News Column

Switching From Credit to Cash Model

August 6, 2014

In 2008, the world faced what was termed by many economists as the worst financial crisis since the Great Depression of 1930s. The crisis was as a result of many factors, among them the burst of the housing bubble in the United States. Prices for houses and mortgage related securities had been on a rise and most market players continued to overvalue mortgage related securities with the assumption that the momentum would continue for a considerable period of time.

In order to increase their profits, banks relaxed their minimum lending requirements which allowed less creditworthy borrowers to access mortgage loans to finance housing purchases.

This resulted in most households being over-borrowed and because the quality of the borrowers had significantly declined, this meant eventually this credit bubble was inevitably going to burst.

The high mortgage defaults led to more foreclosures and it was these toxic assets which had been parcelled out as derivatives and resold across the globe that triggered the global financial crisis and also later the European debt crisis.

Although the global financial crisis of 2008 did not have much effect on Zimbabwe, which during that time was experiencing extreme hyperinflation, in post dollarised Zimbabwe, the country has since 2011 been hit by an acute liquidity crunch. The root cause of the liquidity crunch has mainly been non-performing loans in the banking sectors which came about as a result of weakened governance structures due to the brutality of hyperinflation.

In acknowledgment of this problem some banks have already accounted for their losses by writing off loans that are irrecoverable. NMB provided for irrecoverable loans amounting to U$16,6million through its profit and loss for the period ending 31 December 2013.

This made up close to half of its non-performing loan book. The bank indicated that the other half was adequately secured and hence could be recovered. Consequently, by doing so the bank closed the year in a loss position, but was more confident of their position as they had 'cleaned' their balance sheet.

Banks have therefore become more prudent in their lending so as to significantly reduce incidence of non-performing loans and the very high insider loan exposure in their loan books. One major problem that is emerging in the banking sector is that of highly rated customers that have over a short period of time turned into bad debtors because of the harsh economic environment. The volatile economic environment has made most businesses vulnerable when it comes to the repayment of debts as their cash flows are under severe stress.

Surprise turns for the worst by previously well performing companies are signs of how easily business fortunes can change in this environment. Therefore, in essence, banks are not clear from default risk no matter how prudently they grant their loans.

For other industries such as manufacturing, the decision is mainly a function of the nature of the product that the company produces. For example, producers of volume low cost products such as beverages usually require cash up front, whilst producers of relatively expensive and high value products usually offer credit facilities as an incentive for buyers to purchase their goods. Judging from how banks have been struggling to recover loans, some manufacturing companies have taken a cue from what banks have done and have changed their sales models to strictly cash or a blend of cash and credit depending on the nature and the value of the product.

Turnall is one good example in which over the years, customers have enjoyed purchases mainly on credit, but most recently the company has implemented what it calls the ZESA model which is a blend of credit and cash.

The changing of the company's sales model was in response to the company's relatively high debtors book at around US$19 million, which made up close to 50 percent of the current assets.

Cash generated from operations was also predominantly negative since dollarisation because of the largely credit model that the company pursued. In 2013, the cash flows from operations took a 20 percent knock while cash and cash equivalents were a mere US$243 000 compared to just under $1 million in 2012.

During the same year, the company impaired debtors to the tune of US$3,3million, as they were deemed non-recoverable. The company against these prudential adjustments, made a loss for the year, but in our opinion created a solid platform for future growth especially considering the tight liquidity on the market.

At the beginning of 2014, Turnall scrapped all credit facilities and sales were to be made on a pure cash basis. In addition they went into collection overdrive, to recover all outstanding debts.

Obviously this is a bold move on their part as it involves sacrificing quite a chunk of their normal revenue. Management even acknowledged that 2014 might experience a decline in both revenue and profitability, but however are confident the cash flows will remain positive. Arguably, after having to write off such a significant amount of their debtors in 2013, a cash model is the way to go. Currently the credit market seems to have deteriorated even further, and if Turnall had continued to offer credit, its story would have been much worse at year end of 2014. At the moment, sacrificing revenue to attain positive cash flows seems to make more economic sense than pushing volumes onto a market that has a high probability of not paying up.

