Liabilities, Liquidity, and Cash ManagementB alancing Financial Risks phần 5 potx

113 Virtual Balance Sheets and Real-Time Control commercial real estate, the oil industry, selected major client accounts, certain countries or regions, and other windows on risk. Keep in mind these principles: • Every deal and every company must be risk-rated. • Individual countries and industries must have their own limits or tripwires. • Limits also should exist by geography and by type of product. 9 Not just the corporate top but all line managers also must be accountable for controlling their positions through interactive computational finance. Networks, databases, and knowledge artifacts (agents) must be used to monitor risks in derivatives and all other products worldwide, overseeing risk limits for each trade and product line and tracking both local and overall corporate risk limit. These are the characteristics of a risk-sensitive culture that must permeate the entire organiza- tion. (Note that this culture did not exist at LTCM.) Both direct responsibility of each member of staff and line and advanced technology solutions are necessary to keep financial institutions out of trouble, particularly in times of turbulence. A lot of pain and suffering can be avoided, but that will not occur without hard work and new departures. FROM VIRTUAL BALANCE SHEETS TO FINANCES OF VIRTUAL CORPORATIONS The previous examples demonstrate that virtual financial statements based on intraday information are fundamental to sound management. Several companies recognize this fact but also feel that interday information cannot be compiled in real time because of the diversity of forms, incompati- ble office supports, heterogeneous computer hardware and software—and inertia. Another reason why many financial institutions and industrial companies are moving so slowly to gain competitive advantage through technology is backward culture. Typically, old policies, ossi- fied practices, and embedded legacy systems require a 100-step consolidation process through the company’s information technology maze. Only tier-1 organizations now see to it that the consoli- dation job is done interactively: • At any time • In any place • For any purpose These organizations are ingeniously using their intranets to deliver financial information. They are also dynamically linking intranets with extranets through their corporate landscape and that of their business partners to form the flexible backbone of a virtual entity. The use of publicly avail- able Internet software helps to: • Accelerate the implementation cycle • Tremendously reduce paper transactions • Significantly improve business partnerships • Make cash flow run faster through the system 114 MANAGING LIABILITIES The concept of a virtual company or a virtual office and other virtual structures should be used with prudence. The reader is well advised to avoid clichés like “the virtual office means never hav- ing to commute” or “the virtual marketplace means never having to waste time waiting in line at the mall.” Down to its fundamentals, business and technology need a base to be applied to—and this base is the real world. The virtual company is based on real companies, and it becomes possible because, in more than one way, the new wave in sophisticated use of technology benefits from breakthroughs in model- ing. Not only has real-time simulation reached a mature level, but top-tier companies are reaping operational advantages from an interdisciplinary cross-fertilization of skills and know-how. Cross-fertilization can be seen in the case of the benefits banks have enjoyed through the employment of rocket scientists 10 : physicists, engineers, and mathematicians with experience in nuclear science, weapons systems, and aerospace. Senior bankers should, however, appreciate that rocket science and high technology have no respect for in-grown authority and hierarchical struc- tures. This, too, is a lesson learned from Silicon Valley and the drive of companies to reinvent them- selves every two and a half years in order to survive. Stiff hierarchical solutions are counterproductive not only because rocket scientists are general- ly independent-minded but because significant achievements cannot be reached without: • Independence of spirit and of opinion, and • The freedom to question the obvious Let us make no mistake on this subject. The new technology has been a minefield of costs and deceptions for unsophisticated companies that think they can have their cake and eat it too. Dropping legacy systems is not easy—not because the transition to highly competitive solutions presents major obstacles but because so many careers are associated with the old structures. Yet change is necessary for survival. Virtual companies and virtual offices should be viewed in this light: as necessary. Cultural change is inescapable. A major evolution must take place in the way we look at our busi- ness—even if a long list of unknowns is associated with that change. For instance, virtual financial statements can provide up-to-the minute information, but they also pose a potential problem. When financial analysts in the city and in Wall Street get wind that virtual financial reporting is in place, updated in real time, they will do whatever they can to: • Get hold of its information and • Scrutinize it for clues on the company’s future performance. Financial analysts do understand that even a virtual statement provides a perfect mirror of, say, the bank’s mismatch exposure. Forward-looking scrutiny is a very likely scenario in the coming years, and its