Tài liệu Corporate finance Part 4- Chapter 2 pptx

management of financial risks, particularly interest rate, exchange rate,liquidity, credit risks and the risk of fluctuations in raw materials prices,which is described in Chapter 48.. VAL

Managing net debt and financial risks

In this part, we aim to analyse the day-to-day management of a company’sfinancial resources in terms of:

. management of cash flows and treasury, which we will examine in Chapter 46;and

. management of financial risks, particularly interest rate, exchange rate,liquidity, credit risks and the risk of fluctuations in raw materials prices,which is described in Chapter 48

These components were traditionally managed by distinct corporate functions –i.e., treasury and risk management This said, they have now generally been pooledunder the responsibility of the corporate treasurer given the interlinkage betweenthem His or her role is to oversee:

. a centralised treasury unit responsible for managing cash flows;

. a financing unit responsible for securing funds and negotiating borrowingterms with banks; and

. a front-office unit handling market transactions as well as interest rate andexchange rate risks;

. in large groups, a joint administrative unit (‘‘back office’’) that processestransactions for all units

We will also cover a particular aspect of debt financing, which is closely linkedwith the management of risk: Chapter 47 details how the company can finance itself

by giving in guarantee some of its assets Asset-based financing is often linked tooff-balance-sheet financing, although tighter accounting rules make it now harder

to achieve

Managing cash flows

A balancing act

Cash flow management is the traditional role of the treasury function It handlescash inflows and outflows, as well as intra-group fund transfers With thedevelopment of information systems, this function is usually automated As aresult, the treasurer merely designs or chooses a model, and then only supervisesthe day-to-day operations Nonetheless, we need to take a closer look at the basicmechanics of the treasury function to understand the relevance and the impact ofthe different options

Sections 46.1 and 46.2 explain the basic concepts of cash flow management, aswell as its main tools These factors are common to both small companies andmultinational groups Conversely, the cash-pooling units described in Section 46.3remain the sole preserve of groups In Section 46.4 we describe the products thatthe treasurer may use to invest the firm’s residual cash in hand

Example BigA, a company headquartered in Toulouse, issues a cheque forC

¼1,000 on 15 April to its supplier SmallB in Nice Three different people willrecord the same amount, but not necessarily on the same date:

. BigA’s accountant, for whom the issue of the cheque theoretically makes thesum of C¼1,000 unavailable as soon as the cheque has been issued;

. BigA’s banker, who records the C¼1,000 cheque when it is presented forpayment by SmallB’s bank He then debits the amount from the company’saccount based on this date;

. BigA’s treasurer, for whom the C¼1,000 remains available until the cheque hasbeen debited from the relevant bank account The date of debit depends on

when the cheque is cashed in by the supplier and how long the payment processtakes.

There may be a difference of several days between these three dates, whichdetermines movements in the three separate balances

Cash management based on value dates1 is built on an analysis from thetreasurer’s standpoint The company is interested only in the periods duringwhich funds are actually available Positive balances can then be invested orused, while negative balances generate real interest expense

The date from which a bank makes incoming funds available to its customersdoes not correspond exactly to the payment date As a result, a value date can bedefined as follows:

. for an interest-bearing account, it represents the date from which an amountcredited to the account bears interest following a collection of funds; and thedate from which an amount debited from the account stops bearing interestfollowing a disbursement of funds;

. for a demand deposit account, it represents the date from which an amountcredited to the account may be withdrawn without the account holder having

to pay overdraft interest charges (in the event that the withdrawal would makethe account show a debit balance) following a collection, and the date fromwhich an amount debited from the account becomes unavailable following adisbursement

Under this system, it is therefore obvious that:

. a credit amount is given a value date after the credit date for accountingpurposes;

. a debit amount is given a value date prior to the debit date for accountingpurposes

Let us consider, for example, the deposit of the C¼1,000 cheque received by SmallBwhen the sum is paid into an account We will assume that the cash in process isassigned a value date three calendar days later and that on the day following thedeposit SmallB makes a withdrawal of C¼300 in cash, with a value date of 1 day

VALUE DATES

Although the account balance always remains in credit from a accountingstandpoint, the balance from a value date standpoint shows a debit of C¼300until Dþ 3 The company will therefore incur interest expense, even though itsfinancial statements show a credit balance

1 Note that the

value date basis

and in credit from

an accounting

standpoint.

Consequently, a payment transaction generally leads to a debit for the

company on a value date basis several days prior to the date of the transaction

for accounting purposes Value dates are thus a way of charging for banking services

and covering the corresponding administrative costs Nonetheless, value dates

penalise large debits, the cost of which is no higher from an administrative

standpoint than that of debit transactions for smaller amounts

2 / Account balancing

Company bank current accounts are intended simply to cover day-to-day cash

management They offer borrowing and investment conditions that are far from

satisfactory:

. the cost of an overdraft is much higher than that of any other type of

borrowing;

. the interest rate paid on credit balances is low or zero and is well below the

level that can be obtained on the financial markets

It is therefore easy to understand why it makes little sense for the company to run a

permanent credit or debit balance on a bank account A company generally has

several accounts with various different banks In some cases, an international group

may have several hundred accounts in numerous different currencies, although the

current trend is towards a reduction in the number of accounts operated by

businesses

In the account-balancing process, cash surpluses are pooled on a daily basis into a

concentration account through interbank transfers and are used to finance accounts

in debit

One of the treasurer’s primary tasks is to avoid financial expense (or maximise

financial income) deriving from the fact that some accounts are in credit while

others show a debit balance The practice of account-balancing is based on the

following two principles:

. avoiding the simultaneous existence of debit and credit balances by transferring

funds from accounts in credit to those in debit;

. channelling cash outflows and cash inflows so as to arrive at a balanced overall

cash position

Although the savings achieved in this way have been a decisive factor in the

emergence of the treasury function over the past few decades, only small companies

still have to face this type of problem Banks offer account balancing services,

whereby they automatically make the requisite transfers to optimise the balance

of company accounts

3 / Bank charges

The return on capital employed2generated by a bank from a customer needs to be

analysed by considering all the services, loans and other products the bank offers,

including some:

2 When a bank lends some money,

it ‘‘uses part of the bank equity’’ because it has to constitute a minimum solvency ratio (equity/ weighted assets).

. not charged for and thus representing unprofitable activities for the bank(e.g., cheques deposited by retail customers);

. charged for over and above their actual cost, notably using charging systemsthat do not reflect the nature of the transaction processed

The banking industry is continuously reorganising its system of bank charges Thecurrent trend is for it to cover its administrative processing costs by charging feesand to establish the cost of money (i.e., the cost of the capital lent to customers) bylinking interest rates to financial markets Given the integration between bankingactivities (loans, payment services and investment products), banks generally applyflat rate charges (i.e., not linked to the amount borrowed)

Transfers between Eurozone banks have been made much easier andautomated to a great extent under the aegis of the European Central Bank As aresult, the traditional practice of value-dating has been called into question.Nonetheless, it remains the cornerstone of the system of bank charges in variousdifferent Continental European countries, and particularly France, Italy, Spain andPortugal

The cash budget, showing the amount and duration of expected cash surplusesand deficits, serves two purposes:

. to ensure that the credit lines in place are sufficient to cover any fundingrequirements;

. to define the likely uses of loans by major categories (e.g., the need to discountbased on the company’s portfolio of trade bills and drafts)

Planning cash requirements and resources is a way of adapting borrowing andinvestment facilities to actual needs and, first and foremost, of managing a group’sinterest expense It is easy to see that a better rate loan can be negotiated if the need

is forecast several months in advance Likewise, a treasury investment will be moreprofitable over a predetermined period, during which the company can commit not

to use the funds

The cash budget is a forward-looking management chart showing supply anddemand for liquidity within the company It allows the treasurer to manage interestexpense as efficiently as possible by harnessing competition not only amongdifferent banks, but also with investors on the financial markets

2 / Forecasting horizons

Different budgets cover different forecasting horizons for the company Budgets

can be used to distinguish between the degree of accuracy users are entitled to

expect from the treasurer’s projections

Companies forecast cash flows by major categories over long-term periods and

refine their projections as cash flows draw closer in time Thanks to the various

services offered by banks, budgets do not need to be 100% accurate, but can focus

on achieving the relevant degree of precision for the period they cover

An annual cash budget is generally drawn up at the start of the year based on

the management control budget The annual budgeting process involves translating

the expected profit and loss account into cash flows The top priority at this point is

for cash flow figures to be consistent and material in relation to the company’s

business activities At this stage, cash flows are classified by category rather than by

type of payment

These projections are then refined over periods ranging from 1 to 6 months to

yield rolling cash budgets, usually for monthly periods These documents are used

to update the annual budgets based on the real level of cash inflows and outflows,

rather than using management accounts

Day-to-day forecasting represents the final stage in the process This is the basic

task of a treasurer and the basis on which his or her effectiveness is assessed

Because of the precision required, day-to-day forecasting gives rise to complex

problems:

. it covers all movements affecting the company’s cash position;

. each bank account needs to be analysed;

. it is carried out on a value date basis;

. it exploits the differences between the payment methods used;

