Managing Working Capital in International Finance

Managing Working Capital: International Cash Management

• Managing working capital and cash flow is crucial for businesses, especially international ones
• Analyzing cash flow from a subsidiary perspective differs from a parent perspective
• Various techniques optimize cash flow within a firm
• Optimizing short-term (ST) cash flow involves complications
• Foreign short-term investments have potential benefits and risks

ST Asset and Liability Management: Working Capital

• Short-term financing (ST liabilities) is contrasted with short-term investment decisions (ST assets)
• ST financing mainly focuses on international trade and investment decisions, impacting inventory, accounts receivable, and cash management
• ST financing involves borrowing ST funds and issuing ST securities (e.g., commercial papers)
• Working capital (current assets – current liabilities) is vital for paying creditors in the short term

Working Capital Ratio

• Working capital ratio = (Current Assets) / (Current Liabilities)
• Ratios less than 1 indicate negative working capital
• Ratios greater than 2 suggest excess investment of assets
• A ratio between 1.2 and 2.0 is considered sufficient (Investopedia)

Other Liquidity Ratios

• Quick ratio (QR) = (current assets – inventories) / current liabilities
• QR = (cash & cash equivalents + marketable securities + accounts receivable) / current liabilities
• A higher QR signifies better liquidity
• Acceptable QR is 1 or greater than 1
• Cash ratio = (cash & cash equivalents) / current liabilities
• This is the most frequent liquidity measure
• Advisable range: 0.2 to 0.25

Working Capital & Cash Flow Analysis

• Working capital management directly impacts cash flow amount and timing
• Key areas impacted are inventory management, accounts receivable management, cash management, and liquidity management

Cash Flow Analysis: Subsidiary Perspective

• International material purchases are challenging due to exchange rate fluctuations and quotas
• Volatile sales necessitate larger cash balances for unexpected inventory demands
• International sales are volatile due to exchange rate and business cycle fluctuations; and
• Looser credit standards can boost revenue, but may decrease cash inflow speed

Subsidiary Dividend Payments

• Forecasting cash flows is easier with known dividend payments, fees (royalties and overhead charges) communicated in advance, and denominated in similar currencies to the parent company

Subsidiary Liquidity Management

• After accounting for all cash flows, subsidiaries either invest excess cash or borrow to cover deficiencies
• Access to credit lines and overdraft facilities supports adequate liquidity without significant cash imbalances

International Cash Management

• ICM's primary focus is optimizing cash flow and reinvesting excess funds
• Exchange rate fluctuations significantly impact cross-border cash transfers
• Scope includes subsidiary and HQ perspectives, often leading to centralization of ICM at MNC level

Centralized Cash Management

• Centralized cash management is needed to oversee and often manage parent-subsidiary and inter-subsidiary cash flows
• International cash management is often segmented into optimizing cash flow movements (ST) and investing excess cash

Complications in Optimizing Cash Flows

• Subsidiary payment delays may force other subsidiaries to borrow money
• Certain governments restrict or prevent cash from leaving the country

Characteristics of Banking Systems

• Bank abilities to process MNC cash transfers can differ between countries
• Banking systems in various nations have different operations

Investing Excess Cash

• Excess funds may be invested in domestic or foreign short-term securities like Eurocurrency deposits, bills, and commercial papers
• Foreign short-term securities can sometimes offer higher interest rates
• Firms should consider potential exchange rate movements when investing

Centralized Cash Management - Advantages

• Centralized cash management enables more efficient fund utilization and improved returns
• Separating cash pools for each currency is beneficial in cases involving multiple currencies; investments can be denominated in the needed currencies

Cash Pooling: Practical Case (Aurubis Bulgaria AD)

• A cash pool with affiliates includes cash in bank accounts of the ultimate parent company
• The parent company centrally provides services for securing loans for subsidiaries and depositing their funds

Cash Pooling: Practical Case (Aurubis Bulgaria AD)

• Cash pool with affiliates = 200,493 thousand BGN
• Cash and equivalents = 44,337 thousand BGN
• Data from the statement of financial position for FYE 31.12.2020

Investing Excess Cash - Determining the Effective Yield

• The effective rate for foreign investments = [(1+i)(1+e)] - 1
• i = the quoted interest rate on the investment
• e = the % change in the spot interest rate

Investing Excess Cash - Implications of Interest Rate Parity (IRP)

• A high-interest foreign currency often has a forward discount related to the differential between its interest and the investor's home rate
• Short-term foreign, uncovered investments can still produce a higher effective yield than the local option

Investing Excess Cash - Use of the Forward Rate as a Forecast

• If IRP exists, then the forward rate can be used as a break-even point to evaluate a short-term investment decision
• The effective yield will be higher if the spot rate at maturity exceeds the forward rate at the investment's initiation

Investing Excess Cash - Use of Exchange Rate Forecasts

• Forecasts of exchange rates aid in calculating the projected effective yield of foreign investments and comparing it to local options
• Probability distributions can be used instead of point estimates to compute the break-even exchange rate that equates both yields

Investing Excess Cash - Diversifying Cash Across Currencies

• Diversifying cash among currencies is often preferred when exchange rates' future movements are uncertain
• Portfolio risk reduction is determined by currency correlations

Investing Excess Cash - Use of Dynamic Hedging

• Dynamic hedging strategically hedges when the currencies are expected to depreciate but not when they're predicted to appreciate
• Successful dynamic hedging relies on precise exchange rate movement forecasts

Impact of International Cash Management on an MNC's Value

• MNC value is determined by expected cash flow for a given currency multiplied by its expected exchange rate, all divided by (1+k), where k is the weighted-average cost of capital