Liquidity and Working Capital: A Different Perspective

Improving working capital efficiency leapt to the top of most corporate treasury priority lists just over a year ago. Apart from reduced availability of external liquidity, this has also been driven by the generally weak economic conditions that have depressed sales and seen customers trying to extend their days payable outstanding (DPO).

A few economies have partially bucked this trend, with India being a prominent example. Indian 2Q09 gross domestic product (GDP) came in at +6.1%, which resulted in a year-on-year GDP growth figure of +6.7%. While this was well below the annual GDP growth figure of around +9% seen in the preceding three years, it is radically stronger than countries such as the US, which delivered a -1% 2Q09 GDP decline and a -3.7% year-on-year fall.
Working capital preparation

The working capital position of both domestic and multinational companies with Indian operations appears to reflect this. While those attending the thought-leadership event in Delhi certainly echoed the current mission critical importance of strong working capital management, some were clearly under much less pressure than their counterparts in the US and EU. This was particularly true of non-exporters who had been able to benefit from the comparative resilience of the Indian economy without being exposed to the chill winds blowing globally.

However, while the relatively benign economic conditions in India may have alleviated some of the working capital pressure, a number of companies had clearly invested in improving controls and (where necessary) also restructuring. There was plenty of evidence to suggest that these companies were already running tight working capital agendas long before the global economic crisis blew up.

For example, one international technology company had already established a healthy differential between the days sales outstanding (DSO) and DPO of its Indian operations through the enforcement of strict collection and payment terms. Customers typically have to settle their outstanding invoices within one or two weeks of sale, while suppliers have payment terms of 1-1.5 months.

A major Indian real estate company has enjoyed similar working capital success by leveraging the still relatively buoyant domestic property market to its advantage when matching incoming and outgoing cash flows. Demand for domestic housing (particularly apartments) means that it is able to secure substantial deposits (typically 30%) before construction projects even begin. The company also makes extensive use of joint ventures with construction companies where stage payments are synchronised with pre-payments from future occupants. The net result is a strong working capital position that often allows the company to pre-pay its bank loans.

For some companies operating in India, a major area of focus has been to maximise straight-through processing (STP) as a means of streamlining the processes around working capital. Forum participant LG Electronics is a prominent case in point. “We have made a substantial investment in automation – for example all our payments are now 100% electronic – which has delivered a high level of STP,” said Pradeep Panda, company secretary, LG Electronics India. “We have also directly integrated our ERP [enterprise resource planning] system with the systems of our partner banks.”

Strong Incentive

The spread between the cost of internal and external liquidity has been a strong incentive for such prudence, although in recent months the cost of external liquidity has fallen from the very high rates seen in late 2008 and earlier this year. The Reserve Bank of India has also been encouraging companies to borrow from abroad for domestic investment, without requiring the usual formal permissions.

In addition, Libor has recently fallen steadily, which has been seen as a mark of returning confidence among foreign banks. However, the counter to this has been a rise in the typical lending spread over Libor to 4-5%. For those looking to raise working capital domestically the gap between internal and external liquidity costs is considerably greater. With the Benchmark Prime Lending Rate (BPLR) currently at 12% and a single A rated corporate probably having to pay around 1% above that for a 180 day working capital facility, the motivation to maximise usage of internal liquidity is strong.

Commercial Imperative

However, for certain categories of corporation operating in India, commercial considerations can override working capital orthodoxy – albeit in special circumstances. Brand strength has a very strong influence on the speed with which companies can gather their receivables, which obviously affects their working capital position. Those with a strong brand and long-standing presence in India are in the strongest position, as Chinese companies trying to break into the market have discovered. In certain industry segments, their major competitors will be other international companies who have established a strong foothold over a decade or more. Where these competitors have a particularly strong brand, winning market share can require extraordinary measures.

Telecoms equipment is a case in point, where a handful of global companies have established a dominant position in the Indian market and, as a result, are now able to trade on relatively standard credit terms with both customers and suppliers. By contrast, companies looking to break into this market have found themselves obliged to use extended customer credit terms as a competitive tool; in some cases, they are offering payment terms of two to three years or longer. However, on the purchase side, Reserve Bank of India regulations require these companies to pay their suppliers in overseas (e.g. their parent in China) within one year.

This obviously creates a very significant financing gap. In some cases, this can be partially covered by invoice discounting or similar mechanisms, but this can be difficult to obtain. Many private telecoms companies in India are expanding rapidly and have stretched working capital, which makes them an unattractive risk for many banks. However, larger Chinese telecom exporters operating in India have the advantage of support from Chinese policy banks, which have been mandated by the Chinese government to provide support to these companies. This is usually accomplished by the local company receiving extended credit terms from its Chinese parent on any equipment sold, with the parent in turn receiving support from the policy bank.

Up to Speed

While one might expect multinationals to be up to speed on the latest working capital techniques, it was evident from the forum attendees’ comments that many domestic companies were similarly well-informed. There was a strong bias evident in favour of leveraging technology and innovation to increase cash visibility and mobility. Some companies had clearly devoted considerable effort to researching (and where appropriate also implementing) a wide range of transaction banking and liquidity tools available from both international and domestic banks.

There was also a willingness to adjust the corporate business model in order to benefit the entire organisation’s working capital position. For example, some companies were prepared to diversify into new business areas in order to smooth out corporate cash flows as a whole.
Liquidity management – horses for courses

International companies operating in India have an understandable preference for partnering with their international banks when implementing liquidity management schemes. Apart from anything else, where the partner bank has suitable reporting technology, corporate head offices can enjoy near real-time visibility and control of in-country liquidity. (Although moving such liquidity outside the country obviously requires compliance with exchange control regulations.)

While international banks cannot compete with the branch density of local banks in India, multinationals tend to favour those international banks with the strongest physical presence in India. One reason for this is that international banks need to establish strong working relationships with local banks to facilitate liquidity management schemes outside major cities and those with a strong, long-established network of their own are often best placed to accomplish this. To cover the widest range of international client business models, international banks may need to have local bank relationships right down to the microfinance level.

Simplicity

Despite the major re-evaluation of counterparty relationships that has taken place in the past 18 months, Indian corporations are in many cases happy to use local banks for their liquidity management schemes and also for holding deposits. As with their liquidity management strategies, international companies tend to have a preference for international banks as deposit takers.

However, when it comes to investment strategies for surplus liquidity, both categories of corporation opt for simplicity. Straightforward deposits are favoured, rather than money market funds and yield enhancement strategies. “By managing our incoming and outgoing cash flows carefully we often find that we have a liquidity surplus,” said Saurabh Suri, deputy manager, Strategic Finance, DLF. “Our policy for investing that surplus is relatively conservative; we prefer to use simple deposits that we leave with domestic banks of sound credit and where we have an established relationship.”

Conclusion

Although efficient working capital and liquidity management were clearly a focus for corporates attending the forums, there was a sense that the strength of the Indian economy had to some extent mitigated the challenges. In the case of some domestic companies, the comparative immaturity of Indian public debt markets meant that they had developed a degree of working capital self-reliance by default. The wide spread between the cost of internal and external liquidity in India was a further incentive. As a result, they had already established efficient working capital policies and procedures and were perhaps less affected than some of their counterparts in other regions.

The presence of currency controls also enforces a degree of simplicity on liquidity management strategies used in India, which (particularly in the case of domestic firms with a diverse footprint) often revolve around physical pooling. A similar preference for simplicity applies to investment strategies, which in the case of both domestic and multinational corporates largely consists of vanilla deposits.

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