. as far as possible, it distinguishes between cash flows on a category-by-category

basis

The following table summarises these various aspects

BANK No 1Account value datesMonday Tuesday Wednesday Thursday FridayBills presented for payment

BANK No 1 (cont.)Account value datesMonday Tuesday Wednesday Thursday FridayCustomer bills presented for

collectionCheques paid inStanding orders receivedTransfers receivedInterest on treasury placementsSundry transactions

(2) TOTAL RECEIPTS(2)
(1) ¼ DAILY BALANCE ON AVALUE DATE BASIS

Day-to-day forecasting has been made much easier by IT systems

Thanks to the ERP3 and other IT systems used by most companies, theinformation received by the various parts of the business is processed directlyand can be used to forecast future disbursements instantaneously As a result,cash budgeting is linked to the availability of information and thus of thecharacteristics of the payment methods used

3 / The impact of payment methods

The various payment methods available raise complex problems and may give rise

to uncertainties that are inherent in day-to-day cash forecasting There are twomain types of uncertainty:

. Is the forecast timing of receipts correct? A cheque may have been collected by asales agent without having immediately been paid into the relevant account Itmay not be possible to forecast exactly when a client will pay down its debt bybank transfer

. When will expenditure give rise to actual cash disbursements? It is impossible tosay exactly when the creditor will collect the payment that has been handedover (e.g., cheque, bill of exchange or promissory note)

From a cash-budgeting standpoint, payment methods are more attractive whereone of the two participants in the transaction possesses the initiative both in terms

of setting up the payment and triggering the transfer of funds Where a company hasthis initiative, it has much greater certainty regarding the value dates for thetransfer

The following table shows an analysis of the various different paymentmethods used by companies from this standpoint It does not take into accountthe risk of nonpayment by a debtor (e.g., not enough funds in the account, insuf-ficient account details, refusal to pay) This risk is self-evident and applies to allpayment methods

3 Enterprise

Resources

Planning.

Initiative for setting Initiative for Utility for cash

up the transfer completing the budgeting

fund transfer

Paper bill of exchange4 Creditor Creditor Helpful to both

parties insofar asthe deadlines aremet by the creditorsPaper promissory note5 Debtor Creditor

Electronic bill of Creditor Creditor

exchange6

Electronic promissory Debtor Creditor

note7

From this standpoint, establishing the actual date on which cheques will be paid

represents the major problem facing treasurers Postal delays and the time taken by

the creditor to record the cheque in its accounts and to hand it over to its bank

affect the debit date Consequently, treasurers endeavour to:

. process cheques for small amounts globally, to arrive at a statistical rule of

thumb for collection dates, if possible by periods (10th, 20th, end-of-month);

. monitor large cheques individually to get to know the collection habits of the

main creditors – e.g., public authorities (social security, tax, customs, etc.),

large suppliers and contractors

Large companies negotiate with their banks so that they are debited with a value

date of Dþ 1 for their cheques, where D is the day on which the cheques arrive at

the clearinghouse As a result, they know in the morning which cheques will be

debited with that day’s value date

Although their due date is generally known, domiciled bills and notes can also

cause problems If the creditor is slow to collect the relevant amounts, the debtor,

which sets aside sufficient funds in its account to cover payment on the relevant

date, is obliged to freeze the funds in an account that does not pay any interest

Once again, it is in the interests of the debtor company to work out a statistical rule

of thumb for the collection of domiciled bills and notes and to get to know the

collection habits of its main suppliers

The treasurer’s experience is invaluable, especially when it comes to forecasting

the behaviour of customers (payment dates) and of creditors (collection dates for

the payment methods issued)

Aside from the problems caused by forecasting uncertainties, payment methods do

not all have the same flexibility in terms of domiciliation – i.e., the choice of

account to credit or debit The customer cheques received by a company may be

paid into an account chosen by the treasurer The same does not apply to standing

orders and transfers, where the account details must usually be agreed in advance

and for a certain period of time This lack of flexibility makes it harder to balance

4 Written document, in which the supplier asks the customer

to pay the amount due to its bank on the due date.

5 Written document, in which the customer acknowledges its debt and undertakes to pay the supplier on the due date.

6 Electronic bill

of exchange on a magnetic strip.

7 Electronic promissory note

on a magnetic strip.

8 Order given by the customer to its bank to debit a sum from its account and to credit another account.

9 Payment method, whereby

a debtor asks its creditor to issue standing orders and its bank to pay the standing orders.

accounts Lastly, the various payment methods have different value dates Thetreasurer needs to take the different value dates into account very carefully inorder to manage his or her account balances on a value date basis.

4 / Optimising cash management

Our survey of account balancing naturally leads us to the concept of zero cash, thenirvana of corporate treasurers, which keeps interest expense down to a bareminimum

Even so, this aim can never be completely achieved A treasurer always has todeal with some unpredictable movements, be they disbursements or collections.The greater the number or the volume of unpredictable movements, the moreimprecise cash budgeting will be and the harder it is to optimise This said, severaltechniques may be used to improve cash management significantly

(a) Behavioural analysis

The same type of analysis as performed for payment methods can also yield directbenefits for cash management The company establishes collection times based onthe habits of its suppliers A statistical average for collection times is thencalculated Any deviations from the normal pattern are usually offset where anaccount sees a large number of transactions This enables the company to managecash balance on each account to ‘‘cover’’ payments forecast with a certain delay of up

to 4 or 5 days for value date purposes

Optimising forecasts using behavioural studies directly leads to the optimisation ofcash flow management

In any case, payments will always be covered by the overdraft facilities agreed withbanks, the only risk for the company being that it will run an overdraft for some,but over a limited period and thus pay higher interest expense

(b) Intercompany agreements

Since efficient treasury management can unlock tangible savings, it is only normalfor companies that have commercial relationships with each other to get together tomaximise these gains Various types of contract have been developed to facilitateand increase the reliability of payments between companies Some companies haveattempted to demonstrate to their customers the mutual benefits of harmonisation

of their cash management procedures and have negotiated special agreementswith customers in certain cases In a bid to minimise interest expense attributable

to the use of short-term borrowings, others offer discounts to their customers forswift payment Nonetheless, this approach has drawbacks because for obviouscommercial reasons it is hard to apply the stipulated penalties when contractsare not respected

(c) Lockbox systems

Under the lockbox system, the creditor asks its debtors to send their payments

directly to a PO box that is emptied regularly by its bank The funds are

immedi-ately paid into the banking system, without first being processed by the creditor’s

accounting department

When the creditor’s and debtor’s banks are located in the same place, cheques

can easily be cleared on the spot Such clearing represents another substantial time

saving

(d) Checking bank terms

The complexity of bank charges and the various different items on which they are

based makes them hard to check This task is thus an integral part of a treasurer’s

job

Companies implement systematic procedures to verify all the aspects of bank

charges In particular, treasurers are keen to get their banks to ensure that all

payments are credited or debited with a value date of Dþ 1, with any gains or

losses being set off against the corresponding cash volumes on a monthly or

quarterly basis The conditions used to calculate interest payments and transaction

charges may be verified by reconciling the documents issued by the bank

(particularly interest rate scales and overdraft interest charges) with internal cash

monitoring systems Flat rate charges may be checked on a test basis The most

common bank errors occur when standard conditions are applied rather than the

specific terms negotiated In addition, failure to meet the counter opening times

(which determine the day on which a transaction is deemed to have been executed)

and mistakes in credit and debit interest are also the source of potential bank

errors

Section 46.3

Cash management within a group

Managing the cash positions of the subsidiaries of a group is akin to managing the

individual bank accounts held by each subsidiary Prior to any balancing between

subsidiaries at group level, each subsidiary balances its own accounts

Consequently, managing the cash position of a group adds an additional tier of

data-processing and decision-making based on principles that are exactly the same

as those explained in Sections 46.1 and 46.2 for individual companies (i.e., group

subsidiaries or SMEs10)

1 / Centralised cash management

The methods explained in the previous sections show the scale of the task facing a

treasury department It therefore seems natural to centralise cash management on a

10 Small- and Medium-sized Enterprises.

groupwide basis, a technique known as cash pooling, since it allows a group to takeresponsibility for all the liquidity requirements of its subsidiaries.

