Understanding and Managing Cash in Distressed Companies

Senior Managing Director Melissa S. Kibler presented “Understanding and Managing Cash in Distressed Companies” today at a forum of the Liquidity Crisis Panel at the American Bankruptcy Institute’s (ABI) annual spring meeting.

In the presentation, Kibler, who previously has served as President of the ABI, emphasized the importance of: a strong internal and external communications plan; a proactive approach with customers, suppliers, vendors and employees; strengthening of forecasting and measurement tools; prioritization and reduction of expenses; a review committee for cash oversight; taking appropriate steps to optimize working capital; and well considered pre-bankruptcy steps. The notes of Kibler’s presentation at the ABI conference are below.

Summary

Executives must have the knowledge to identify and address impending cash shortages in time to avoid a crisis.

• Cash will drive most significant decisions, including timing, personnel, investment and value allocation in a restructuring.
• The mandate for implementing an effective cash management system needs to come from the top.

Managing Cash in a Distressed Company

• Cash (vs. Accrual): Rather than earnings per share or other accrual metrics, cash is what matters in a distressed situation. Cash increases optionality in addressing operational problems and negotiating the terms of a financial restructuring; it allows offensive rather than defensive strategies.
• Timely: The outlook must be much more frequent than monthly or quarterly – weekly for the near term, daily if in a liquidity crisis.
• Detailed: Information must be detailed enough to enable a true understanding of the various sources and uses of cash.

Communication around Cash Forecasting

• Internal Communication: Companies must look beyond traditional reporting lines and involve organizational leaders across functional, operational and geographic areas.
  • Changes in both process and mindset are required.
  • Management should regularly re-examine spending decisions and balance priorities.
• External Communication: Lack of reliable information on cash and liquidity is often the first concern voiced by lenders and other creditor groups.
  • Lenders will expect a 13-week cash-flow forecast and regular reports of actual results and explanations of variances.
  • Providing reasonable projections, quickly addressing issues that are identified, and eliminating surprises help establish management’s credibility.
  • For in-court restructurings, longer term cash forecasts will be the basis of sizing and covenants for debtor-in-possession (DIP) financing or cash collateral usage.
  • Forecasts determine the “length of the runway”.

Implementing an Effective Cash Management System

• Gaps in Traditional Tools: Decentralized cash controls, compartmentalized management, and historic focus often fail to provide comprehensive and detailed liquidity information needed for decision-making and can mask the real issues.
• Internal Resistance: Changes to “business as usual” may create tension among and within various internal functions.
  • Treasury may already prepare cash forecasts, which should be evaluated for enhancement. Running the new and old systems in parallel can allow time for adequate testing and modification and for obtaining “buy-in.”
  • Finance often has responsibility for long-term earnings projections, operations for business forecasts, and treasury for short-term cash management – and all will have to coordinate.
  • Information technology may resist the reporting changes needed to extract new data in a different manner.
  • Departments will frequently have been downsized and may already be overtaxed.
• Change Management: Leaders should openly acknowledge these dynamics and emphasize the importance of the cash forecasting process to the success of the restructuring.
  • Creating accountability within each of the different functions is a key to obtaining cooperation.
  • Using the forecast for decision making will elicit greater effort in preparation and reporting.

Obtaining the Data

• Current reporting: The first step is determining what historical financial data and budgets/forecasts are available.
• Timeliness: Can information normally produced monthly, quarterly or annually be extracted more frequently?
• Detail: Can revenue be tracked by sources and expense by categories with sufficient detail?
• Accessibility: Is obtaining the information worth the time and cost?  Can the data population and updates be automated?
• Relevance and Reliability: How are the operations managed? What internal and external factors have the most significant impact on the company’s cash position?
  • The best cash forecasting processes combine accessible data with individuals who know how to interpret that data.

Preparing the Forecast

• Forecasting Approaches: Basis includes extrapolation of longer-range projections and historical run rate.
• Timing: Revenue and expense must be translated into receipts and disbursements, requiring identification of material periodic and irregular cash flows.
• Working Capital: Fluctuations in working capital often have a big impact on overall cash balances; asset-based lenders will focus on borrowing base.
• Minimum Cash Balance: Assumption should consider in-transit items, cash on hand, anticipated variability and one-time items.

Selected Drivers in cash-flow forecasting

Revenue/receipts – price, volume, growth, seasonality, billing cycle, accounts receivable, sales outstanding, bad debts.

Cost of sales/gross margin – product/materials, inventory purchases, direct labor, overheads, inventory balances, inventory turns, terms/days payable outstanding.

Payroll and benefits – headcount, wages, bonuses, commissions, payroll taxes, healthcare costs, benefits.

Operating expenses – sales, general and administrative (SG&A), occupancy, locations, fixed vs variable, percentage of sales, terms/ days payable outstanding.

Taxes – income tax rates, refunds.

Capital expenditures – maintenance level, remodels, acquisitions, dispositions.

Financing – revolver, borrowing base, debt service, letters of credit, interest, fees, refinancing.

