Treasury stress tests
There will always be situations in which a company's viability is unexpectedly put to the test. Often the crucial question in such cases is not how well you react, but how well prepared you are.
The Corona crisis shows that critical situations are sometimes not handled with the necessary degree of seriousness. All of a sudden, many treasurers are starting to focus on liquidity transparency. While this may be all well and good, the question remains as to whether a different crisis situation might not also require a different kind of preparedness.
After all, the reasons for corporate crises are as diverse as the companies themselves. They range from a sudden plunge in sales, as we are experiencing during the Corona crisis, to an outright unexpected loss of human resources. Unforeseen events pose unique challenges for each company and treasury departments, and require stress-tested approaches to ensure that the company's going concern remains realistic.
Even in the event of a crisis, the treasury department should always be in a position to fulfill its core task of ensuring the company's solvency. However, experience has shown time and time again that companies will seek help only after things are already looking bleak.
We have summarized two such examples in anonymized form.
The unforeseen absence of a large part or even almost all sales (for an initially unspecified period of time) presents treasurers with an unprecedented task. The analysis of cash inflows and outflows must be fundamentally reconfigured.
On the revenue side, various scenarios have to be simulated, since the extent of the sales slump typically cannot be predicted with sufficient accuracy. These scenarios often range from "most likely" to "worst case". They must be combined with an assessment of the customer credit risk in order to determine the likelihood of payment resulting from a sale. Expected payments from products and services already sold but not yet paid for must also be taken into account. At first, such a situation may seem surreal, but it can occur as a result of major buyers being unexpectedly placed on embargo or sanctions lists, structural political changes or – as has happened just now – due to a pandemic. On the expenditure side, it is especially important for liquidity planning to take into account short-term operational measures. In this context, the treasury department must be assured that it is included in the comprehensive flow of information and data at an early stage.
Regardless of the reasons, liquidity planning that factors in the new situation is a core element for gaining an initial overview of the situation and being able to take the necessary steps. In the current situation, we are seeing that treasurers who have long put off projects to create transparency on liquidity are now confronted with unpleasant questions from Management.
Conventional measures used to counter sudden slumps in revenue are:
However, it is important to adhere to insolvency law for such far-reaching decisions as the inclusion or exclusion of individual companies from a common cash pool, so as to avoid personal liability of the parties involved. Being under time pressure often makes for mistakes with severe consequences. Therefore, it is essential that decision-makers understand their maneuvering room and the relevant constraints.
Treasury departments that have made the necessary provisions know which assets can be sold and also factor in tax effects in their evaluation. Companies holding shares in other companies, fund assets, art or treasury shares may liquidate these assets to improve the company’s cash position in the short term. For this purpose, it is essential to document these actions, including the acquisition data and an approximate current value of these assets in order to best include the proceeds in liquidity planning on the one hand and to determine a fair disposal value on the other hand. Tax effects resulting from disposals must be identified and evaluated before the sale. Next to the measures mentioned above, government loans or support programs may also be a good way to ensure a company’s liquidity.
What caught some Treasurers by surprise was that previously hedged exchange rates had to be adjusted and the resulting profits or losses had to be considered. From a hedge accounting perspective, if there is a foreseeable reduction in the underlying transaction, the hedging instruments concluded for this should be terminated; however, not only could such an action bring about price gains, but also significant losses. These must also be included in the liquidity planning in order to present a picture that is as close to reality as possible.
Employees who become unexpectedly ill and therefore cannot work or important knowledge carriers who suddenly leave present many companies with unexpected challenges. It is unfortunately all too common that work steps are not properly documented and that a smooth functioning of a department is mostly due to the many years of routine an experienced team has built up over many years. If a person is suddenly absent, his or her colleagues will take over that person’s tasks; this may still be possible in the case of two or three absent employees. However, if all of a sudden an entire department falls absent or is no longer with the company, this could become an existential threat to the company. Such a situation could be caused by different combinations of terminations, retirements, parental leaves, sick leaves or accidents, to mention just a few.
In the worst of all cases, a CFO might be faced not only with an unstaffed Treasury department but also with a complete loss of know-how. Because work processes and policies have never been properly documented, even experienced interim treasurers are often not a satisfactory transitional solution. Getting them up to speed would require marginally less time than just hiring new employees and starting from scratch. However, it should be noted that hiring new employees will also not solve the existing problem. Because of a lack of documentation, policies and regulations, all processes and responsibilities have to be re-defined and documented. Generally, this means drawing up the following points:
Apart from a structured concept that clearly defines the responsibilities, the four-eyes principle must be ensured even in extreme situations. Such control is absolutely essential from a control point of view and also helps to avoid expensive errors, such as hedging in the opposite direction.
Not only is an up-to-date liquidity planning necessary but also the drawing up of the required (future) financing. After all, the company should be financially viable both today and in the future even in times that require a complete rebuilding of the treasury.
It is usually quick and easy to extract an overview of existing hedges (e.g. for foreign currencies, interest rates or commodities) from the Treasury Management System. In this particular area it is more a question of monitoring the hedges concluded, and, if necessary, to adjust these or conclude new ones. In this context, it is also important to continue to comply with the rules when forming valuation units or applying hedge accounting.
Although our two anonymized case studies may seem unrealistic at first glance, reality however shows that these things happen much more frequently than companies are prepared for. However, the measures mentioned only partially cover the necessary steps. The spectrum of necessary actions is so broad and individual that each company has to find its own way out of the crisis. Despite this, proper preparation for such a black swan event is often the decisive factor that will ensure the company’s going concern.
Source: KPMG Corporate Treasury News, Edition 101, May 2020
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