The cash positions of the subsidiaries (lenders or borrowers) can thus be pooled

in the same way as the various accounts of a single company, thereby creating agenuine internal money market The group will thus save on all the additional costsderiving from the inefficiencies of the financial markets (bank charges, brokeragefees, differences between lending and borrowing rates, etc.) In particular, cashpooling enables a group to hold onto the borrowing/lending margin that banksare normally able to charge

Cash pooling balances the accounts of a group’s subsidiaries, thereby saving on theinterest expense deriving from the market’s inefficiencies

This is not the only benefit of pooling It gives a relatively big group comprising alarge number of small companies the option of tapping financial markets Informa-tion-related costs and brokerage fees on an organised market may prevent a largenumber of subsidiaries from receiving the same financing or investment conditions

as the group as a whole With the introduction of cash pooling, the corporatetreasurer satisfies in the markets the financing needs of the group The treasurerthen organises an internal refinancing of each subsidiary on the same financingterms as the group receives

Cash pooling has numerous advantages The manager’s workload is notproportional to the number of transactions or the size of the funds undermanagement Consequently, there is no need to double the size of a departmenthandling the cash needs of twice the number of companies The skills of existingteams will nevertheless need to be enhanced Likewise, investment in systems(hardware, software, communication systems, etc.) can be reduced when they arepooled within a single central department Information-gathering costs can yieldthe same type of saving Consequently, cash pooling offers scope for genuine

‘‘industrial’’ economies of scale

The compelling logic of having such a unit sometimes masks its raison d’eˆtrebecause although the creation of a cash-pooling unit may be justified by very goodreasons, it may also lead to an unwise financial strategy and possibly even manage-ment errors Notably, cash pooling will give rise to an internal debt market totallydisconnected from the assets being financed Certain corporate financiers may still

be heard to claim that they have secured better financing or investment terms byleveraging the group’s size or the size of the funds under management But suchclaims do not stand up to analysis because the level of risk associated withinvestments alone determines their financing cost in a market economy If theintegration of a company within a larger group enables it to secure better financingterms, this improvement will be to the detriment of the overall entity’s borrowingcosts We recommend that any readers still tempted to believe in financialeconomies of scale take another look at the analysis in Chapter 35

In theory, once a company has achieved the critical mass needed to give it access tothe financial markets, any economies of scale generated by cash pooling are

‘‘industrial’’ rather than financial

This said, we concede that cash pooling may create a mass effect leading certain

banks concerned solely with their market share to overlook the link between risk

and profitability!

A prerequisite for cash pooling is the existence of an efficient system

transmit-ting information between the parent company and its subsidiaries (or between the

head office and decentralised units) The system requires the subsidiaries to send

their forecasts to the head office in real time The rapidity of fund movements –

i.e., the unit’s efficiency – depends on the quality of these forecasts, as well as on

that of the corporate information system

Lastly, a high degree of centralisation reduces the subsidiaries’ ability to take

initiatives The limited responsibilities granted to local cash managers may not

encourage them to optimise their own management, when it comes to either

conducting behavioural analysis of payments or controlling internal parameters

Local borrowing opportunities at competitive rates may therefore go begging

To avoid demotivating the subsidiaries’ treasurers, they may be given greater

responsibility for local cash management

2 / The different types and degrees of centralisation

Looking beyond its unifying nature in theory, there are many different ways of

pooling a group’s cash resources in practice, ranging from the outright elimination

of the subsidiaries’ cash management departments to highly decentralised

management There are two major types of organisation, which reflect two opposite

approaches:

. Most common is the centralisation of balances and liquidity, which involves

the groupwide pooling of cash from the subsidiaries’ bank accounts The group

balances the accounts of its subsidiaries just as the subsidiaries balance their

bank accounts There are various different variations on this system

. Significantly rarer is the centralisation of cash flows, under which the group’s

cash management department not only receives all incoming payments, but

may also even make all the disbursements The department deals with issues

such as due dates for customer payments and customer payment risks, reducing

the role of any subsidiary to providing information and forecasting This type

of organisation may be described as hypercentralised

The centralisation of cash balances can be dictated from above or carried out

upon the request of the subsidiary In the latter case, each subsidiary decides to

use the group’s cash or external resources in line with the rates charged, thereby

creating competition between the banks, the market and internal funds This

flexibility can help alleviate any demotivation caused by the centralisation of

cash management

In addition, coherent cash management requires the definition of uniform

banking terms and conditions within a group In particular, fund transfers between

subsidiaries should not be subject to value dating

NOTIONAL POOLING AND THE RISK OF BANKRUPTCY

Notional pooling provides a relatively flexible way of exploiting the benefits of cashpooling With notional pooling, subsidiaries’ account balances are never actuallybalanced, but the group’s bank recalculates credit or debit interest based on thefictitious balance of the overall entity This method yields exactly the same result as

if the accounts had been perfectly balanced, but the fund transfers are never carriedout in practice As a result, this method leaves subsidiaries’ some room formanoeuvre and does not impact their independence

A high-risk subsidiary thus receives financing on exactly the same terms as thegroup as a whole, while the group can benefit from limited liability from a legalstandpoint by declaring its subsidiary bankrupt Notional pooling prevents a bankfrom adjusting its charges, thus introducing additional restrictions and settingreciprocal guarantees between each of the companies participating in the poolingarrangements This network of contracts may prove to be extremely hard andcomplex to manage

Consequently, cash balances are more commonly pooled by means of the dailybalancing of the subsidiaries’ positions The Zero Balance Account (ZBA) conceptrequires subsidiaries to balance their position (i.e., the balance of their bankaccounts) each day by using the concentration accounts managed at group orsubgroup level The banks offer automated balancing systems and can performall these tasks on behalf of companies

To sum up, the degree of centralisation of cash management and the methodused by a group do not depend on financial criteria only The three key factors are

as follows:

. the group’s managerial culture – e.g., notional pooling is more suited to highlydecentralised organisations than daily position balancing;

. regulations and tax systems in the relevant countries;

. the cost of banking services While position balancing is carried out by thegroup, notional pooling is the task of the bank

3 / International cash management

The problems arising with cash pooling are particularly acute in an internationalenvironment This said, international cash management techniques are exactly the

same as those used at national level – i.e., pooling on demand, notional pooling,

account balancing

Regulatory differences make the direct pooling of account balances of foreign

subsidiaries a tricky task Indeed, many groups find that they cannot do without

the services of local banks, which are able to collect payments throughout a given

zone Consequently, multinational groups tend to apply a two-tier pooling system

A local concentration bank performs the initial pooling process within each

country, and an international banking group, called an overlay bank, then handles

the international pooling process

INTERNATIONAL CASH POOLING

The international bank sends the funds across the border, as shown in the above

chart, which helps to dispense with a large number of regulatory problems

At local level, centralisation can be tailored to the specific regulatory

require-ments in each country, while at the higher level the international bank can carry out

both notional pooling and daily account balancing Lastly, it can manage the

subsidiaries’ interest and exchange rate risks (see Chapter 48) by offering exchange

rate and interest rate guarantees The structure set up can be used to manage all the

group’s financial issues rather than just the cash management aspects

Within the Eurozone, the interconnection of payment systems under the aegis

of the European Central Bank has made it possible to carry out fund transfers in

real time, more cheaply and without having to face the issue of value dating In the

Eurozone, cash pooling may thus be carried out with the assistance of a single

concentration bank in each country with cross-border transfers not presenting any

problems

Section 46.4

Investment of cash

Financial novices may wonder why debt-burdened companies do not use their cash

to reduce debt There are two good reasons for this:

. Paying back debt in advance can be costly because of early repayment penalties

or unwise, if the debt was contracted at a rate that is lower than rates prevailingtoday

. Keeping cash on hand enables the company to seize investment opportunitiesquickly and without constraints or to withstand changes in the economicenvironment Some research papers11 have demonstrated that companieswith strong growth or volatile cash flows tend to have more free cash thanaverage Conversely, companies that have access to financial markets orexcellent credit ratings have less cash than average

Obviously, all financing products used by companies have a mirror image asinvestment products, since the two operations are symmetrical The corporatetreasurer’s role in investing the company’s cash is nevertheless somewhat specificbecause the purpose of the company is not to make profits by engaging in riskyfinancial investments This is why specific products have been created to meet thiscriterion

Remember that all investment policies are based on anticipated developments

in the bank balances of each account managed by the company or, if it is a group,

on consolidated, multicurrency forecasts The treasurer cannot decide to make aninvestment without first estimating its amount and the duration Any mistake andthe treasurer is forced to choose between two alternatives:

. either having to resort to new loans to meet the financial shortage created if toomuch cash was invested, thus generating a loss on the difference betweenlending and borrowing rates (i.e., the interest rate spread);

. or having to retrieve the amounts invested and incur the attendant penalties,lost interest or, in certain cases such as bond investments, risk of a capital loss.Since corporate treasurers rarely know exactly how much cash they will haveavailable for a given period, their main concern when choosing an investment isits liquidity – that is, how fast can it be converted back into cash For an investment

to be cashed in immediately, it must have an active secondary market or a redemptionclause that can be activated at any time

The corporate treasurer’s first concern in investing cash is liquidity

Of course, if an investment can be terminated at any time, its rate of return isuncertain since the exit price is uncertain A 91-day Treasury bill at a nominal rate

of 4% can be sold at will, but its actual rate of return will depend on whether thebill was sold for more or less than its nominal value However, if the rate of return

is set in advance it is virtually impossible to exit the investment before its maturitysince there is no secondary market or redemption clause, or else, only at aprohibitive cost

The treasurer’s second concern – security – is thus closely linked to the first.Security is measured in terms of the risk to the interest and principal

When making this tradeoff between liquidity and security, the treasurer will, ofcourse, try to obtain the best return taking into consideration tax issues, sincevarious investment products may be subject to different tax regimes

11 T Opler, L.

Pinkowitz, R.

Stulz and R.

Williamson.