Cash on hand – minimum levels, float, historical variability.

Reporting and Updating the Forecast

• Reporting: Both internal and external users of the cash forecast will expect reporting on a weekly basis and an explanation of variances.
  • Variances should be tracked weekly and cumulatively.
  • Explanations should indicate whether differences are timing or permanent.
• Book vs. Bank: Both book and bank cash balances are useful to track.
• Frequency of Updates: Presenting the most accurate possible picture of the company’s cash horizon necessitates regular updates; measuring progress against the original forecast for the entire 13-week period allows for a thorough assessment of both accuracy and inputs.
  • Actual results can be compared to both the original and updated forecasts to achieve both reliability and accountability.
• Scenario Analysis: Assessing downside scenarios can be an important part of prudent contingency planning.

Maximizing Cash

• Prioritization: While not always sacrificing the long term for the short term, a distressed company must ensure that it lives to fight another day.
  • Expenditures should be prioritized by rate of return and payback.
• Expense Reduction: This is the time to eliminate waste and over-capacity and to consolidate support functions.
  • This process will entail renegotiating or terminating contracts and commitments.
  • Discounted cash settlements to avoid future obligations may be appropriate, such as buying out a lease for a closed facility.
  • Non-critical capital and other spending may need to be deferred to preserve cash, even if total cost will increase.
• Working Capital: Working capital management can contribute greatly to liquidity.
  • Negotiating longer vendor terms, eliminating excess or obsolete inventory, and aggressively pursuing customer collections will all help.
• Spending Commitments: Senior management should continually re-evaluate significant expenditures and commitments.
  • Spending authority should be reconsidered, with a bias towards decision-making at a more senior and centralized level.

Commitment Review Committee

• Spending Discipline: A commitment review committee meets regularly to review and approve, defer or decline all non-payroll operating and capital expenditures over a certain threshold.
• Senior Management: Members include the heads of operations, customer service, information technology, sales, marketing and supply chain management, as well as the CFO.
• Goals:
  • Increase organization focus and controls around cash usage through enhanced executive oversight.
  • Achieve stronger alignment between cash spending and strategic priorities.
  • Balance the needs of the business units in spending decisions.
  • Impact cost structure and improve profitability through reduced spending.
  • Achieve indirect spending reductions through greater employee awareness of spending discipline and a decrease in requests submitted.

Cash Requirements – Preparing for Bankruptcy

• Incremental Cash Needs: While the automatic stay prevents the collection of pre-petition debts, additional cash requirements accompany a bankruptcy filing.
• Pre-Petition Payments: To reduce uncertainty, a company preparing to file bankruptcy should consider making advance payments for items including:
  • Employee payroll, expense reimbursements and payroll taxes;
  • Insurance premiums and retirement benefit contributions;
  • Single-source vendors; and
  • Essential service providers.
• Key Employee Retention and Incentive Plans: Plans that compensate key employees for staying with the debtor for a certain period have been significantly restricted, but a debtor may obtain approval for incentive plans with appropriate targets.
  • Implementing such plans pre–petition may be advantageous.
• Professional Fees: Having competent attorneys and advisors is key; the debtor is responsible for paying its own professionals and those of certain creditors.
  • Providing adequate pre-petition retainers to all the debtor’s legal and financial professionals ensures that unpaid fees do not create disabling conflicts.
• Committee: Payment decisions pre-petition will affect the composition of the Unsecured Creditors Committee, which will be influential in the reorganization.
• COD/CIA: Vendors may require cash on delivery (COD) or cash in advance (CIA).
  • Critical vendor agreements often require typical trade terms.
• United States Trustee Fees: Fees based on disbursement levels must be paid quarterly and can be material.
• Utilities: Utilities are entitled to a deposit, normally for two to four weeks of service, as assurance for payment for continued service after a bankruptcy.
• Priority and Administrative Claims: Certain claims require payment at or before confirmation, or other consideration authorized by the Bankruptcy Code:
  • Section (503)(b)(9): Sellers of goods received by the debtor within 20 days before bankruptcy have administrative claim status.
  • Reclamation Claims: Suppliers may demand return of goods received 45 days or fewer before bankruptcy.
  • PACA/PASA Claims: Suppliers of perishable fruits and vegetables or unprocessed meats may be entitled to a priority claim.
  • Employees: Employees may be entitled to a claim of up to $13,650 for unpaid wages and benefits.

Conclusion

• A company must manage its cash well to undertake a restructuring, particularly in a bankruptcy proceeding.
• A proactive approach should include an enhanced focus on preserving cash and improved tools for forecasting and reporting the cash position.
• Management needs liquidity and visibility to balance the needs of employees, customers, suppliers and capital providers.
• Knowing how to manage cash and doing it well will not necessarily ensure success for a distressed company, but not doing so will certainly engender failure.

Source:   Kibler, Melissa S., et al. (2010) When cash is king: Understanding cash requirements for distressed companies and maintaining effective management and reporting systems, Navigating Today’s Environment: The Directors’ and Officers’ Guide to Restructuring.