pivot point will be the virtual balance sheet. What is certain is that new financial reporting practices, new regulations, marking to model, internal swaps on interest rates, and virtu- al balance sheets will radically change the way we value equity. These same elements will also greatly impact on the manner we look at cash flow and profits. Cisco, Intel, Microsoft, Motorola, Sun Microsystems, and other high-tech companies have been able to produce a daily financial statement updated every 24 hours. They have moved to intraday reporting because they appreciate that: 115 Virtual Balance Sheets and Real-Time Control • The number-one criterion for good management is timeliness and accuracy. • Precision is more important to general accounting and regulatory reporting. Even if such a report involves, for example, a potential 3 percent error, management loves to have a balance sheet available on request, ad hoc, in real time and a virtual close that can be updat- ed intraday. We are at the threshold of institutionalizing virtual financial statements that are sup- ported by models, are available interactively, and help in increasing a company’s competitiveness in a market that is tougher than ever. MANAGING THE LIABILITIES ACCOUNTS OF VIRTUAL COMPANIES The management of liabilities of virtual companies defies what is written in accounting and finance books, because such entities are ephemeral and their alliance(s) may last no more than the current project on which they are working together. At the same time, since in the course of their work together they complement one another in terms of engineering know-how, production facilities, and/or distribution outlets, the one company’s liabilities are the other company’s assets. The way to manage risk within this perspective of temporary integrated liabilities due to ephemeral alliances is not the same as what has been known so far about a simple company’s con- solidated balance sheet. We must break down each post to its basic A&L elements and pay due attention to risk tolerances, not only at each entity’s level but within the virtual company as well and within the project that is under way. A good deal can be learned from the financial industry. At investment banks, for example, risk tolerance at trader level is allocated by the desk head. To each desk senior management assigns a risk tolerance limit, after having decided about the level of corporate risk tolerance. Hence risk con- trol becomes part of a coordinated system but also maintains a significant level of detail that makes it possible to focus on risk and return. Theoretically, a virtual company works in a similar way to a real company. Practically, there is the added complexity that it is not a fixed but a temporary consortium of independent entities com- ing together to quickly exploit fast-changing local, national, or international business opportunities. Virtual enterprises share costs, skills, and core competencies that collectively enable them to: • Access the market in a cost/effective manner • Provide world-class solutions their members could not deliver individually It is particularly important that virtual companies working on common projects and solutions follow in a multidimensional manner their current liabilities—that is, obligations whose liquidation is expected to require current assets. Usually this concerns projects on which they work together, but it also might have to do with the creation of new liabilities for each one of the cooperating enti- ties. These liabilities might consist of: • Obligations for items that have entered into the operating cycle, such as payables incurred in the acquisition of labor, materials, and other supplies. • Collections received in advance of the delivery of goods and services, and taxes accrued but not yet paid. 116 MANAGING LIABILITIES • Debts that arise from operations directly related to projects they are doing together and servic- es they provide to one another regarding the completion of such projects. Notes payable to banks and trade acceptances are a good example. It is sound accounting prac- tice to show the various note obligations separate in the balance sheet. In the virtual company envi- ronment, however, this must be done at a greater level of detail, specifically by business partner and project, including collaterals (if any), but without netting incurred liabilities with those assets that enter into bilateral transactions of the partnership. A distinction that is not uniformly accepted in accounting circles but that can be helpful in trans- actions of virtual companies is that of loans payable. The term identifies loans from officers, rela- tives, or friends, accepted as a friendly gesture to the creditor and used in place of bank borrowing; such a practice is often used in small companies. Many virtual companies are composed of small entities, and might use this type of financing. What complicates matters is that receivables may not be collected by the borrower but by a busi- ness partner who assembles—and who will be in debt to the borrower, not to the party that has advanced the funds. This adds a layer of credit risk. Another example of a virtual company’s more complex accounting is subordinate debentures. These issues are subordinated in principal and interest to senior, or prior, debt. Under typical pro- visions, subordinate debentures are more like preferred stock aspects than they are like debt. Each of the business partners in a virtual company alliance might issue such debentures; some of the companies might be partnerships; and all of the companies might