Financial Journalist

31 October 2008 — Gerry O’Kane, Finance Week

Many British businesses are ignorant of working capital and need to understand forecasting, cashflow and the financial supply chain. But there are solutions to both ignorance and problematic working capital. Gerry O’Kane talks to working capital expert John Mardle.

If British business people do not learn how to handle working capital more professionally, the current recession will last much longer than it need do. This is the viewpoint of John Mardle, an expert in how to make working capital perform efficiently and managing director at Develin & Partners. He also warns simply delaying payments or cutting suppliers’ margins is not the solution.

“I’ve got a pessimistic outlook and groups like CIMA and the ACT have got to get finance directors up to speed on working capital,” he says. He estimates it’ll take at least nine months of education but should business people become more aware of handling their working capital, the supply chain finance and their forecasting, the impact on nationwide free cash flow could have a beneficial dramatic effect on UK business.

The down side, in his view, is that it will take 18 months to work.

As access to alternative finance for companies, whether from private equity companies or from banks, has been shrinking for nearly a year, finding money for new equipment or even paying wages is proving difficult and companies’ working capital needs to be handled more efficiently.“Companies are desperate for every penny of that £10,000 invoice, and think they can manage it well, but few do so,” he argues. Mardle lectures for CIMA in their Mastercourse qualifications, mentors at Cranfield Business School and will be lecturing at the ACT’s seminar on working capital in Reading in November.

He points out that British industry is often led by those with strict accounting backgrounds and their grasp of working capital was slim. “They haven’t been taught what it is or top 10 tips to reducing working capital. When the economy was moving along well they sat back on their laurels and didn’t look at it properly,” explains Mardle.

There was an ability to analyse debt but not how to practically improve working capital.

While every case will have its own characteristics, Mardle argues that there are several steps all companies can take to (a) assess their future liabilities and (b) cut the pain to the company.

While he agrees there are methods like factoring and asset-based lending to increase working capital, these are much less available in the current market. “In terms of factoring who is going to want to fund invoicing efficiently?” he asks.

He points out that companies in Europe and the UK do not collect monies owed very efficiently. “And they also do not look at the financial supply chain any further than who they are directly dealing,” says Mardle. In the US it is not uncommon for the supply chain to be analysed seven companies down the line, in order to reduce risk or find ways to solve any glitches in the system (see ‘How to boost working capital with a broader view of supply chain finance’).

Another side of the same coin is examining how your other suppliers will be able to pay. Cutting what you’re prepared to pay by 10% might simply put your supplier out of business.

Go and talk to that supplier: it might be that you’re getting something that is completely over-engineered for what you require,” says Mardle. You might be getting benefits of economies of scale but paying a price for a premium product. With a few adjustments perhaps the product could give the same performance but save money to both you and the maker.

He gave the example of Rolls Royce requiring bolts for aeroplane engines. By dropping the specification from the over-engineered supplier, it saved 50% per bolt – or $500.

He warns that unreasonableness in cutting payments are lazy and sometimes self-damaging. “I already know of some companies who have reprogrammed their ERP systems not to pay invoices over £10,000 or under £5,000, but it’s the wrong way as it creates uncertainty. It’s important to know when payments are going to be there,” he adds.

The second area he sees as important is examining your own customer base. “A lot of firms are dealing with non-profitable customers, they’re just looking at revenues, when in fact delays in payment and profit margins might be low. It might be better to lose them and concentrate resources on the profitable customers,” explains Mardle.

John Mardle’s next CIMA Mastercourse on ‘Managing Work Capital’ is on 7 May 2009 in London. Go here for details of this and other CIMA Mastercourses.

working capital

October 2008 FT Mandate

The one consistency the markets have been showing in recent months is volatility. Where there is movement, the investment sector finds opportunity and in recent years volatility trading has found a ready market amongst the top-feeders, hedge funds. But there are indications that more traditional investors, pension funds and insurance companies, have embraced forms of volatility trading too.

Backed by options, OTC products or the limited number of volatility indices, it allows traders and institutions to invest in the volatility of the trading markets, volatility being defined as the standard deviation of shares or indices and in falling markets there are elevated levels of volatility compared with climbing markets.

“In terms of trading in the current world, we’re seeing strategies evolving by minutes,” says Adrian Valenzuela, head of equity derivatives investor sales at JPMorgan. “Volatility trading was traditionally the domain of hedge funds, even until three years ago in its purest form it was almost exclusively their territory.”

Even then, however, those hedge funds were not as much in demand as they are now. “At least until two years ago volatility was operating in a tight band – about 15 per cent. There was a lot of convergence, companies had low debt levels and then the banks had solid asset asset to equity ratios,” explains Gerry Fowler, head of European multi-strategy trading at Citi.

As the markets have changed, especially at the start of 2007 as US real estate problems started to become noticed, volatility began to increase. The fairly neutral market of the previous five years began offering volatility players opportunities with spikes hitting up to 25 per cent and higher. RBS has gone from 2 per cent volatility to 105.

“In general this was good for volatility trading positioning long and there was a scramble for put options,” explains Mr Fowler. The use of put options has found favour among traditional long-only asset managers. These options give the holder the right to sell a security for a fixed price at or before a given date. Investors use options to guard against fluctuations in the price of securities they own, speculating on volatility.

While getting reliable figures for the volume of trades relating to volatility strategies are difficult, the huge leap in equity derivative contracts (up 75 per cent year-on-year for Eurex) indicate its growing acceptance. As counterparty worries have continued, the OTC volatility products, most commonly variance swaps, have taken a back-seat to exchange-traded derivatives.

Currently the first index (1990), the Chicago Board Options Exchange Volatility Index (VIX) measuring volatility based on the price of options, hit a record high at the beginning of October, moving to 56.32. To put this in perspective its previous high was 49.53 set in October 1998, when Long-Term Capital Management collapsed.

“There are two basic ways to trade volatility: to diversify portfolio or smooth out the risk profile by exposure to returns,” explains Nick Tranter, head of European equity derivative flow sales at BNP Paribas.

“The most significant area of change in the past two years are institutional clients looking at hedge fund volatility players, not so much for profit but for risk,” explains Mr Tranter. He points to insurance companies as moving to exploiting these strategies for risk purposes, “With CP195 rules to realistically mark to market of liabilities of insurance companies, they have used hedge funds, but also options effectively taking a notional benchmark such as the FTSE 100 and play an option with a 25 year maturity.”

JP Morgan’s Mr Valenzuela also points to more complex strategies including expressing views on skew as correlation and broadly arbitraging option prices as ways of building positions on de-corollated assets, but warns these deals require well-groomed pricing, structuring and trading skills.

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