Capital management is a core part of any chief financial officer’s (CFO’s) role. But this practice is a balancing act. It’s essential for finance chiefs to put the business’s capital to good use, or risk being accused of having a lazy balance sheet.
In recent years the risk-averse nature of most CFOs has seen many maintain a healthy cash balance on their books. But now the approach to capital management is changing.
KPMG director Paul Travers says CFOs’ approach to capital management is very much dependent on the industry in which the business operates.
“In mining, oil and energy, capital preservation is top of mind, given the current point in the commodity price cycle. These businesses are cutting exploration activity and holding on to capital,” he said. A good example is BHP Billiton, which has cut its dividend to preserve cash and its rating.
“Capital preservation is even more important for mid-market miners. They are looking at releasing capital locked up in their inventory and lengthening the time they hold cash. This is also important for businesses that want to preserve their credit ratings,” he added.
According to Travers, when it comes to manufacturing and service sector businesses, generating good returns from capital at the moment is a genuine challenge. “We are seeing these businesses return capital to shareholders,” he said.
In the public sector, the focus is on ‘churning’ capital. For instance, proceeds from the sale of NSW’s electricity assets are now being used to fund major infrastructure projects like WestConnex and the CBD light rail project.
However, Travers says there is still a focus on cost cutting and working capital management.
“During the financial crisis treasurers and CFOs couldn’t get access to capital from markets, so they used working capital efficiencies. We are seeing that approach again to manage working capital more effectively.”
He says there is a willingness among CFOs to release capital. But the challenge is identifying appropriate growth opportunities to put capital to work. There are examples to be found in the hospitality space, where businesses are looking to acquire venues that are already profitable, rather than buy discounted, underperforming assets.
A conservative approach
Simon James, partner, HLB Mann Judd, discussed that many finance chiefs are considering making acquisitions using the cash on their balance sheets, to help improve the growth profile of their organisations.
“There are opportunities to make bolt-on acquisitions to generate growth, but CFOs are not taking massive risks; no-one is doing anything particularly left field,” he said, adding that many businesses are deciding whether they should invest in opening up new market segments or, alternatively, put funds towards developing new products.
He says overall, CFOs are pursuing organic opportunities to develop their markets and are also looking to make acquisitions.
However, given ongoing volatility and concerns about global risks such as the slowdown in China having a knock-on effect to other markets such as Australia, CFOs are still looking to keep a certain level of cash in the business as a buffer against any near-term economic downturn. So the question is what’s the right cash buffer for businesses given the commercial environment?
“There’s a level of conservatism built into budget forecasts. But there are concerns about business’s lazy balance sheets, especially in an environment in which debt is cheap and now is the time to borrow for good opportunities,” James explained.
He suggests that businesses looking to borrow should ensure the term of the loan matches the lifecycle of the asset.
“If you’re borrowing to make an acquisition that will deliver a return for the business in five years then you need a facility that aligns to that,” James explained.
Travers says given the low interest rate environment, there could be an opportunity to create certainty around the cost of capital by locking in long-term lending facilities at low interest rates. “But the challenge is that if you create too much certainty you could put the business at a disadvantage.”
For instance, CFOs don’t want to lock in today’s rates if the Reserve Bank of Australia (RBA) lowers interest rates again, which could give finance chiefs access to even cheaper funding.
Taking an objective approach
According to James, too few businesses measure their return on the capital they deploy. “And it’s not just return on capital, it’s also the timeline for returns to be made.”
Similarly, Travers says all too often, firms only turn their attention to capital management when they are required to – for instance if their credit rating is under threat.
“Often a business won’t have a capital management policy; there’s been a lot of academic work in this area, but CFOs can feel a textbook approach won’t suit their business. Then, they can be caught off guard when they do need to look at their capital management practices,” he explained.
When it comes to working out a business’s weighted average cost of capital (WACC), Travers suggests CFOs against working towards a single number, because different projects will have different capital requirements and risk parameters.
“A lot of CFOs do this intuitively, but they don’t apply the next step and use WACC to decide which projects to go after,” he said.
As such CFOs are urged to put rigour around their capital management policies, to put the business in the best position possible no matter what the economy is doing or where interest rates are.
- A formal capital management strategy can help put your business in a better position in the event of a potential credit downgrade.
- Take advantage of low interest rates to lock in long-term funding.
- Make sure the term of the facility matches the lifecycle of the asset.