1 / Investment products with no secondary market

Interest-bearing current accounts are the simplest way to earn interest on cash

Nevertheless, interest paid by banks on such accounts is usually significantly

lower than what the money market offers

Time deposits are fixed term deposits on an interest-bearing bank account that

are governed by a letter signed by the account holder The interest on deposits with

maturity of at least 1 month is negotiated between the bank and the client It can be

at a fixed rate or indexed to the money market No interest is paid if the client

withdraws the funds before the agreed maturity date

Repos (repurchase agreements) are agreements whereby institutional investors

or companies can exchange cash for securities for a fixed period of time (a securities

for cash agreement is called a reverse repo) At the end of the contract, which can

take various legal forms, the securities are returned to their initial owner All title

and rights to the securities are transferred to the buyer of the securities for the

duration of the contract

The remuneration of the buyer of the securities can be determined at the outset

according to how the contract will be unwound The agreement can be adapted to

various requirements The only risk is that the borrower of the cash (the repo seller)

will default

Repo sellers hold equity or bond portfolios, while repo buyers are looking for

cash revenues From the buyer’s point of view, a repo is basically an alternative

solution when a time deposit is not feasible – for example, for periods of less than

1 month A repo allows the seller to obtain cash immediately by pledging securities

with the assurance that it can buy them back

Since the procedure is fairly unwieldy, it is only used for large amounts, well

above C¼2m This means that it competes with negotiable debt securities, such as

commercial paper However, the development of money market mutual funds

investing in repos has lowered the C¼2m threshold and opened up the market to

a larger number of companies

The principle of securities lending is similar to that of repurchase agreements

It enables a company with a large cash surplus or listed investments to improve the

yield on its financial instruments by entrusting them to institutional investors

These investors use them in the course of forward transactions while paying to

the original owner (the company) the income arising on the securities and a

borrowing fee No cash changes hands in the course of the transaction The

incremental return thus stems from the remuneration of default risk on the part

of the institutional investors borrowing the securities

2 / Secondary market investment products

Marketable Treasury bills and notes are issued by governments at monthly or

weekly auctions for periods ranging from 2 weeks to 5 years They are the safest

of all investments given the creditworthiness of the issuer (governments), but their

other features make them less flexible and competitive However, the substantialamount of outstanding negotiable Treasury bills and notes ensures sufficientliquidity, even for large volumes These instruments can be fairly good vehiclesfor short-term investments.

Certificates of deposit (CDs) are quite simply time deposits represented by

a dematerialised negotiable debt security in the form of a bearer certificate ororder issued by an authorised financial institution Certificates of deposit areissued in minimum amounts of C¼150,000 for periods ranging from 1 day to

1 year with fixed maturity dates In fact, they are a form of short-terminvestment CDs are issued by banks, for which they are a frequent means ofrefinancing, on a continuous basis depending on demand Their yield is veryclose to that of the money market, and their main advantage is that they can betraded on the secondary market, thus avoiding the heavy penalties of cashing intime deposits before their maturity date The flipside is that they carry an interestrate risk

We described the main characteristics of commercial paper and medium-termnegotiable notes on pp 497 and 519

Money market or cash mutual funds are funds that issue or buy back theirshares at the request of investors at prices that must be published daily.The return on a money market capitalisation mutual fund arises on the dailyappreciation in Net Asset Value (NAV) This return is similar to that of themoney market Depending on the mutual fund’s stated objective, the increase innet asset value is more or less steady A very regular progression can only beobtained at the cost of profitability

In order to meet its objectives, each cash mutual fund invests in a selection ofTreasury bills, certificates of deposit, commercial paper, repos, variable or fixedrate bonds with short residual maturity Its investment policy is backed by quitesophisticated interest rate risk management The management fees of cashmutual funds are paid out of the fund’s net asset value (there is no direct entry

or exit fee)

Securitisation vehicles are special-purpose vehicles created to take over theclaims sold by a credit institution or company engaging in a securitisationtransaction (see p 961) In exchange, these vehicles issue units that the institutionsells to investors

In theory, bond investments should yield higher returns than money market ormoney-market-indexed investments However, interest rate fluctuations generatecapital risks on bond portfolios that must be hedged, unless the treasurer hasopted for variable rate bonds Investing in bonds therefore calls for a certaindegree of technical knowhow and constant monitoring of the market Only alimited number of institutional investors have the resources to invest directly inbonds

The high yields arising on investing surplus cash in the equity market overlong periods become far more uncertain on shorter horizons, when the capitalrisk exposure is very high, well above that of a bond investment Treasurersmust keep a constant eye on the secondary market, and sharp market swingshave rendered the few treasurers still invested in the equity market extremelycautious However, treasurers may be charged with monitoring portfolios ofequity interests

A treasurer’s job is to perform the following tasks:

forecast trends in the credit and debit balances of the company’s accounts;

keep dormant funds to a minimum;

invest excess cash as efficiently as possible;

finance borrowing requirements as cheaply as possible

Cash balances for treasury purposes are not the same as the balances shown in a

company’s accounts or the accounting balance of its assets held by the bank In particular,

treasurers must take account of value dating The value date is the date from which a

credited amount accrues interest when paid into an interest-bearing account or becomes

available when paid into a demand account

The aim of the cash budget is to determine the amount and duration of cash requirements

and surpluses A cash budget shows all the receipts and all the disbursements that the

business expects to collect or make Day-to-day forecasting, which takes into account

value dating, requires paying considerable attention to the payment methods used

Forecasts are more reliable when the treasurer has the initiative both for setting up a

payment and for carrying out the fund transfer

Account balancing is the final stage in the liquidity management process It eliminates the

additional costs deriving from differences between borrowing and investment rates

Lastly, optimised cash management entails the acceleration of the collection process

and the extension of suppliers’ payment deadlines

Cash pooling – the centralisation of subsidiaries’ account balances within a group – is

comparable with the process of balancing all of a subsidiary’s accounts Pooling is

generally backed up by an integrated information system and a groupwide agreement

concerning banking terms and conditions At the international level, regulatory difficulties

concerning cross-border transfers prevent the direct balancing of subsidiaries’ accounts

Instead, the initial pooling process is carried out by a local bank in each country, and then

the resulting balances are pooled by an international banking group

The corporate treasurer’s first concern in investing cash is liquidity The treasurer’s

second concern – security – is thus closely linked to the first Security is measured in

terms of the risk to the interest and principal The products he can use can be split

between products with a secondary market (Treasury bills, money market funds, .) or

without (time deposit, repos, .)

Website of the Association of Corporate Treasurers:

www.treasurers.org

General:

J Graham, C Harvey, The theory and practice of corporate finance: Evidence from the field, Journal

of Financial Economics, 60(2–3), 179–185, June 2001.

M Dolfe, European Cash Management: A Guide to Best Practice, John Wiley & Sons, 1999.

R Cooper, Corporate Treasury and Cash Management, Palgrave Macmillan, 2003.

T Opler, L Pinkowitz, R Stulz, R Williamson, The determinants and implications of corporate cash

holdings, Journal of Financial Economics, 52, 3–46, 1999.

SUMMARY

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BIBLIOGRAPHY

Asset-based financing

There is something rotten in this kingdom of accounting

Since the beginning of time, companies have tried to remove assets and liabilitiesfrom their balance sheets The aim is to reduce the company’s apparent debtburden or to base financing on specific assets, thereby reducing, theoretically, thecost The discounting of bills of exchange, an early example, has been part of thebanker’s bread and butter for centuries As you will soon discover, many morecomplicated techniques have since been developed!

After enjoying great popularity in the 1990s, most asset-based financing niques will now be included in the balance sheet according to IASB1 rules Inparticular, Enron’s spectacular bankruptcy towards the end of 2001 is causingthe accounting profession to tighten up treatment of some financing products

tech-Section 47.1

Reasons for using asset-based financing

Five nonmutually exclusive objectives might prompt a company to use asset-basedfinancing:

? Find a new source of financing that is less expensive than the company’s overallcost of financing A Special Purpose Vehicle (SPV) is created to own certainassets The SPV then obtains a higher rating than the company By segmentingrisks, the company is better able to attract investors looking to specialise in aparticular type of risk (property risks, default risk, etc.) They are ready to pay

a higher price to gain access to exactly the risk/return profiles they seek Thecatch is this: for the transaction to be value-creating, the increase in theperceived risk of the rest of the group must be smaller than the savings derivedfrom the cheaper financing the SPV obtained on the assets transferred.Unfortunately, the theory of perfect capital markets does not leave muchroom for manoeuvre!

? Transfer risk The company may decide that assuming the risk of fluctuations

in the property market, in the value of used cars, etc., is not its core business.Selling an asset, then leasing it back may enable the company to get rid ofthe risk associated with the asset, while still reaping the benefits of its use

1 International

Accounting

Standards Board.

Similarly, deadbeat customers can take a heavy toll on a company, whereas

using a factor reduces this risk thanks to the law of large numbers Factors

are skilled in measuring payment risks that the company is ill-equipped to

evaluate They make that expertise available to the company and help it

make better client selections in the future Only in this last way can factoring

create value for the company Transfer of risk alone is simply a risk/return

tradeoff and does not create value

? Re-engineer the company operationally: outsourcing certain functions so as to

increase flexibility constitutes the most advanced form of off-balance-sheet

technique (it is then more than just financing) When a company rents its

offices, for example, it is less hesitant to move to a location that better

accommodates its needs This flexibility can be limited, however, if the contract

signed when the structure is first put in place is a long-term one, especially in

case of a very specific asset

? Reduce taxes: always a worthy cause!

