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7 lessons from Credit crisis – How to Better Sail through the Rough Waters in Future?

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The credit crisis – as the name suggests is related to the sudden tightening of the credit in the market. More so, it is all about the squeeze in availability of loans and funding requirements from the financial institutions. Simply put, it is nothing but liquidity taps turning dry leading to paucity of fund flow.

Ultimately, it sums up to supply crunch in terms of funding working capital requirements for the organizations. And, most of us know that, when credit supply falls short of its prevailing demand, it leads to spike in interest rates. In fact, even at high interest rates there would be no surety that the demand for funding requirements would be fulfilled during a severe crisis.

Recession-global-credit-crisis

We witnessed a similar sort of credit crunch in mid 2008, when the global confidence in the financial markets had slumped to its lowest on account of credit contraction in the system. Some of the reasons that led to such crisis of confidence were sub-prime crisis in the US followed by the bankruptcy of Lehman Brothers.

Over here, I’m concentrating specifically on the lessons from the credit crisis and not the reasons that led to it. As to how an organization needs to balance the capital movement, cash flow and capital expenditure during the liquidity crunch.

1) Ensuring Availability of Liquidity

During a credit crunch, the most significant aspect for a CFO of a company is to ensure that the much-needed liquidity is available to the business. He needs to channel funds from those who have them – be it at any cost, at least in the short-term duration. Though, at a later date when the crisis becomes subdued, he can restructure the loan with a much cheaper long duration loan.

One can compare this situation with the health of a human body. For example, suppose a patient is seriously ill, the physician treats the patient with a direct injection of syringe to ensure prompt stabilizing of the health. Subsequently, the doctor also administers a regular dose of drugs once the emergency situation is appropriately dealt with.

2) Creating a Liquidity Buffer

Dealing with the impact of the liquidity crisis is not just limited to procuring credit from the financial institutions. The finance team also has to remain abreast with the future requirements of the liquidity for the business. When a credit crisis is in full swing, it is not possible to forecast as to how long will the crisis last in the system.

Looking from the hindsight we now know that the credit crisis lasted for 1 year. But, it is no where in written that the future bouts of credit crisis, if any, will last for only 1 year. If at all there is a third global depression going into the future, the liquidity crunch can’t be ruled out for a much longer duration.

Thus, a CFO has to monitor the lead indicators for liquidity in the external environment and plan its capital raising efforts based on the same, to ensure that there is no paucity of funds to run daily business operations.

3) Determining Sources of Liquidity

For an organization there are various sources of raising funds such as loans from banks, diluting equity and corporate fixed deposits amongst others. The finance team has to arrive at a decision by analyzing and calculating as to which sources of funds are light on the company’s balance sheet.

Take, for example, if a company has a large equity base, it might not be favorable to further dilute its equity by issuing new shares as it goes against the interests of existing shareholders by way of lower earnings per share and consequently the company’s stock price.

On the other hand, there is always a limit that a company can raise funds through loans from the financial institutions. In fact, during the credit crisis, raising loans from banks is also fraught with risks of exorbitantly high interest rates. The interest rate is also dependent on the vagaries of credit rating of the borrowing company during such times.

4) Cutting Costs and Restructuring Internal Capex Requirements

During the credit crunch, borrowing from external sources is inevitable if the company suffers from the constrained cash flow position. However, the crisis of confidence calls for several cost cutting and austerity measures in order to avoid falling into the liquidity trap. Cost cutting can lead to a big amount of savings for the company and to that extent lesser requirement to borrow money from outside.

The company also needs to restructure the consumption of liquidity amongst the internal parts of its business and its operations, depending upon the priority need to feed funds. The CFO is primarily responsible to link the finance and operational departments of the organization for effectively channelizing the funds internally.

5) Deferring Expansion Plans

During the crisis situation, it would work in the best interest of the organization to stall the implementation of any major expansionary projects that would require fresh consumption of capital. Such new plans need to be deferred for a later date.

It might not be worthwhile to continue with fresh projects as it would mean that the company has to borrow funds at exorbitantly high coupon rates. This would translate into higher funding costs, lower margins and at the same time raise apprehensions about the business case for such expensively funded projects.

6) Assessing Credit Risk of Customers

Dealing with the credit crisis is not simply limited to managing capital costs. It also entails assessing risks associated while dealing with customers and their capacity to ensure proper rotation of business operation for themselves.

Take, for example, your company has sold goods to some reliable and a regular customer. But, in turn, your customer’s payment is stuck from his own party’s side, triggered by the credit crunch. During such instance, if your customer enjoys healthy cash flow position, he might be able to pay your business dues promptly. But, if your customer’s cash flows are not strong, your payment for the goods sold might also be stuck temporarily – blocking your capital.

7) Proper Inventory Management

It is but obvious that during a global crisis, the demand for the goods gets hurt on account of reasons more than one. Hence, during such time, it would call for prudent management of inventory pile up. The company officials should review their inventory portfolio more dynamically during the crisis period as the demand for the goods takes a hit globally.

In fact, proper inventory management during such times would translate into more free cash flows which could be further channelized into priority operations for the company’s internal requirements. Also, proper management of inventory would guard your organization from the vagaries of sharp volatility in the raw-material costs, which usually go on a downtrend on account of shaky global demand.

Do you have anything to add to my above list of lessons?

  1. Dhananjay Nene says

    Great points. Couple of others come to my mind which are more preparatory :

    a. For businesses that it is feasible – cash in the bank for the rainy day. This is the ultimate hedge. However it requires continuous planning and upfront efforts to focus not just on the profits but also to ensure net positive cashflow sometimes even requiring containing or deferring new investments.

    b. Always have an idea of where you will tighten the belt should push come to shove – upfront. Thus every operational plan should always have a plan B ready to be implemented under adverse circumstances.

    1. Viral says

      Hello Dhananjay,

      Completely agreed with you.

      Speaking not just about a crisis situation, a small portion of liquid cash, at any point of time, to deal with the rainy day is always desirable and gives a comfortable position for the management to be in.

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