We have seen many companies come and go during financial crises, but the winners are those with management teams who excel in five tactical areas in the early days of a crisis.
1. Understand and Maximize the Current Cash Position
Understanding the company’s cash position is the first and most important step for management in weathering a financial storm. When a crisis hits, revenue streams and credit lines dry up. First, companies must understand their sources and uses of funds, asset and liability management, and ICR.
Second, they must manage cash through inventories, accounts receivable, and accounts payable. One of our clients in Korea, for example, recalls from the 1997 financial crisis, “Almost every creditor was trying to walk away from us. They were cutting their credit lines drastically. Cash really does become king.”
Ayhan Yavrucu, CEO of Alarko, a Turkish mid-sized holding company that has been through numerous crises over the past two decades, explains it another way: “Our company’s approach to cash management is guided by our founder, Uzeyir Garih: ‘Managing a business in crisis conditions is like juggling three balls. Two of them are rubber and can bounce back if you drop them—these are profitability and equity. The third is made of glass and will break if you drop it—this is cash.’ ”3Without knowing how much cash is moving in and out of the company, managers will never know how bad the bleeding is, where it is coming from, and what must be done to stop it.
Understanding the Company’s Cash Position During the first hundred days, three immediate actions are required to track a company’s cash position: get a clear picture of its cash position; map out the sources of cash and look for any potential disruptions; and monitor the company’s ability to pay off its debts by calculating its ICR.
First, management must get an immediate picture of its current cash position, broken out by business line, and update it on a daily basis. As basic as this seems, some managers fail to realize that profits do not mean cash.
Profits, after all, can overstate or understate free cash flow, depending on factors like the number of days of accounts receivable or accounts payable, inventory positions, and amount of depreciation taken.
Tracking the company’s cash position requires constant vigilance. In Turkey, for instance, chronic high inflation, reaching over 120 percent dur- ing the 1994 crisis, has forced Alarko to adopt a crisis approach in its every- day business activities. A large part of its revenues comes from sales of heating and cooling systems, second only to revenues from construction.
Managers carefully monitor monthly reports from over 400 dealers for any issues with sales, inventories, and accounts receivable. “What matters is not just sales to the dealers, but healthy sales from dealers to end users,”
explains CEO Yavrucu.4
Alarko illustrates the importance of not just monitoring apparent cash flow, but also the actual major sources of cash—such as customer receiv- ables, loans, commercial paper, and foreign exchange positions. During the Korean financial crisis, for example, one of our clients with over a thousand loan contracts had up to six or seven of them maturing on a single day. Under normal conditions, that might not be a problem, but in a financial crisis, credit, credit extensions, and reasonable interest rates may not be available.
In addition, asset-liability mismatches (interest rate, currency, and maturity) can lead to severe internal liquidity crises, emphasizing the importance of monitoring both sides of the balance sheet and tracking cash flow on the income statement. We discuss asset-liability mismatches in greater detail in Appendix 4.2: in particular, how management can prepare in advance to reduce the threat of such mismatches on internal liquidity.
Even after the crisis hits, how well management understands potential mismatches can make a big difference. The Indonesian retail chain Rama- yana, for example, recognized early during the Asian financial crisis that a currency mismatch—in the form of dollar-denominated leasing rates for eighteen stores and two warehouses—could become an even greater prob- lem if the rupiah slid further, especially since 100 percent of its income was in rupiah.5Management worked quickly to fix the exchange rates in new and renewing contracts at an average of Rp 3,000 to the dollar for the whole of 1998. This turned out to be a wise move. Before the end of the year, the rupiah would fall to more than Rp 15,000 against the dollar.