? Reduce gearing on the balance sheet and improve financial ratios As clear

as these motives are, achieving them often requires committing to future

operating results or assuming higher overall financing costs Indeed, the

choice is often between optimising financing costs and dressing up the balance

sheet In either case, no value is created

Of the five reasons we have identified, the only questionable one is ‘‘Reduce

gearing’’ A company that raises off-balance-sheet financing with this objective in

mind is trying to give itself a better image than it really deserves Nevertheless, we

must admit that it has become very commonplace, even for the most respected

groups

Let’s think back to Coca-Cola Coca-Cola’s after-tax Return on Capital

Em-ployed (ROCE) appears to be excellent (23% in 2004, excluding equity and other

investments) and its debt moderate (0.06 times EBITDA2) But the bottling assets,

worth $35bn or four times the assets shown on the consolidated balance sheet

($6.3bn), are conveniently lodged in 40%-owned affiliates These affiliates are

financed with the $16bn debt (c 2.4 times EBITDA) Naturally, the affiliates are

accounted for using the equity method as Coca-Cola follows US GAAP.3 Hence,

neither the debt nor the assets appear on the balance sheet of Coca-Cola

The ROCE of these off-balance-sheet assets is 6% We cannot even imagine

Coca-Cola letting these affiliates go bankrupt They carry its name and constitute

an integral part of its business If we were to reintegrate them into the consolidated

balance sheet, Coca-Cola’s restated, after-tax ROCE would be 12%, not 23%, and

its debt would be c 1.2 times EBITDA, not 0.06 times

Companies often provide this information, as Coca-Cola does, in the notes to

the financial statements, which deserve very attentive analysis!

2 Earnings Before Interest, Taxes, Depreciation and Amortisation.

3 Generally Accepted Accounting Principles.

2 / Discounting

Discounting is a financing transaction wherein a company remits an unexpiredcommercial bill of exchange to the bank in return for an advance of the amount

of the bill, less interest and fees

The discounting bank becomes the owner of the bill and, ordinarily, is repaid when

it presents the bill to its customer’s customer for payment If, at maturity, the billremains unpaid, the bank turns to the company, which assumes the bankruptcy risk

of its customer (such discounting is called ‘‘discounting with recourse’’)

In principle, a company uses discounting to obtain financing based on thecredit it extends to its own customers, which may be better known to the bankingsystem than the company is In this way, the company may be able to obtain betterfinancing rates

In discounting, the bank does not finance the company itself, but only certainreceivables in its portfolio – i.e., the bills of exchange These bills offer the bank abetter guarantee of repayment, given the credit quality of the buyers of thecompany’s products

For the bank, the risk is bounded by a double guarantee: the credit quality ofits customer, backed by that of the issuer of the bill of exchange

In consolidated accounting, discounted bills are reintegrated into accountsreceivable and bank advances reported as debt

For this reason, banks now also offer nonrecourse discounting, which is astraight sale of customer receivables, wherein the bank has no recourse to itscustomer if the bill remains unpaid at maturity This technique may allow the

4 See p 127.

company to remove the receivables from its balance and from its off-balance-sheet

commitments and contingencies

3 / Factoring

Factoring actually consists of four different services, sold together or separately:

1 Financing at a competitive cost

2 Outsourcing of the recovery function

3 Bad debt insurance

4 Remove assets from the balance sheet

Factoring is discounting packaged with services

Depending on the type of service rendered, the receivable may or may not

remain on the balance sheet of the company

4 / Leases

Although banks rarely offer long-term loans (more than 7 years) based solely on

the creditworthiness of the borrower, loans backed by specific corporate assets

accompanied by an appropriate legal structure are another story The presence

of these assets considerably reduces the credit risk the bank faces and enables

the bank to grant the loan for the long term Financial leases are such

arrange-ments They take maximum advantage of the collateral offered by the borrower,

and the financing arrangements are structured around the collateral

In a lease contract, the firm (lessee) commits itself to making fixed payments,

usually monthly or semi-annually, to the owner of the asset (lessor) for the right to

use the asset These payments are either fully or partially tax-deductible, depending

on how the lease is categorised for accounting purposes The lessor is either the

asset’s manufacturer or an independent leasing company

Failure by the firm to make fixed payments usually results in the loss of the

asset, and even in bankruptcy, although the claim of the lessor is normally

subordinated to those of other lenders

The lease contract may take a number of different forms, but normally it is

categorised as either an operating or a financial lease

For operating leases, the term of the lease contract is shorter than the economic

life of the asset Consequently, the present value of lease payments is normally

lower than the market value of the asset At the end of the contract the asset reverts

back to the lessor, who can either offer to sell it to the lessee or lease it again to

somebody else In an operating lease, the lessee generally has the right to cancel

the lease and return the asset to the lessor Thus, the lessee bears little or no risk if

the asset becomes obsolete

A financial (or capital) lease normally lasts for the entire economic life of the

asset The present value of fixed payments tends to cover the market value of

the asset At the end of the contract, the lease can be renewed at a reduced rate

or the lessee can buy the asset at a favourable price This contract cannot be

cancelled by the lessee.5

5 There are two other typologies of financial leases The sale and leaseback, see

p 963 Leveraged leases are a three- sided arrangement among the lessor, the lessee and the lenders The principal difference with other leases is that the lender supplies a percentage of the financing to the lessor – who will use this amount to co-finance the acquisition of the asset – and receive interest payments from the lessor.

Financial leases are attractive to ‘‘lenders’’ because they allow them to grantloans collateralised by assets that are legally separate from the company’s otherassets In fact, leases are often among the lender’s best collateralised loans Leasingcan also be used in complex arrangements to reduce taxes.

Through financial leasing, a company can fully use its operating assets (land,buildings or other fixed assets) while renting them, with an option to purchase them

at the expiry of the lease at a price specified in the contract

According to IASB principles, financial leases are integrated into the balance sheet

to reflect economic reality The asset is recorded as a fixed asset and correspondingfuture payments as financial debt

Some arrangements aim to remove from the balance sheet some particularly largeinvestments that cannot be financed by debt and would seriously degrade thebalance sheet if left in For example, aeroplanes purchased by airlines or lorries

by road hauliers are usually financed by finance leases, the archetypical structuredtransaction for improving the look of a balance sheet A separate entity, usually asubsidiary of a financial institution, buys the assets and makes them available to thelessee in return for the stream of lease payments The lessee therefore can use anasset that doesn’t appear on the balance sheet The lessee can purchase the asset atthe expiry of the contract, at a low price that takes into account the wear and tear

on the asset The leasing company meets its commitments through the leasepayments it receives and, potentially, the ultimate sale of the asset

As with investment analysis, the analysis of whether a firm should buy or leasefollows the same principles already illustrated There are basically three alternativesfor valuing the relative convenience of leases:

1 The decision can be based according to the present value of incremental tax cash flows of the two alternatives In computing the present value of thecash flows for a lease, we should use the after-tax cost of borrowing since weare comparing two borrowing alternatives A lease payment is like the debtservice on a secured bond issued by the lessee, and the discount rate should beapproximately the same as the interest rate on such debt

after-2 Alternatively, we can compare the IRR6of the two alternatives and choose theone with the lower rate

3 Or, finally, we could compute the difference between the two cash flows (buyingand leasing) and compute the IRR on these differential cash flows This rateshould then be compared with the after-tax cost of debt to determine whichalternative is more attractive

5 / Defeasance

In defeasance, the borrower simultaneously sells debt and a portfolio of assets to aSpecial Purpose Vehicle (SPV) The portfolio of assets is designed to meet theinterest payments and repay the principal of the debt

Technically, the SPV is independent of the company Hence, the company isnot required to consolidate it In most cases, the SPV is a subsidiary of a financialinstitution The SPV is created especially for the transaction, and the transaction is

6 Internal Rate of

Return.

its only raison d’eˆtre The assets of the SPV are risk-free or low risk They can

be government bonds or other, short-term government obligations, or a portfolio

of receivables, properties or investments The sale of assets and liabilities is

irrevocable The approval of the company’s creditors is not necessarily required

For that matter, the probability of debt repayment is bigger, because the risk is no

longer that of the company, but the government, the portfolio of assets or the

securities For this reason, the transferred debt appreciates in value upon the

announcement of a defeasance operation The value of the company’s other debt

declines as the overall assets held by the company have become more risky!