follow accounting systems dif- ferent from one another. The aspect that is of interest to virtual companies is that subordinate debenture holders will not commence or join any other creditor in commencing a bankruptcy, receivership, dissolution, or sim- ilar proceedings. Relationships developing in a virtual company, however, may involve both senior debt regarding money guaranteed in a joint project, and junior debt from current or previous trans- actions into which each of the real companies had engaged. A virtual organization must handle plenty of basic accounting concepts in a way that leaves no ambiguity regarding its financial obligations (as a whole) and the obligations of each of the organi- zation’s ephemeral partners. Furthermore, each of its activities that must be entered into the alliance’s accounts has to be costed, evaluated in terms of exposure, and subjected to financial plan- ning and control. This approach requires that: • Management makes goals explicit. • Financial obligations taken by different entities are unambiguous. • There is in place an accounting system that tracks everything that moves and everything that does not move. Virtual companies are practicable if the infrastructure, including networks and computer-based models, facilitates the use of complementary resources that exist in cooperating firms. Such resources are left in place but are integrated in an accounting sense to support a particular product effort for as long as doing so is viable. In principle, resources are selectively allocated to the virtu- al company if: 117 Virtual Balance Sheets and Real-Time Control • They can be utilized more profitably than in the home company. • They can be supported by virtual office systems based on agents to help expand the boundaries of each individual organization. The books must be precise for general accounting reasons; in addition, they must be timely and accurate for management accounting. Financial reporting internal to the virtual company should be done by means of virtual balance sheets and virtual profit and loss statements. These statements must be executed in a way that facilitates interactions between business partners in a depth and breadth greater than is possible under traditional approaches. Because in a dynamic market intra- and intercompany resource availability can change minute to minute, advantages are accruing to parties able to arbitrage available resources rapidly. Virtual organizations must use information technology in a sophisticated way to supplement their cognitive capabilities; doing so will provide them with an advantage, given tight time constraints and the need to reallocate finite resources. NOTES 1. D. N. Chorafas, Implementing and Auditing the Internal Control System (London: Macmillan, 2001). 2. D. N. Chorafas, The 1996 Market Risk Amendment: Understanding the Marking-to-Model and Value-at-Risk (Burr Ridge, IL: McGraw-Hill, 1998). 3. D. N. Chorafas, Reliable Financial Reporting and Internal Control: A Global Implementation Guide (New York: John Wiley & Sons, 2000). 4. Business Week, October 28, 1996. 5. A hypothesis is a tentative statement made to solve a problem or to lead to the investigation of other problems. 6. See D. N. Chorafas, Agent Technology Handbook (New York: McGraw-Hill, 1998). 7. Chorafas, The 1996 Market Risk Amendment. 8. D. N. Chorafas, Managing Credit Risk, Vol. 2: The Lessons of VAR Failures and Imprudent Exposure (London: Euromoney Bank, 2000). 9. D. N. Chorafas, Setting Limits for Market Risk (London: Euromoney Books, 1999). 10. See D. N. Chorafas, Rocket Scientists in Banking (London: Lafferty Publications, 1995). 119 CHAPTER 7 Liquidity Management and the Risk of Default Liquidity is the quality or state of being liquid. In finance, this term is used in respect to securities and other assets that can be converted into cash at fair market price without loss associated to fire sale or other stress conditions. A good liquidity depends on the ability to instantly and easily trade assets. In general, and with only a few exceptions, it is wise to stay liquid, although it is not neces- sary to hold the assets in cash (see Chapters 9 and 10). Liquidity is ammunition, permitting quick mobilization of monetary resources, whether for defensive reasons or to take advantage of business opportunities. Every market, every company, and every financial instrument has liquidity characteristics of its own. While futures markets are usually liquid, very large orders might have to be broken down into smaller units to prevent an adverse price change, which often happens when transactions overwhelm the available store of value. In their seminal book Money and Banking, 1 Dr. W. H. Steiner and Dr. Eli Shapiro say that the character, amount, and distribution of its assets conditions a bank’s capacity to meet its liabilities and extend credit—thereby answering the community’s financing needs. “A critical problem for bank managements as well as the monetary control authorities is the need for resolving the conflict between liquidity, solvency, and yield,” say Steiner and Shapiro. “A bank is liquid when it is able to exchange its assets for cash rapidly enough to meet the demands made upon it for cash payments.” “We have a flat, flexible, decentralized organization, with unity of direction,” says Manuel Martin of Banco Popular. “The focus is on profitability, enforcing strict liquidity and solvency cri- teria, and concentrating on areas of business that we know about—sticking to the knitting.” 