These mismatches—interest rate, currency, and maturity—can occur simultaneously, as was the case with Samsung Corporation, a large trading company in Korea. When the crisis hit, Samsung Corporation had almost two-thirds of its total debt in current short-term borrowing with term struc- tures of less than one year, and about 20 percent of this amount in foreign currencies. Corporate bond rates skyrocketed from 12.6 percent at the beginning of November to over 30 percent by year’s end, and the Korean won depreciated by 75 percent. However, the company learned from this experience, and two years later Samsung Corporation’s current short-term debt was down to less than 20 percent of the total, while its interest rate and currency exposures were much better matched.6
Finally, it is important to understand the company’s ability to repay its immediate and near-term loans. Specifically, management must be able to calculate and monitor its ICR, the ratio of cash flow generated to the amount of debt interest payments that must be paid over the same time period.
Maximizing the Company’s Cash Position Once management has determined the company’s cash position, the next step is to move swiftly to maximize it.
This action may include canceling or postponing spending on overhead, fixed assets, or advertising, for example. It also means actively maximizing
cash across the three areas of working capital: inventories, accounts receiv- able, and accounts payable.
Inventories. Depending on the company’s businesses, management may want to cut inventories, perhaps adjusting prices to reflect what might be plunging consumer demand or rising replacement costs.
We typically divide inventories into three blocks. The “A” block includes the fast-moving items, for which turnover is relatively high and car- rying costs are consequently low; the “B” block is comprised of dated, slow- moving products, for which the carrying costs are fairly significant; and the
“C” block is made up of products that have not sold for a long time. Man- agement should do whatever they can to move the “B” and “C” inventories.
However, the company needs to be more cautious about slashing prices on the “A” block merchandise: During a financial crisis, with its exchange rate fluctuations, executives may find that replacement costs are greater than what they had imagined. In fact, the company may want to increase prices.7 One way to dispose of slow-moving inventories is to manage them, along with underutilized assets (e.g., plant equipment, company cars, furni- ture), through a legally separate asset management company. When the cri- sis hit the Korean chaebol LG Group in late 1997, Yong Nam—then vice president of LG Electronics and head of the multimedia division, and now CEO of LG Telecom—set a target that the division find over $400 million in cash from the approximately $1.5 billion business. When he realized that none of his senior managers knew what their asset inventories and utiliza- tion levels were, he gave them two weeks to do their homework. By the end of that time, managers had accounted for “every screwdriver in the factory.”
They were surprised to discover that for some assets, utilization levels were as low as 10 percent. Nam then asked them to find ways to increase their cash position in each department.
Borrowing the workout concept from the banking sector, Nam created an internal “bad company” to aggregate inefficiently used assets within the com- pany and sell them off externally, including to the local marketplaces in Seoul.
Nam now believes that this dramatically sped up the disposal of unused assets, including slow-moving inventories. This and other initiatives—purchase cost reduction programs, layoffs, and divestitures—were so successful that the division ultimately realized its $400 million cash target within six months.
Accounts receivable. When it comes to accounts receivable, both mer- chandisers and service providers should work to lower the number of days receivable. This area can be a large potential source of cash, but an even larger drain on the company’s cash position. This action means examining exposure to key debtors, developing strategies to respond to key risks, and executing quickly.
One food manufacturer in Asia segments its wholesalers by their financial condition and their preferred product manufacturer, in order
to determine what kind of cash and credit policies to pursue. For example, if a wholesaler is financially strong and prefers the manufacturer’s own prod- ucts, then the latter works to support the former and extend credit lines. If, on the other hand, a wholesaler is financially weak and actually prefers a competitor’s products, then the manufacturer does its best to limit its expo- sure by demanding payment in cash. This not only helps the manufacturer to manage its cash more strictly, but also to balance the cost of credit with concerns about loss of share among key wholesalers.
Managing credit risk requires that management find out what is needed to keep good-credit customers current. But it also means that for customers whose debt is beyond recovery, the company may need to do more than change its credit policies. Sometimes, it may need to get the merchandise back, or at least secure the loan or accounts receivable as quickly as possible.