Accounting-wise, the transaction removes the assets and the debt from the

balance sheet at a value above or below book value The difference between

the two values passes through the income statement As a result, the company

bears the cost of the transaction as a one-off charge For example, suppose the

company issued a bond of 100, at 10%, with a bullet repayment in 3 years If the

yield on government bonds is 3%, the company will have to transfer government

bonds of 120 to the SPV to enable it to meet its interest and principal repayment

obligations Such transfer gives rise to a charge of 20, which corresponds to the

difference between the net present value of the company’s debts and the market

value of the government bonds In this example, 20 is the price the company must

pay to ‘‘clean up’’ its balance sheet The technique enables the company to make a

clean sweep of the past It brings forward the cost of the debt

Don’t forget the fundamental principle: assuming no tax savings, defeasance

does not create value It enables the company to separate the wheat from the chaff,

allowing the rest of the company’s assets to flourish, ‘‘unfettered’’ by the legacy of a

heavy debt burden

US and international standards do not allow the assets and the debt to be

treated as off-balance-sheet items They allow debt to be removed from the balance

sheet only through repayment, expiration or cancellation by the lender

6 / Securitisation

Securitisation was initially used by credit institutions looking to refinance part of

their assets – in other words, to convert customer loans into negotiable securities

Securitisation works as follows: a bank first selects mortgages or consumer

loans, as well as unsecured loans such as credit card receivables, based on the

quality of the collateral they offer or their level of risk To reduce risk, the loans

are then grouped into an SPV so as to pool risks and take advantage once again of

the law of large numbers The SPV buys the loans and finances itself by issuing

securities to outside investors The new entity – a debt securitisation fund, for

example – receives the flow of interest and principal payments emanating from

the loans it bought from the banks (or nonbank companies) The fund uses the

proceeds to cover its obligations on the securities it has issued

To boost the rating of the securities, the SPV buys more loans than the volume

of securities to be issued, the excess serving as enhancement Alternatively, the SPV

can take out an insurance policy with an insurance company The SPV might also

obtain a short-term line of credit to ensure the payment of interest in the event of a

temporary interruption in the flow of interest and principal payments

Most of the time, the securitisation vehicle subcontracts administration of the fundand recovery to one service provider and cash management to another Morecomplicated structures, often based on swaps (see p 979), can also be used whenthe SPV does not need to reproduce the exact cash flows of the original loans.Instead, cash flows can be reorganised to satisfy the requirements of the variousinvestors involved: no income stream, steady income stream, increasing incomestream, etc

With the help of securitisation specialists, some industrial companies regularlysecuritise accounts receivable, inventories, buildings or other assets In short,the whole balance sheet is made liquid Certain assets, once isolated, are ofhigher quality than the balance sheet as a whole, thus allowing the company tofinance them at preferential rates This said, the cost of these arrangements ishigher than that of straight debt, especially for a high-quality borrower with anattractive cost of debt

For example, the European group Arcelor is securitising its accounts receivable,Avis its rental fleet, while the Swiss group Glencore is doing the same thing with itslead, nickel, zinc, copper and aluminium inventories

EUROPEAN SECURITISATION ISSUANCE

7 / Sale–leaseback transactions

In a sale–leaseback transaction, a company that owns equipment or other industrial

or commercial assets sells the asset to a leasing company, which then immediately

makes it available to the company through a leasing transaction Such transactions

are not generally intended to increase the company’s liquidity They usually serve

as a source of long-term capital to finance new investments or to consolidate

short-term bridge loans and strengthen the balance sheet Remember, however, that in

consolidated accounting, the fac¸ade falls away The leased assets are reintegrated

into the balance sheet, while the corresponding financing appears on the liabilities

side

The sale–leaseback technique is often used in property transactions A

partnership is created between the financial institution and the property user

The financial institution manages the partnership and holds most of the capital,

thereby financing most of the investment The partnership, after buying the land

and the buildings, leases the properties to the user At the expiry of the contract, the

user may exercise its purchase option by buying up the shares of the partnership

Alternatively, the user may be the owner of the land on which the buildings are

to be built Instead of setting up a sale–leaseback structure, the user grants a

long-term lease on the land, analogous to a transfer of title, to the leasing company In

practice, however, this technique is rarely used

8 / Outsourcing

Outsourcing is the ultimate technique to remove assets from the balance sheet The

company voluntarily reduces itself to a service provider that designs products and

finds customers, while assigning production to third parties

A company in the agri-food sector or the textile industry, for example, sets up

an SPV owned by a bank and/or financial investors The SPV buys raw materials

Within Europe, the

UK is the most active securitisation market.

Under contract with the SPV, the company then processes the raw material intofinished products, which belong to the SPV The company has the right of firstrefusal7on the inventories held by the SPV and has a say in how they are managed.

At the same time the inventories do not belong to the company, and therefore donot appear on its balance sheet The company then buys finished product inventoryfrom the SPV as needed to fill orders from customers

The company may even sell its factories and equipment, then lease them backfrom their new owners

The SPV may choose to finance the inventories by securitising them if thecompany has made a firm commitment to repurchase them or if the company’scustomers are contractually forced to buy the finished goods over a certain period

of time The investors in these securities would then be assuming the risk of thecompany or the company’s customers

Section 47.3

Accounting treatment

In an effort to stop the most egregious practices, accounting rules now require therestatement of the transactions executed for pure window-dressing purposes Assetsand liabilities must be reintegrated into the balance sheet Accordingly, discountedbills and leasing transactions have been included in consolidated accounts for along time But the cat-and-mouse game is never-ending, and the accountingprofession is constantly trying to keep pace Each time a new off-balance-sheetfinancing technique is developed, accounting standards are revised in an attempt

to separate legitimate use from potentially fraudulent practices Currently, theprinciples are as follows:8

1 / Unconsolidated financial assets (investments in subsidiaries, receivables, etc.)

US standards here are based on an analysis of legal status, whereas internationalstandards are based much more on economic analysis

Under international standards, an asset can be removed from the consolidatedbalance sheet only if the seller does not have the right to repurchase the asset at

a price other than its fair value at the time of repurchase Therefore, there must be areal secondary market for the asset; in other words, the asset must not be toospecific Similarly, there cannot be a resale agreement allowing the buyer to earn

a return similar to what it could have earned by granting a loan to the seller withthe asset as collateral The risks and rewards associated with the asset must notremain with the seller (via a total return swap9 or a put9 on the seller)

7 That is, the

Under US standards, an asset can be removed from the balance sheet only if

the seller cedes control over it and if payment made is of something other than the

right to all or part of the cash flows to be generated by the asset To be removed

from the balance sheet, the asset must be out of reach of the company and of

its creditors in the event the company goes bankrupt The new owner must be

able to sell it at will and there must not be a potentially advantageous repurchase

option

2 / Off-balance-sheet SPVs

Whether an SPV that has purchased assets from a company has to be consolidated

or not depends (surprise, surprise!) on the accounting standards used:

? Under IASB standards, any controlled entity, even if the selling company does

not own a penny capital of the special-purpose vehicle, must be consolidated

Specifically, the selling company is deemed to control the SPV if (i) it has

decision-making power or management control over it, through voting rights

or a shareholder pact; (ii) it benefits from the results of the SPV, through rights

to cash flows or to the residual net assets of the SPV; or (iii) it bears risks

related to the SPV (general warranties, etc.)

? Under US standards, a distinction is made between financial and nonfinancial

assets, as follows:

e Financial assets Assets transferred to the SPV have no control features,

such as bonds, nonvoting shares or derivatives other than options (swaps,

forwards, etc.) If the SPV is a ‘‘qualifying’’ SPV, it must not appear on the

balance sheet To be deemed ‘‘qualifying’’, an SPV must be independent

from the seller The seller cannot have unilateral power to dissolve the

SPV and at least 10% of the SPV’s beneficial interests must be held by

third parties The SPV’s activities must be limited and spelled out in the

by-laws

e Nonfinancial – i.e., all other assets In the case of an operating lease with a

noncontrolled SPV as lessor, the SPV must be consolidated if:

– its purpose is essentially to lease assets to a single lessee;

– the residual risks and rewards related to the leased asset or to the SPV

remain primarily with the lessee; and

– the controlling entity has not invested more than 3% of the value of

the SPV’s assets, which remain at risk throughout the duration of the

lease

Thus, a noncontrolled and nonqualifying SPV must be nonconsolidated if

the ordinary shares held by third parties represent more than 3% of the value

of the assets

IASB standards are strict in this area and emphasise a principle rather than a set ofrules They allow very little accounting leeway In contrast, US standards are muchmore flexible regarding removing assets from the balance sheet, because the exist-ence in US GAAP of very precise rules allows transaction designers to createfeatures that comply only with the ‘‘letter of the law’’.

