of all ordinary South Africans. In the business arena, a clear distinction was drawn between ‘essential’ and ‘non- essential services’.

For companies operating in the ‘essential services’ arena, the impact was arguably less severe; some companies found themselves in the complex (but less severely impacted) space of a ‘quasi-essential services’ provider and then lastly, the remaining group of companies were faced with the daunting impact of a complete elimination of all revenue-generating activities.

The distressing prospect of the first post-lockdown supplier payment run, further exacerbated by the month-end payroll and defaulting customers, left management with the following questions:

Is there an immediate cash crisis?
When will a cash injection be needed, and how much cash is required?
Is the cash crisis the result of fundamental business issues, capital structure issues or both?
Is this a distressed situation or just a performance improvement scenario?
Is there a chance that the company may need to file for business rescue or liquidation?
What areas of the business are the most capital intensive?
What levers can be pulled to mitigate potential cash shortfalls?

It is critical that the ‘business response journey’ is well planned and coordinated, including the following phases:

Liquidity and solvency assessment,
Strengthening the balance sheet; and
Lowering the break-even point.

Christo Roux

John Geel

Mickey Bove

“A treasury cash flow forecast – providing a summary of sources and uses of cash – is essential, whereas the IFRS based cash flow does not provide the granularity required.”

STEP 1
Liquidity Assessment
When the economy is operating in positive territory and quarterly cash inflow is exceeding outflows, most successful businesses believe they can weather an economic storm.

But experience shows that very few companies have sufficient liquidity built into their normal operating model to survive a quarter where cash inflow is significantly impacted.

The cash flow impact of the current lockdown and the uncertainty related to issues like:

lockdown duration;
debtor recoverability;
inventory valuations; and
changes in customer behaviour

requires executives to assess whether the business is adequately resourced to weather the short-term liquidity storm and, if not, which available levers can be implemented most efficiently.

Typical Activities include the following:
Immediate:

Prepare weekly rolling cash forecasts. Review the cash trajectory and forecast the weekly closing cash balance. Review the timing of major cash commitments.
Short-term cash forecasting processes and procedures to improve the visibility of cash requirements.

Next 3-6 months:

Focus on the major cash events impacting the company. Analyse and understand working capital changes and assess sustainability (some short-term positive impacts might have an unfavourable longer term effect on the business).
Identify times when funds are likely to be at their tightest and make sure cash is managed accordingly.
Assessment of the validity of market and strategic assumptions.

STEP 2

“Balance sheet restructuring can be complex, due to the divergent interests of different stakeholder groups, and the legal processes required to implement a transaction.”

Strengthening the Balance Sheet
Prolonged periods of deteriorating trading conditions inadvertently lead to cash depletion, weakening of the balance sheet and share price decline. Balance sheet strength directly impacts the number of available levers for survival, whilst it also has a significant bearing on the cost associated with various turnaround initiatives.

Significant deterioration in balance sheet ratios typically contained in loan covenants can lead to further liquidity pressures due to defaults allowing creditors to call for immediate payment of principle debt and interest.

Equipping management to successfully steer the company through periods of economic distress requires a robust financial review of the business. This must be followed by a detailed options analysis – together with scenario planning and appraisal – with the ultimate aim of short term survival (without negatively impacting the long-term trajectory and value of the firm).

“A truly successful restructuring solution often requires some form of business re-organisation, including site closures, profit enhancement (primarily through cost reduction opportunities) and the delivery of working capital initiatives to improve cash flow.”

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STEP 3
Lowering the Break-Even Point
An economic shock, followed by a subsequent downturn, begs the question whether the current strategy and target operating model is fit for purpose to survive the ‘new normal’.

In the quest to survive in an economic downturn, it is important to understand the linkage between cost and value creation.

Faced with a dwindling demand and overcrowded supply, the focus shifts to creating a competitive survival advantage by lowering the break-even point.

Not only does a reduction in the cost reduce liquidity pressure by reducing the immediate cash burn rate, it also creates revenue enhancement opportunities by allowing business to be competitive at price points previously not feasible.

Operational restructuring requires a proper understanding of the ‘impactable cost base’, segregated into two baselines; namely, the organisational head count analysis and financial baseline.

The organisational head count analysis baseline is impacted by changes in the organisational structure, while an impact to the financial baseline is achieved through strategic cost reduction.

Irrespective of which operational restructuring initiative management decides on, it is of paramount importance to have a clear understanding of the potential “size of the prize”, together with its associated implementation risk and complexity.

Addressing the Concerns
An operational improvement plan can deliver significant tangible financial and operational benefits, and an approach centred on the identification and delivery of sustainable benefits will help to drive operational change within the business.

Roux is Senior Managing Director, Business Transformation and Geel and Bove are Senior Managing Directors, Corporate Finance at FTI Consulting South Africa.