High interest rates are forcing CFOs to leave no stone unturned in the search for working capital.
The March banking crisis in the US and Europe—still reverberating in the acquisition of First Republic Bank by JPMorgan on May 1—took central banks, regulators and bank customers by surprise. But perhaps it shouldn’t have. In the sudden need for interventions following crises at Silicon Valley Bank (SVB), Signature Bank, Credit Suisse and First Republic was an old and familiar story: a sharp, widely announced increase in the cost of money. Higher interest rates broke some banks because of the way they had managed—or failed to manage—their assets and liabilities.
The Headline Credit Index of the American Bankers Association (ABA) fell in the second quarter of 2023 to 5.8, its lowest level since the onset of the Covid-19 pandemic. “The reading indicates broad-based expectations for weaker credit market conditions over the next six months among bank economists,” the ABA said in an April statement. “Banks are likely to grow more cautious about extending credit.”
While the current cycle of rate hikes could be near its peak, some observers anticipate the new regime—interest rates above expected inflation—to last. “Since that was the norm from the dawn of time until 2007, it’s hard to say that should be a disaster,” says John Cochrane, an economist specializing in financial economics at the Hoover Institution. “The late 1980s, most recently, had high interest rates during disinflation; but that was an economic boom.”
Yet, for a generation of corporate finance executives, the higher cost and lower availability of credit is a startlingly new and unfamiliar environment. Bankruptcies can be expected to rise and M&A deals to decline. “There’s more to come,” Kofi Bruce, CFO of General Mills, forecast to The Conference Board in April. “As banks tighten up, I think access to capital, especially for a lot of high-growth, early-stage companies, will become a lot harder. I do think that investment decisions are subjected to a lot more scrutiny.”
Cash (Management) Is King
Tighter credit conditions will push CFOs to concentrate far more on management of working capital. “Working capital is all about maintaining an appropriate level of cash available for day-to-day needs as well as managing the funds to invest in your business for tomorrow,” says Dan Ginsberg, managing director, private equity, at SGS Maine Pointe, a global supply chain and operations consultancy. “When financing is cheap and widely available, you tend to not worry or analyze your liquidity needs or future investment requirements, as you are flush with cash. As interest rates increase, the ability of CFOs to really manage that account, and have enough money for day-to-day needs and future needs, is under a lot of stress.”
While the higher-rate period lasts, working capital should be managed more carefully. “This is one place where higher nominal rates matter,” Cochrane argues. “If inflation is 5% and the interest rate is 5%, that’s not the same as interest rate 0% and inflation 0%; because cash does not pay interest and overdue bills depreciate. We could return to an era of more-careful cash management and bill collection.”
A Price to Pay
Inventory—raw materials, work in process and finished goods—is typically the largest pool of locked cash value in any business, notes Ginsberg. Many businesses built up excess inventory over the last couple of years due to the pandemic and supply chain uncertainties. Now they have too much tied up in higher-cost, old and sometimes distant inventory. If they want to unlock that liquidity, they can adopt disposition strategies to quickly move goods out of warehouses and distribution networks—although at a heavy discount. “There may be opportunities to break even, but time is your enemy,” Ginsberg says. “The sooner companies move on to those strategies, the higher the probabilities that they’re going to be able to avoid a significant loss.”
In one example, SGS Maine Pointe assisted a consumer goods designer that distributes to wholesalers and mall retail chains. The designer had experienced decreasing inventory turns and higher days inventory outstanding to quickly appraise the value of its finished goods inventory. The company was able to sell the inventory to a channel provider in the South American consumer market, recovering 85% of full retail value.
Speeding up receivables is another area of opportunity for companies looking to access cash. If done right, it can have the added benefit of improving customer service, Ginsberg suggests. “We discovered that more than three-quarters of disputes are not technically disputes at all,” he says, “but rather questions for clarification that can be resolved in a phone interaction or self-service web portal instead of multiple collections calls, dunning letters and outsourcing to third-party collectors.” Thus, by understanding the root causes of the disputes and automating the resolution process, companies can remove bottlenecks, decrease the cost of bill collection and accelerate payments—at the same time improving the customers’ perception of them as providers.