3 / Leases

Leases fall into two categories:

. Financial Under this type of arrangement, called a finance lease (IASB) or

a capital lease (US), the lease payments are intended to finance the asset.The lessee can subsequently become the owner of the asset under certaincircumstances

. Operating There is no effect on the balance sheet, because there are noprovisions enabling the lessee to become the owner of the asset

Under a finance lease, the leased asset appears on the assets side of the lessee’sbalance sheet and the future lease payments appear as debt The amount of debtequals the lesser of the present value of future lease payments and the fair value ofthe leased asset Lease payments are apportioned between interest expense andamortisation of debt

Under an operating lease, there is no balance sheet entry and lease paymentsare spread evenly over the life of the lease

IASB rule SIC-15 clarifies the recognition of incentives related to operatingleases by both the lessee and lessor SIC-17 ‘‘Dealing with leases’’, became effectivefor annual financial statements covering periods beginning on or after January

1999 According to these principles:

. finance leases are those that transfer substantially all risks and rewards to thelessee;

. lessees should capitalise a finance lease at whichever is lower between the fairvalue and the present value of the minimum lease payments;

. rental payments should be split into (i) a reduction of liability, and (ii) a financecharge designed to reduce in line with the liability;

. lessees should calculate depreciation on leased assets using its useful life, unlessthere is no reasonable certainty of eventual ownership In the latter case, theshorter of useful life and lease term should be used; and

. lessees should expense operating lease payments

US accounting standards use the decision tree displayed at the top of the next page

to determine whether a lease is a finance lease or an operating lease:

CLASSIFYING A LEASE UNDER US GAAP

Let us take the example of Company Van Breda NV, which owns an office

building with an economic life of 99 years Van Breda leases the building to an

SPV – for example, a trust – and immediately receives the present value of future

lease payments The proceeds equal, given the lifetime of the lease and the

economic life of the building (99 years), the fair value of the building The trust

turns around and subleases the building to Van Breda for 30 years The present

value of the 30 years of lease payments equals 85% of the present value of the

building The trust finances 85% of the purchase with a loan and the remainder

with capital from an outside investor

AN ASSET WITH A 99-YEAR LIFETIME

The headlease is a finance lease Its duration is more than 75% of the economic life

of the asset, and the present value of the lease payment exceeds 90% of fair value.From an accounting point of view, the trust becomes the ‘‘owner’’ of the building.The sublease is an operating lease Its duration is less than 75% of theeconomic life of the building (30 out of 99 years), and the present value of thelease payment (85%) is less than 90% of fair value Ownership is therefore nottransferred from the trust to Van Breda

Consequently, the asset leaves Van Breda’s balance sheet and does not return,under both US and IASB accounting standards

Economically, we note that the trust has a downside risk of only 15% of thevalue of the building If its value declines by more than 15%, given the trust’sfinancial structure, it becomes insolvent On the other hand, the trust retains all

of the upside potential

Starting with the above scenario, let us now suppose that Van Breda has anoption to repurchase the headlease at the end of the sublease and that the trust has

an option to sell the headlease to Van Breda at the end of the sublease, ing it a minimum return Van Breda still carries the downside risk in the value ofthe building, because it has given the trust a put option, while its call option allows

guarantee-it to benefit from the upside potential

Section 47.4

Consequences for financial analysis

If auditors agree to treat these transactions as off-balance-sheet, the impact onfinancial reporting will often be complex, but the overall effects are as follows:. decrease in total assets;

. decrease in net debt;

. generally, a decrease in EBITDA and EBIT, as lease payments reflect both

depreciation/amortisation and the cost of financing Some structures (synthetic

leases) reduce this negative impact significantly by limiting the amount of the

lease payments to little more than the financing costs In such structures,

the asset must be repurchased at the end of the lease period at a price close

to the initial price of the asset when the structure is put together Conceptually,

this is tantamount to a nominee agreement;

. higher cash flow breakeven point, because these transactions substitute a cash

expense (lease payments) for a noncash expense (depreciation/amortisation);

. the impact on net profit or loss and on shareholders’ equity depends to a great

extent on how the transaction is structured Companies seeking to finance

assets off-balance-sheet must weigh the current sale price of the assets against

the amount (present value) of future lease payments The higher the first is, the

higher the second will be

In other words, a company that wants to realise a large capital gain and increase

liquidity today will have to commit to a long stream of lease payments that are

significantly above the market average for a normal rent

In certain sectors, such as transport or cinemas, extensive use of these

techniques have prompted analysts to reason in terms of ‘‘EBITDA before

rents’’ or ‘‘EBITDAR’’ Using EBITDAR makes sense only when you compare

companies with different rental policies and provided you remember that

EBITDAR is not cash flow but a figure further upstream in the income statement

Likewise, when it comes to valuing the company using a multiple of EBITDAR,

you must not lose sight of the fact that the lease commitments represent financial –

often long-term – debt

Financial analysts are increasingly familiar with these transactions They rarely

restate them, but they take them into account when formulating their overall

opinion of the risks a company runs The rating agencies systematically reintegrate

securitised assets and sale–leaseback transactions into a company’s balance sheet

In this regard, if a significant portion of a group’s financing (20%) derives from

securitisation, sale–leasebacks or other arrangements involving structural

subordination, the company may be put on credit watch with negative implications,

reflecting possible deterioration in the group’s financial condition, as they did when

US airlines securitised their spare parts inventories

In conclusion, you should not hesitate to read the notes to the financial statements

in detail Although they don’t explain everything about these techniques, they will

often allow you to pick up their scent

Companies have always tried to remove assets and/or liabilities from their balance sheets

in order to reduce the apparent debt burden or base financing on specific assets, thereby

reducing, theoretically, the overall cost of debt

Five objectives may prompt a company to use asset-based financing:

find a new or less expensive source of financing, backed by assets that present the

precise risk profile sought by certain investors;

SUMMARY

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transfer a risk that the company is no longer willing to run;

re-engineer the company so as to increase flexibility;

reduce taxes;

reduce the real or apparent debt burden and gearing ratios

The principal techniques are as follows:

discounting of bills of exchange, no-recourse discounting, factoring;

leasing and sale–leaseback;

defeasance;

securitisation;

outsourcing

The accounting treatment in this instance is fundamental, because it determines whether

or not the company must consolidate an asset (or a liability) IASB standards are morestrict than US standards as IASB standards emphasise principles whereas US GAAP putsforward strict ratios In contrast, the ‘‘letter-of-the-law’’ approach of US standards make itpossible to structure a transaction so as to circumvent the principles In any event, thespectacular bankruptcy of Enron, which used off-balance-sheet financing to reportfictitious profits and hide debt, will cause both sets of standards to be tightened upsignificantly Every cloud has a silver lining!

Off-balance-sheet financing often leads to lower debt, but at the cost of lower or morevolatile future profits because of the significantly increasing cash breakeven point

1/Does off-balance-sheet financing create value?

2/Is off-balance-sheet financing a fraudulent practice?

3/Balzac was already using off-balance-sheet financing by discounting bills However,consolidated balance sheets only came into being in the early 20th century Stateyour views

4/What advantages are there, on a macroeconomic level, to off-balance-sheetfinancing?

5/What is the difference between discounting and factoring?

6/What services can be offered as part of factoring?

7/What is the main difference between property leasing and equipment leasing?

8/In a securitisation transaction, is a company that transfers assets to an SPV at risk ifthese assets do not cover the debts of the SPV?

9/In the area of off-balance-sheet financing, is the predominance of form oversubstance a feature of IASB or US GAAP?

10/What is a long-term debt? What is a long-term operating lease? Explain why ing regulators are seeking to harmonise the treatment of long-term operating leases

account-QUESTIONS

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11/What do you think of the following statement: ‘‘off-balance-sheet financing only fools

those who want to be fooled’’?

1/As a general rule, no, since the counterpart of, for example, a lower financing cost on

certain assets, is a higher financing cost on others

2/No, as it is permitted by law What is fraudulent is using off-balance-sheet financing

to create fictitious profits, hide sales, and conceal debts which are not asset-backed

3/The issue here is semantic: off-balance-sheet financing is not the right term Rather,

we should speak of removal from the balance sheet!

4/It gives investors the exact risk and flows profile they’re looking for

5/In factoring, the company can effectively transfer the risk of nonpayment to the

factor, while in discounting, the company will always bear the risk

6/Financing, recovery, bad debt insurance, removing assets from the balance sheet

7/The type of the asset leased and the term of the lease, which is obviously much

longer for property leasing

8/Normally no The SPV bears the risk and insures itself against, by oversizing the

assets transferred

9/US GAAP

10/It is an undertaking to pay flows in the future Also an undertaking to pay flows in

the future Both are undertakings to pay Why should one be treated as a debt and

the other not?

11/This is just common sense Auditors’ footnotes are there to be read, not for

decorative purposes!

IASB: www.iasb.org.uk, IAS-17, -35, SIC-12 and -27

US GAAP: www.fasb.org, FAS-13, -66 and -140.

EITF 90-15: www.europeansecuritisation.com, European securitisation site.