2 Solvency and profitability are two concepts that often conflict with one another. A bank is solvent when the realizable value of its assets is at least sufficient to cover all of its lia- bilities. The solvency of the bank depends on the size of the capital accounts, the size of its reserves, and the stability of value of its assets. Adequacy of reserves is a central issue in terms of current and coming capital requirements. • If banks held only currency, which over short time periods is a fixed-price asset, • Then there would be little or no need for capital accounts to serve as a guarantee fund. 120 MANAGING LIABILITIES The currency itself would be used for liquidity purposes, an asset sold at the fixed price at which it was acquired. But this is not rewarding in profitability terms. Also, over the medium to longer term, no currency or other financial assets have a fixed price. “They fluctuate,” as J. P. Morgan wise- ly advised a young man who asked about prices and investments in the stock market. Given this fluctuation, if the need arises to liquidate, there must be a settlement by agreement or legal process of an amount corresponding to that of indebtedness or other obligation. Maintaining a good liquidity enables one to avoid the necessity of a fire sale. Good liquidity makes it easier to clear up the liabilities side of the business, settling the accounts by matching assets and debts. An orderly procedure is not possible, however, when a bank faces liquidity problems. Another crucial issue connected to the same concept is market liquidity and its associated oppor- tunities and risks. (See Chapter 8.) Financial institutions tend to define market liquidity with refer- ence to the extent to which prices move as a result of the institutions’ own transactions. Normally, market liquidity is affected by many factors: money supply, velocity of circulation of money, mar- ket psychology, and others. Due to increased transaction size and more aggressive short-term trad- ing, market makers sometimes are swamped by one-way market moves. LIQUID ASSETS AND THE CONCEPT OF LIQUIDITY ANALYSIS Liquidity analysis is the process of measuring a company’s ability to meet its maturing obligations. Companies usually position themselves against such obligations by holding liquid assets and assets that can be liquefied easily without loss of value. Liquid assets include cash on hand, cash generated from operations (accounts receivable), balances due from banks, and short-term lines of credit. Assets easy to liquefy are typically short-term investments, usually in high-grade securities. In general, • liquid assets mature within the next three months, and • they should be presented in the balance sheet at fair value. The more liquid assets a company has, the more liquid it is; the less liquid assets it has, the more the amount of overdrafts in its banking account. Overdrafts can get out of hand. It is therefore wise that top management follows very closely current liquidity and ensures that carefully established limits are always observed. Exhibit 7.1 shows that this can be done effectively on an intraday basis through statistical quality control charts. 3 Because primary sources of liquidity are cash generated from operations and borrowings, it is appropriate to watch these chapters in detail and have their values available ad hoc, interactively in real time. A consolidated statement of cash flows addresses cash inflows, cash outflows, and changes in cash balances. (See Chapter 9 for information on the concept underpinning cash flows.) The following text outlines the most pertinent issues: 1. Cash Flows from Operational Activities 1.1 Income from continuing operations 1.2 Adjustments required to reconcile income to cash flows from operations: • Change in inventories • Change in accounts receivable • Change in accounts payable and accrued compensation 121 Liquidity Management and the Risk of Default • Depreciation and amortization • Provision for doubtful accounts • Provision for postretirement medical benefits, net of payments • Undistributed equity in income of affiliated companies • Net change in current and deferred income taxes • Other, net charges 2. Cash Flows from Investment Activities 2.1 Cost of additions to: • Land • Buildings • Equipment • Subsidiaries 2.2 Proceeds from sales of: • Land • Buildings • Equipment • Subsidiaries 2.3 Net change for discontinued operations 2.4 Purchase of interest in other firms 2.5 Other, net charges 3. Cash Flows from Financing Activities 3.1 Net change in loans from the banking industry 3.2 Net change in commercial paper and bonds Exhibit 7.1 Using Statistical Quality Control to Intraday Overdrafts or Any Other Variable Whose Limits Must Be Controlled TEAMFLY Team-Fly ® 122 MANAGING LIABILITIES 3.3 Net change in other debt 3.4 Dividends on common and preferred stock 3.5 Proceeds from sale of common and preferred stock 3.6 Repurchase of common and preferred stock 3.7 Proceeds from issuance of different redeemable securities 4. Effect of Exchange Rate Changes on Cash 4.1 Net change from exchange rate volatility in countries/currencies with stable establishments 4.2 Net change from exchange rate volatility in major export markets 4.3 Net change from exchange rate volatility in major import markets 4.4 Net change from exchange rate volatility in secondary export/import markets Every well-managed company sees to it that any term funding related to its nonfinancing busi- nesses is based on the prevailing interest-rate environment and overall capital market conditions. A sound underlying strategy is to continue to extend funding duration while balancing the typical yield curve of floating