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Funding working capital

Funding working capital

One of the major business issues of our time is small and medium sized businesses (SME’s) access to funding.

As banks try to repair their balance sheets, they have looked to make more conservative lending decisions. As a result banks have shied away from the riskier property investments of the pre-2008 era. But for SME’s things have gotten worse. In the good times their access to bank loans was already a problem and in some countries it’s got to the stage where SME’s almost no access to bank lending.

Instead the banks want to lend to large stable companies that already have robust balance sheets. And it’s not the large companies chasing the banks for cheap loans. It’s very much the other way around. While there are lots of large intelligent firms that are using the climate of cheap debt to restructure their long term debt profiles, there are many cases where banks are actively soliciting companies to borrow money they do not need.

In a recent case, a bank offered to factor the entire Japanese receivables book of a major FTSE 100 company at less than 1% APR.

It’s very difficult for large companies to turn down these lucrative offers. Even if they ultimately get a poor investment return on the money they borrowed, they only need to make sure that the return is in excess of the low borrowing cost for the transaction to justify itself.

In another case, one company worked out that it was a good deal for their shareholders to borrow billions of dollars to pay for increased dividends. The shareholders were very happy with extra cash in their pockets and the share price rose dramatically.

Cheap liquidity

In other cases companies are giving back cash to shareholders via share buyback schemes that are again funded by debt. This suggests that these companies have run out of ideas of how to create a return for their shareholders. All of this is only possible because of the availability of cheap liquidity and the risk-averse stance of banking institutions.

Working Capital Management vs Funding

The effect on working capital management has been that many large companies are not concentrating on working capital management, but are concentrating on funding. There is no doubt that if there is an opportunity to restructure long term debt at super cheap rates, that only a fool wouldn’t do so. But there are many cases of rising levels working capital being funded by debt. There will always be cases of businesses that require more working capital in order to grow, but here we are talking about cheap debt being a substitute for better working capital management.

During the dot.com bubble, I remember having a conversation with the CFO of a major Dutch multinational of the time about working capital. He told me that he saw no need to improve working capital management as long as cheap debt was available. This company expanded at a phenomenal rate over a five year period and when the dot.com bubble burst they were unable to pay their debts against a profile of rapidly falling revenues. This company is now a small shadow of its former self.

Exotic financial transactions vs basic business banking

Banks have transformed themselves into financial behemoths that conduct gigantic and potentially exotic financial transactions that most people in the street don’t even understand. Banks have lost many of the basic skills of business banking – spotting a good business opportunity and backing it as a means to making a profit. As banks have grown bigger in the last 100 years the independence of the local bank manager has been very much reduced. Their ability to spot opportunities has faded away. This has opened up avenues for venture capitalists and private equity companies who are prepared to take controlled risks, but these guys don’t have the capacity that banks have to make lending decisions that will affect the economy at large.

So, who focuses on Working Capital Management?

So in this era of cheap credit, the remaining large companies that are focusing on working capital management fall into two groups.

  • The first are those that understand that the world is changing and becoming more challenging. This might not be an immediate problem but they realise that improving working capital management in the short term will make them far more resilient companies when the expected tougher market conditions do arrive in the coming years.
  • The other group of large companies focusing on working capital are those that are not deemed good risks by the markets and therefore have very restricted access to funds.

There is always a selection of these companies at any given moment. Their need for cash is high and the pressure to improve internal processes quickly is immense. The additional stress then makes it even harder to improve and increases the chances of catastrophic failure. So planning ahead is vital for the long term health of a company.

 

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