ANSWERS

BIBLIOGRAPHY

Managing financial risks

Forbidden, but useful tools

In the last 30 years, fluctuations have become so severe in interest and exchangerates, raw material prices, and so forth, that companies are now faced with a newset of risks, risks that could threaten their very survival unless properly managed

As companies have become aware of these risks, they have been increasinglyusing hedging instruments that allow to diminish or totally eliminate the risks.The trend of recent years is to break risks down and to offer more sophisticatedand more flexible hedging tools where there had been few or no such tools before.The instruments concerned are most often listed and not correlated with traditionalassets such as stocks and bonds These instruments help investors diversify theirportfolios just as globalisation is increasing the degree of correlation betweentraditional products (see p 398) and thus reduce the impact of diversification

Section 48.1

The various sources of financial risk

Companies face four types of financial risk:

? Market risk is exposure to unfavourable trends in product prices, interest rates,exchange rates, raw material prices or stock prices

Market risk occurs at various levels:

e a position (a debt, for example, or an expected income in foreign currencies,etc.);

e a business activity (purchases paid in a currency other than that in which theproducts are sold, etc.); or

e a portfolio (short- and long-term financial holdings)

? Liquidity risk is the impossibility at a given moment of meeting a debtpayment, because:

e the company no longer has assets than can rapidly be turned into cash;

e a financial crisis (a market crash, for example) has made it very difficult toliquidate assets, except at a very great loss in value; or

e it is impossible to find investors willing to offer new funding

? Counterparty or credit risk This is the risk of loss on an outstanding receivable

or, more generally, on a debt that is not paid on time It naturally depends on

three parameters: the amount of the debt, the likelihood of default and the

portion of the debt that will be collected in the event of a default

? Political risk results from events, decisions and actions of a political or

admin-istrative nature, on a national or international scale, that could lead to losses

for importing and exporting companies, and companies that work or invest

outside their home country

Section 48.2

Measuring financial risks

Different financial risks are measured in very different ways Measurement is:

. quite sophisticated for market risks, for example, with the notion of position

and Value at Risk (VaR), and for liquidity risks;

. less sophisticated for counterparty risks;

. quite unsatisfactory for political risks

Most risk measurement tools were initially developed by banks – whose activities

make them highly exposed to financial risks – before being gradually adopted by

other companies

1 / Position and measure of market risks

Market risk is exposure to fluctuations in value of an asset called the ‘‘underlying

asset’’ An operator’s position is the residual market exposure on his balance sheet

at any given moment

When an operator has bought more in an underlying asset than he has sold, he

is long (for interest or exchange rates a long position is when the underlying asset is

worth more than the corresponding liability) It is possible, for example, to be long

in euros, long in bonds or long 3 months out (i.e., having lent more than borrowed

3 months out) The market risk on a long position is the risk of a fall in market

value of the underlying asset (or an increase in interest rates)

On the other hand, when an operator has sold more in the underlying asset

than he has bought, he is said to be short The market risk on a short position is the

risk of an increase in market value of the underlying asset (or a fall in interest

rates)

The notion of position is very important for banks operating on the fixed

income and currency markets Generally speaking, traders are allowed to keep a

given amount in an open position, depending on their anticipations However,

clients buy and sell products constantly, each time modifying traders’ position

At a given moment, a trader could even have a position that runs counter to his

anticipations Whenever this is the case, he can close out his position (by realising a

transaction that cancels out his position) in the interbank market

2 / Companies’ market positions

Like banks, at any given moment, an industrial company can have positions visthe various categories of risk (the most common being currency and interest raterisk) Such positions do not generally arise from the company’s choice or apurchase of derivatives, but are rather a natural consequence of its businessactivities, financing and the geographical location of its subsidiaries A company’saggregate position results from the following three items:

vis-a`-. its commercial position;

. its financial position;

. its accounting position

Let us first consider currency risk Exposure to currency risk arises first of all fromthe purchases and sales of currencies that a company makes in the course ofcarrying out its business activities Let us say, for example, that a Eurozonecompany is due to receive $10m in 6 months, and has no dollar payables at thesame date That company is said to be long in 6-month dollars Depending on thecompany’s business cycle, the actual timeframe can range from a few days toseveral years (if the order backlog is equivalent to several years of revenues) Thecompany must therefore quantify its total currency risk exposure, by settingreceipts against expenditure, currency by currency, at the level of existing billingsand forecast billings By doing so, it obtains its commercial currency position.There is also a risk in holding financial assets and liabilities denominated inforeign currencies If our Eurozone company has raised funds in dollars, it is nowshort in dollars, as some of its liabilities are denominated in dollars with nothing tooffset them on the asset side The main sources of this risk are: (1) loans,borrowings and current accounts denominated in foreign currencies, with theirrelated interest charges; and (2) investments in foreign currencies Taken as awhole, these risks express companies’ financial currency positions

The third component of currency risk is accounting currency risk, which arisesfrom the consolidation of foreign subsidiaries, including equity denominated inforeign currencies, dividend flows, financial investments denominated in foreigncurrencies and exchange rate discrepancies (i.e., the use of an average exchangerate for the P&L and the closing rate for the balance sheet) Note, however, thatthis is reflected in the currency translation differential in the consolidated accountsand therefore has no impact

The same thing can apply to the interest rate risk Commercial interest rate riskdepends on the level of inflation of the currencies in which the goods are boughtand sold, while the financial interest rate is obviously tied directly to the terms acompany has obtained for its borrowings and investments Floating rateborrowings, for example, expose companies to an increase in the benchmarkrate, while fixed rate borrowings expose them to opportunity cost if they cannottake advantage of a possible cut in rates

In addition to currencies and interest rates, other market-related risks requirecompanies to take positions In many sectors, for example, raw material prices are

a key factor A company can have a strategically important position on oil, coffee,semiconductors or electricity markets, for example

3 / Value at Risk (VaR)

VaR (Value at Risk) is a finer measure of market risk It represents an investor’s

maximum potential loss on the value of an asset or a portfolio of financial assets

and liabilities, based on the investment timeframe and a confidence interval This

potential loss is calculated on the basis of historical data or deduced from normal

statistical laws

Hence, a portfolio worth C¼100m, with a VaR of
C¼2.5m at 95% (calculated

on a monthly basis) has just a 5% chance of shrinking more than C¼2.5m in 1month

VaR is often used by financial establishments as a tool in managing risk and is

closely tied to duration.1

VaR is beginning to be used by major industrial groups TeleDanmark, for

example, includes it in its annual reports However, VaR has two drawbacks:

. it assumes that the markets follow normal distribution laws, an assumption

that underestimates the frequency of extreme values;

. it tells us absolutely nothing about the potential loss that could occur when

stepping outside the confidence interval Based on the above example, how

much can be lost in those 5% of cases: C¼2.6m, C¼10m or C¼100m? VaR tells

us nothing on this point, stress scenario can then be implemented

4 / Measuring other financial risks

Liquidity risk is measured by comparing contractual debt maturities with estimated

future cash flow, via either a cash flow statement or curves such as those presented

on p 224 Contracts carrying clauses on the company’s financial ratios or ratings

must not be included under debt maturing in more than 1 year because a worsening

in the company’s ratios or a downgrade could trigger early repayment of

outstanding loans

In addition to conventional financial analysis techniques and credit scoring,

credit and counterparty risk is measured mainly via tests for breaking down

risks Such tests include the proportion of the company’s top 10 clients in total

receivables, number of clients with credit lines above a certain level, etc

The measure of political risk is still in its infancy

Section 48.3

Principles of financial risk management

Financial risk management comes in four forms:

. self-hedging, a seemingly passive stance that is taken only by a few very large

companies and only on some of their risks;

. locking in prices or interest rates for a future transaction, which has the

drawback of preventing the company from benefiting from a favourable shift

in prices or rates should shift favourably;

1 See p 500.

. insurance, which consists in paying a premium in some form to a third party,which will then assume the risk, if it materialises; this approach allows thecompany to benefit from a favourable shift in prices or rates;

. immediate disposal of a risky asset or liability

1 / Self-hedging

Self-hedging consists, in fact, in not hedging a risk This is a reasonable strategyonly for very large groups Such groups assume that the law of averages applies tothem and that they are therefore certain to experience some negative events on aregular basis, such as devaluations, customer bankruptcy, etc Risk thus becomes acertainty and, hence, a cost Self-hedging is based on the principle that a companyhas no interest in passing on the risk (and the profit) to a third party Rather thanpaying what amounts to an insurance premium, the company provisions a sumeach year to meet claims that will inevitably occur, thus becoming its own insurer.The risk can be diminished, but not eliminated, by natural hedges A Europeancompany, for example, that sells in the US will also produce there, so that its costscan be in dollars rather than euros It will take on debt in the US rather than inEurope, to set dollar-denominated liabilities against dollar-denominated assets

Self-hedging is a strategy adopted by either irresponsible companies or a limitednumber of very large companies who serve as their own insurance company!

One sophisticated procedure consists in setting up a captive insurance company,which will invest the premiums thus saved to build up reserves in order to meetfuture claims In the meantime, some of the risk can be sold on the reinsurancemarket

2 / Locking in future prices or rates through forward transactions

Forward transactions can fully eliminate risk by locking in now the price or rate atwhich a transaction will be done in the future This costs the company nothing butdoes prevent it from benefiting from a favourable shift in price or rates

Forward transactions sometimes defy conventional logic, as they allow one to

‘‘sell’’ what one does not yet possess or to ‘‘buy’’ a product before it is available.However, they are not abstractions divorced from economic reality As we willshow, forward transactions can be broken down into the simple, familiaroperations of: spot purchasing or selling, borrowing and lending

(a) Forward currency transactions

Let us take the example of a US company that is to receive C¼100m in 3 months.Let’s say the euro is currently trading at $1.0510 Unless he is speculating on a rise

in the euro, the company treasurer wants to lock in today the exchange rate atwhich he will be able to sell these euros So he offers to sell euros now that he will