Payables pose both opportunity and challenge. “Most companies are in effect being financed by their suppliers; because after they place a significant order, they do not pay the supplier until the merchandise is delivered,” Ginsberg explains. “The longer you can hold on to your cash and use it for other purposes, the better.” Companies can retain cash longer by extending payment terms. At the same time, most prices of raw materials have recently declined, suggesting to CFOs that they go back to suppliers and renegotiate better prices. “But it’s hard to get a better price when you’re also asking for an extension of the payment terms,” Ginsberg adds, “and therein lies your challenge in balancing your liquidity with your costs.”
Even if companies do their best to husband their liquidity, tighter credit means a more difficult environment. Banking gurus, as well as figures like JPMorgan Chase CEO Jamie Dimon, say the banking crisis is not over yet. That will likely translate into tougher external conditions, with more companies going bankrupt and less money flowing into investments, R&D or other future-oriented needs. Lack of credit will ultimately impact growth and, most likely, innovation.
“Companies have less money to spend on investing in themselves—in their people, systems, equipment and facilities—and on the next product, on potential acquisitions, expansion into other countries, investment in new talent, and on the ability to provide more training to customers,” says Ginsberg. “Whatever the case may be, there are fewer funds available for my business.”
High Risk for Real Estate
Some industries are likely to feel the impact more strongly than others. Particularly at risk is commercial real estate in both the US and Europe, says Ed Eyerman, head of European leverage finance at Fitch Ratings, since this sector holds a lot of floating rate debt. “As the rates go up, they can’t pass that on to their customers,” he says.
For issuers of jumbo loans—$700,000 and more—the impact of tighter credit will be both higher rates and more-stringent borrowing conditions, says Michael Fratantoni, chief economist at the Mortgage Bankers Association, with the most pain falling on the higher end of the real estate market.
“You’re already seeing a bigger drop in home sales volume, a bigger drop in home prices in those areas where home sales are declining,” Fratantoni says. “My expectation for the next couple of months is that, because of this tighter credit, you’ll see even more of a reduction at the top end of the market.”
In parallel, builders are also feeling the squeeze. “The combination of higher cost of capital and now tighter credit conditions, in light of failures at SVB and Signature Bank, portends softer demand for construction services emerging from private developers,” says Anirban Basu, chief economist for Associated Builders and Contractors. The impact will be felt across the market, he predicts. “This is likely to impact office, hotel and retail construction. However, given strong demand for housing, the multifamily segment should remain a bulwark of stability even if the economy enters recession later this year or at some point in early 2024.”
Managing working capital will be especially important for builders, says Basu. “Those who manage construction firms would be wise to stockpile some cash during the months ahead. Some will need to accumulate working capital to work on large-scale projects. Others will need additional liquidity to contend with a slowdown in activity.”
Bankruptcy: The Debt Trap
The first months of 2023 have already seen an uptick in bankruptcies in the US. The increase showed up “across all major US filing categories,” according to Epiq Bankruptcy, a provider of bankruptcy data and case management services. “A total of 42,368 new bankruptcies were filed in March, up 17% from the 36,068 filings registered in March 2022, and marking the highest number of monthly filings since 40,931 bankruptcies were recorded in April 2021,” Epiq reported.
“I think it’s [in part] the economy shifting from Covid-19, where everyone was buying goods and not spending on services,” says Eyerman. “We’re seeing sectors like restaurants, hotels and tourism improve, while we’re seeing sectors like consumer products deteriorate.”
A silver lining, Eyerman notes, is that many companies took advantage of the low level of rates in 2021 to renew long-term loans.
“Typically in this environment, there’s more advantage to being a price setter than a price taker,” he says, “For example, if you can delay payments or extract savings through your market position. We’re seeing this as well as companies with the ability to pass on rising prices so their profit margins have not been compromised.”
Companies facing the most stress—the ones that will therefore need to be most mindful of their liquidity and capital costs—are those with a lot of debt and not much pricing power, with maturities coming due soon, says Eyerman. “The good news is that there are few companies in this space. I would say less than 5% of outstanding debt is due this year, in both Europe and the US.”