rates and reduced volatility obtained from fixed-rate financing. Basic expo- sure always must be counted in a coordinate system of volatility, liquidity, and assumed credit risk, as shown in Exhibit 7.2. The reference to any term must be qualified. The discussion so far mainly concerned the one- to three-month period. The liquidity of assets maturing in the next short-term timeframes, four to six months and seven to 12 months, is often assured through diversification. Several financial institu- tions studied commented that it is very difficult to define the correlation between liquidity and diversification in a sufficiently crisp manner—that is, in a way that can be used for establishing a common base of reference. But they do try to do so. Exhibit 7.2 A Coordinate System for Measuring Basic Exposure in Connection to a Bank’s Solvency CR ED IT R ISK LIQU IDITY V O L A TILIT Y BASIC EXPOSURE [...]... account for their inventories, and for some companies inventory pricing is more subjective than objective Cash Velocity Cash velocity is one of the activity ratios that measures how effectively a given company is employing its resources Cash velocity is computed as sales divided by cash and cash equivalents (i.e., short-term negotiable securities) It indicates the number of times cash has been turned over... during the year In principle, high cash velocity suggests that cash is being used effectively But if the liquidity ratios are weak, then a high cash velocity may be an indication of liquidity problems faced by the company The family of cash flow ratios discussed in Chapter 9 both compete with and complement cash velocity as a criterion of cash management I chose to include cash velocity in this list because,... For instance, Austrian regulations demand that commercial banks shall: • • • • Adopt company-specific finance and liquidity planning, based on their business experience Adequately provide for the settlement of future discrepancies between cash income and cash expenditures by permanently holding liquid funds Establish and maintain systems able to effectively monitor and control the interest-rate risk on... AAA to D, and each of the main classes has graduations .5 Modigliani and Miller further assumed that corporate taxes are the only form of governmental levy This is evidently false Governments levy wealth taxes on corporations and personal taxes on the dividends of their shareholders Another unrealistic assumption is that all cash flow streams are perpetuities It is not so Cash flow both grows and wanes... Liquidity Management and the Risk of Default Yet, in spite of resting on the aforementioned list of unrealistic assumptions, the ModiglianiMiller model has taken academia by storm It also has followers at Wall Street and in the city By contrast, the liquidity, assets /liabilities, and other financial ratios used by analysts in their evaluation of an entity’s health have both a longer history and a more solid... subjective and inflated and therefore unreliable Serious financial analysts do not appreciate the often exaggerated value of intangible assets Three financial ratios—total debt (including derivatives) to total assets, current liabilities to net worth, and fixed assets to net worth—complement the leverage ratio The same is true of other ratios, such as retained earnings to assets, liquidity, and the acid... trading book and banking book The other concerns the global liquidity pie chart and that of the main markets to which the company addresses itself The company’s business characteristics impact on its trading book and banking book Generally, banks have a different approach from securities firms and industrial outfits in regard to cash liquidity and funding risk, but differences in opinion and in approach... forecasts and pay due attention to risk control Credit risk, however, is not the only exposure The company is also exposed to market risk from changes in foreign currency exchange rates and interest rates that could impact results from operations and financial condition Lucent manages its exposure to these market risks through: • • Its regular operating and financing activities The use of derivative financial. .. bankruptcies, and when its inventory becomes damaged goods COMPUTATION OF LEVERAGE AND DEFAULT INCLUDING DERIVATIVES EXPOSURE Since performance is judged, at least in major part, in terms of balance sheet and income statement, management’s business plans and their execution will be evaluated on the basis of both actual and anticipated effects of current decisions on balance sheets and profit and loss statements... six months, and seven months to one year, incorporating all derivative products and their recognized but not realized profits and losses Loans and trading have at least this common element in a dependability sense If owners do not put enough funds into the firm to cover its obligations, suppliers of longer-term funds and trading partners will not be willing to expose themselves to risks, and the company . conflict between liquidity, solvency, and yield,” say Steiner and Shapiro. “A bank is liquid when it is able to exchange its assets for cash rapidly enough to meet the demands made upon it for cash payments.” “We. consolidated statement of cash flows addresses cash inflows, cash outflows, and changes in cash balances. (See Chapter 9 for information on the concept underpinning cash flows.) The following. Street and in the city. By contrast, the liquidity, assets /liabilities, and other financial ratios used by analysts in their evalua- tion of an entity’s health have both a longer history and a