When the Russian crisis hit in 1998, for instance, Roust, a company best known at the time for its alcoholic beverage distribution business, awakened to the realization that much of its stock sitting on shelves across the country might not be repaid. Fortunately, Roust rallied its sales force, and within several days pulled back most of its stock across the country. The com- pany benefited from a favorable negotiating position vis-à-vis distributors because of its strong product portfolio. But it also realized early on that it should focus on wholesalers rather than supermarkets, since the former were less likely than the latter to make payments. Roust told its wholesalers that it would be glad to restock the products, but only if they paid in advance.
Accounts payable. Accounts payable is the third component of work- ing capital. The main goal in this area is to increase the number of days payable, either by rescheduling payments or seeking price reductions from suppliers unless the payables are in foreign currency, in which case the company may want to pay on time or even prepay. As mentioned earlier, management needs to aggressively monitor the company’s payments sched- ule to make sure that it is aware of any interest payments due or loans maturing. The options in accounts payable are typically much more limited than with accounts receivable or inventories, mainly because suppliers will likely be trying to improve their own receivables to guarantee cash for themselves.
Still, making the right moves at the right time can significantly benefit the company’s cash position. Mexican supermarket chain Aurrera, for instance, reacted to the 1982 peso crisis by learning how to run a negative working capital situation, driven primarily by an aggressive accounts payable program. It negotiated special terms with suppliers that allowed it 60 to 90 days on accounts payable and minimized accounts receivable days, thus producing a negative working capital position. Aurrera was conse- quently able to self-finance its growth during the 1980s—a decade in which the rest of the Mexican economy stagnated—and the 1990s. The company
was eventually bought by Wal-Mart in 1996 in a deal that was highly lucra- tive for Aurrera’s private owners.
Like Aurrera, LG Electronics’ multimedia division also realized nega- tive working capital positions after strong efforts across all these elements of working capital in the first twelve months of the crisis. At first, no one knew anything about managing working capital, but Nam says, “This was simply something that had to be learned and done.”8Nam trained his managers the best way he knew how—by asking lots of questions. Six months later, the first business unit achieved this goal, followed shortly thereafter by others. In fact, managers had gotten the concept down so well that some were telling suppliers that not until the final products were completely assembled would this division assume the suppliers’ inputs as liabilities. Soon, vendors were even setting up their own warehouses at the company’s production facilities.
Today, Nam cites this as a key component of the division’s crisis recovery.
Nam’s experience illustrates another important lesson for managers:
During a crisis, asking the right questions can make all the difference in a company’s quest to optimize cash. Management should constantly review the company’s options. For example, has the accounts receivable status of some customers been impaired? Would an adjustment of credit terms im- prove their recovery value? These are just some of the tough questions that must be asked.
In addition, management should ask if there might be significant oppor- tunities to maximize cash in operational areas such as purchasing. There are standardized, ready-to-use processes that can help companies start to pull out between 8 to 12 percent of their total purchasing costs within six months. During the Asian financial crisis, all of our manufacturing clients realized substantial savings through purchasing improvement initiatives.
Managers analyzed vendors and systematically categorized components by degree of specialization and importance to the production processes. One of them created an online, closed-network marketplace for supplier bidding that led to cost savings of over $100 million on an annualized basis.
2. Identify and Aggressively Minimize Operational Risk
During the early days of the Mexican financial crisis of 1982, senior man- agers at Banamex realized that if there were a run on the bank they might not have enough cash on hand to give to their depositors. This could cause a tragic cascading effect in which the depositors—believing that their money had either been frozen, devalued or, worse, expropriated—could panic. By midyear, the conditions had deteriorated even further. Branch managers were spending most of their time frantically reassuring depositors that their money was safe. Management realized that it absolutely had to meet the withdrawal demand.
There was a small problem, however. The bank needed to keep supply- ing the branches with money, but the number of armored cars available to do so was limited. The bank came up with a clever solution: It hired a fleet of off-duty ambulances to shuttle cash from bank to bank. The distribution plan worked, and the needs of depositors were met without interruption.
