Capital allocation: Creating a risk-resilient cash plan amid COVID-19

Introduction

Plenty of sayings describe how the best laid plans can go awry—and none of them even mention a pandemic. But now that COVID-19 is disrupting business with a vengeance, finance chiefs are having to revisit, and often rewrite, many of the capital plans they so carefully created.

CFOs obviously know they should act deliberately, but quickly, to adapt capital models and cash strategies in response to such black swan events. But lacking the advanced planning tools and a playbook for coordinating both can make decisions difficult to coordinate and execute. The result, during previous financial shocks, has been that many organizations were too slow to respond with needed actions to preserve cash flow for operations.

During the previous financial crisis and recession, for example, companies quickly pulled back from M&A and stock repurchases, but cutting capital expenditures (capex) in line with slowing cash flows took much longer. In fact, among small-cap S&P companies, capex continued to rise 12 months after the crisis began.

Similarly, when oil prices collapsed in the second half of 2014, falling by more than half in six months and by 75 percent before bottoming out 18 months later, oil and gas company finances took a huge hit. In many cases, it took companies until 2016 to announce significant (20 percent-25 percent) capital spending reductions, meaning that they weren’t reducing capex as quickly as their operating cash flows were falling, a situation that led to credit downgrades.

Why have some executives moved slowly to make their balance sheets more resilient by right-sizing capex planning during a crisis? Such decisions can be enormously complex, especially for large companies whose multiple business units may have thousands of projects to manage. In addition, many just don’t have the analytical and decision-making capabilities necessary to quickly determine which projects to stop, which ones to slow, and which ones to defer in order to preserve cash flow for operations. And in this issue of CFO Insights, we’ll discuss four steps CFOs can take to develop a risk-resilient capex plan for today’s environment.

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Building a risk-resilient playbook

Organizations that have built the capability to adapt quickly to fast-changing business conditions—using portfolio optimization and dynamic risk-modeling tools to guide crisis response capital allocation decisions—are now finding it well worth their time and effort. Yet, even CFOs who don’t have these tools can quickly and effectively put together a risk-resilient cash strategy playbook in response to the COVID-19 outbreak. Mainly, it requires framing the existing risk-modeling capabilities within finance and the capital allocation decision-making process with solid logic and discipline―the qualitative aspects of risk-intelligent decision-making.

The following framework can help CFOs develop a risk-resilient plan to understand, prepare for, and mitigate business impacts and uncertainties.

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Financing and liquidity: A COVID-19 checklist

Recently, two special issues of CFO Insights offered checklists for finance executives in 10 different areas, including scenario planning and financial disclosure (see Part I and Part II, of "COVID-19 checklist; Practical steps for the immediate, midterm, and long term”). In this environment, of course, liquidity and cash flow are paramount. As the following checklist illustrates, CFOs should identify financial constraints that could endanger viability and consider alternatives.

• Determine cash profile. Estimate weeks of cash and undrawn funding lines available to fund the business based on current free cash flow profile.
• Model cash flow. Review expected cash flow for the next three months in detail and identify potential mitigating actions that can be taken to preserve cash in the short and medium term. 
• Shore up debt. Estimate your ability to fund short-term maturities or rollovers; pre-fund longer-term maturities, where possible.
• Assess alternatives. Not every investment lends itself to a rudimentary thumbs-up or thumbs-down. In some cases, there may be cheaper, second-best alternatives. Some expenditures in fixed assets, such as equipment, can be delayed with little consequence.
• Work with current financing partners. Assess your current financing sources and actively engage with existing financing partners to seek waivers where necessary; understand if available lines of credit will remain open and what changes, if any, may be coming.
• Diversify financing sources. Continue to nurture other financing relationships, such as banks you have approached, but not done business with yet. In addition, explore alternative lenders and markets.
• Assess the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Consider the implications of government relief programs on your current and future liquidity position.
• Manage inventory closely. Focus on the cash-to-cash conversion cycle; in these abnormal business circumstances, a coordinated focus on payables, receivables, and inventory can often be more important than focusing on profits and losses.
• Consider additional cost cutting. Revisit variable costs; reduce nonessential expenses.
• Manage receivables. Reset the receivables cycle, collections process, and key performance indicators (KPIs); conversely, if necessary, consider taking a larger float by extending payment terms to suppliers.
• Leverage tax planning. Consider tax planning to conserve cash in the nearer term, including repatriating cash from non-US jurisdictions, cash tax planning with respect to analyzing and filing refund claims, and accelerating deductions or deferring revenue. Assess CARES Act provisions for potential tax relief.

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