However, a business that over-sacrifices its revenue for cash may face viability problems in certain industries, as below a certain level of revenue it would not make sense to continue in business. Other players in the manufacturing sector argue that companies such as Turnall can afford to take a 'harsh' stance on their buyers, as they somewhat have a monopoly in their industry.

For fragmented industries, customers can simply switch to other suppliers offering credit over those on a cash only basis, putting the latter at risk of going out of business. Astra paints have pointed out this fact, stating that only 15 percent of their sales are conducted in cash, while the rest are done on credit because of the competitiveness of their market.

However, the problem of this model is that some of their debtors are struggling to meet their maximum 30 day credit repayment period. At the same time, they cannot afford to scrap credit as customers will simply move to their competitors who will offer credit. Astra currently has a market share of 40 percent therefore their customers have several supplier options from which to purchase from in the event that the company introduces unfavourable terms of payment.

Astra is not the only company in this tough predicament as clothing retailers have an equally challenging problem. They have long been fighting against cheap imports and their advantage over such competitors has been their ability to offer credit.

That way, they can implement their pricing system, which is relatively higher and still push volumes because consumers could manage their cash flows by spreading payments. Going the cash route implies that customers will simply refrain from purchasing from bigger clothing retailers in favour of relatively cheaper imports.

Even with clothing retailers offering six months or greater credit offers, their sales have remained relatively low as most of their customers are over-borrowed anyway, and just do not have the capacity to accumulate more debt. Furthermore, company shut-downs, retrenchments, unpaid leave and all sort of income reducing exercises are on the rise and clothing becomes less of a priority to a consumer.

In fact, unless tenor of credit is actually extended to accommodate more flexible repayments, consumers will just scale down on spending in line with the reduced income. For these reasons, Edgars and Truworths have taken a stance against market sentiments on credit and further extended their tenor for chosen clients. This is aimed at incentivising customers to purchase more.

Ironically, default of clothing consumers is even more worrying as retailers essentially have no fallback security. All the retailer can do in the event of default is take the defaulter to court, which will most likely take into consideration the predicaments of the consumer and spread the repayment after considering their capability to repay. In the meantime, the consumer continues to enjoy their unpaid for merchandise!

In a nutshell, even though the market is characterized with defaults, the decision to go the cash route is not a simple one. Not all businesses can cut it if they choose to remove credit privileges as it could actually lead to their demise. At same time, managing debtors has proven to be the most difficult task in this environment and a business can equally go under for failing to do so. What is the optimal position then? Creativity with credit will be necessary to minimise the risk of accumulating a bad debtors' book.

Truworths, for example, is offering a credit card facility to their top clients where they are able to purchase on credit for a maximum tenor of 36 months. In turn the book is underwritten by CABS, who pay Truworths cash upfront and collect from the customers on a monthly basis.

Technically, Truworths has successfully converted part of their credit sales into cash, which is injected into the business at an instant for working capital purposes.

This is seemingly a middle of the road approach that strikes a balance between credit and cash. For other players, there has not been any similar arrangements and their thrust is to prudently manage debtors, which can still go wrong anyway if capabilities to repay are threatened.

Overall we cannot deny the superiority of having a positive cash flow over and above being just profitable. Failing to adopt to the changes in credit dynamics of the market, through switching to cash or being creative with lending, can only lead to disaster.

The country continues to face liquidity challenges and no significant amount of foreign direct investment has come through into the country. A mere US$410 million came through the whole of 2013, which is a pittance compared to US$6 billion channelled through Mozambique in the same year, for example.

As long as there are no material capital inflows, many companies will continue to tighten their belts and consumer disposable income will remain squeezed. As companies struggle, they heighten their probabilities of default on credit, and businesses that conduct most of their businesses on credit will suffer as a result.

Until liquidity issues are resolved, a reversal from credit to cash models is likely going to be the order of the day going forward. -- Zimnat Asset Management

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Source: AllAfrica

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