As the Banamex story illustrates, operational problems are common in financial crises. They are a priority that must be managed, with as much care and ingenuity as possible. Generally speaking, there are two elements to this: managing upstream and downstream links in the supply chain.
Managing Upstream Links Supply chain interruptions are even more threaten- ing during financial crises because, at the same time, the competitive land- scape is rapidly changing, making one company’s loss another’s gain.9 During the 1997 Korean financial crisis, one automobile company had a substantial portion of its parts suppliers go under. Without backup suppliers in place, it could not ramp up production for the export market after the devaluation of the Korean won. While their foreign distributors were beg- ging for more cars to sell, some of the production lines in Korea were idle due to a lack of critical parts. The company managed to revive itself but never fully recovered its market position. It was bought out eventually stream by another domestic auto company that used the crisis to rapidly expand its global market share.
Suppliers are prone to the same liquidity issues that all companies face in financial crises. Doubts may arise about the ability of the afflicted parties to pay. Even those willing to extend credit may face the shutdown of the international payments system and correspondent banking lines, making further transactions impossible.10 The consequences can be devastating;
thus, the companies that rely heavily on suppliers may need to lend them a hand when a crisis hits. Ramayana, for example, used its favorable cash position during the Asian financial crisis to make early payments to some of its 2,000 suppliers, which helped keep them afloat until the banks were functioning again. In exchange, Ramayana received rebates from its suppli- ers, ranging from 3 to 8 percent, which allowed it to offset crisis-related increases to its cost of goods.
Because retailers and manufacturers in developed markets source many of their critical components from developing markets, the supply chain operations in those developing markets are of particular importance to them. Suppliers and shippers in developing markets will almost certainly face liquidity issues in a crisis, and may halt shipments of critical inputs unless they receive assistance.
During the Mexican financial crises of the 1980s, for example, Volks- wagen helped out its suppliers by signing long-term contracts with them.
Although Volkswagen did not guarantee the loans, it provided the suppliers with the credibility they required to obtain financing. The company also helped suppliers negotiate with their labor unions, acquire land at a reason- able cost, and obtain tax incentives.
Managing Downstream Links Financial crises can also impact the purchase of goods by affecting the purchasing power of consumers. This is particularly true of luxury items and goods whose purchase can be postponed. Further- more, a breakdown in the domestic payment systems, as seen in Argentina in 2002, can devastate business by restricting the amount of cash in the economy.
At Alarko, for example, managers work closely with the company’s dealer network to provide support during crisis periods. When the current crisis first hit Turkey at the beginning of 2001, for instance, they focused on identifying ways that the company could help support the financial needs of its dealers through more frequent localized promotions, higher margins to dealers, or longer payment terms. Alarko managed to keep a loyal and moti- vated dealer network. Currently in 2002, one year after the beginning of the crisis, managers are going through another round of dealer assessments to search for other ways in which the company can support them.11
During and before a crisis, management needs to have a better under- standing of which customer and supplier relationships should be nurtured and which should be terminated. Using this information, it can refocus its marketing, sales, and pricing efforts on the most attractive geographic, prod- uct, and customer segments. This process is also important for helping com- panies prioritize with whom they need to communicate first during a crisis.
Making the most of the harsh, post-crisis landscape, of course, takes a lot of ingenuity. During the crisis, Ramayana found that it needed to cut costs and keep operating expenses under a targeted 18 percent. The com- pany did this cleverly, working with its suppliers to use fewer print designs and accessories such as imported buttons from Taiwan and Korea, and to cut the amount of material in each article of clothing to save on the cost of fabric. At the same time, it decided not to raise its prices—to retain its lower-income and more price-sensitive customers—and thus endured a slight decline in its gross margins, which fell from 28.8 percent in 1996 to 25.9 percent in 1998.12Through this and other efforts, Ramayana was able to retain price-sensitive customers and continue to make a profit.
3. Conduct Rigorous Scenario Planning
Scenario planning is necessary to understand the effects of a financial crisis on the company’s performance. These analyses give managers both a picture