Tag: due diligence

2013 Audit Season: Joke #4


Inventory CountI remember a few years ago, during a business lunch, somebody was recapping an episode from one of the numerous crime series all networks are running to compete against each other.  My head was preoccupied with the business purpose of the meeting, nevertheless I do recall that the murder plot turned on a discovery that one of the characters, a compulsive gambler, bet his classy wife's sexual favors in poker and lost.  FBI questioned if the payoff actually took place.  Of course, it did: the real gamblers are "men of honor."  When asked how the pimped out wife handled it, the winner said, "She was willing, but not happy."  I bet this is the best line the screenwriter who churns out this pedestrian crap has ever written! 

Willing, but not happy…  The state of mind applicable to so many situations.  This is exactly how all corporate accountants feel about financial audits, lenders' exams, investors' due diligence, etc.  Commercial and fiscal needs of our employers throw us at mercy of the outsiders: we are forced to carve out time from our main responsibilities and open ourselves up to various poking, probing, and testing.  Oh, we totally understand the importance and the unavoidable necessity of it.  Frequently,  it's our own search for new financing resources that culminates in these proceedings.  Yes, we are totally willing, but we are not happy to go through with it.

I devoted two whole chapters (29 and 30) of CFO Techniques to advising readers on how to deal with auditors, keep yourself focused on the ultimate benefits for the company, and minimize the pains of distraction and intrusion.  It helps to remind yourself that your company needs it more than the one that sends people to conduct the examinations.

And I have to say, most of these specialists of prodding are well aware of the invasive nature of their jobs.  They understand that a financial executive abides by their standards and accommodates all their requirements, because he wants good results, and that this puts a CFO or a Controller into a subservient position. Many auditors are very apologetic for the endless interruptions, inquiries, requests, follow-ups, etc.

Of course, there are always exceptions…

For the CFO with exposure to international measurement systems from this season's joke #2, the last stage of the bank's field exam included physical inventory counts at three locations specifically selected by the bank.  This is habitually done by auditors and examiners in order to (a) establish the presence of various inventories and (b) verify the accuracy of the subject's records.  Obviously, nobody at the audited company has any impact on the choices of locations, timing, or people sent to perform the task.  In fact, the CFO, who every year faces a financial audit and three bank exams, never knows who the hell the counters (usually junior auditors) are. 

This time was bound to be different.  One of the locations the bank selected was the company's storage in Savannah, GA.  A day before the scheduled visit the CFO gets a phone call.  An agitated young man in the receiver tells her that he is from the bank's Jacksonville office and that, according to Google Maps, the drive is 2 hours and 40 minutes each way.  "And it's Friday!  This is outrageous," he says.

The CFO was perplexed: anyone who had dealt with these matters even for one month would know that she had nothing to do with the rookie's plight; that, if it was up to her, she would much rather avoid the scrutiny.  Considering her executive position and professional status, she could've just hung up on this wimp.  But she is the one with a sense of humor, remember?  So, she asked the boy, "Well, what would you like me to do?  Move the inventory to Jacksonville, or cancel your visit?"

"Could you, please, cancel it?" was a hopeful answer.     

The Trade Finance Prison


Images-1Theoretically, you can imagine an international business operating without a trade finance facility – no letters of credit, document negotiations, confirmations, etc. Your suppliers would be more than happy if you always pay in advance. On the other side of the equation, there are some desperate for product customers that you may be able to coerce into pre-payment plans, but, if you want to grow your volume, you will most likely end up extending them unsecured credit terms instead.

Let's pretend for a minute that we don't see the elephant in the room – the cost of working capital, which, under this stretched cycle of paying way before the product is received and collecting long after, turns into a painful burden on the profit margin. Let's ignore it and agree that yes, it is possible to conduct business in this way, especially if the company is cash-rich. It's possible, but dangerous and stupid for reasons too numerous to elaborate in one blog post. I'd say that the top 5 hazards of such modus operandi are as follows:

1. Risk that a foreign supplier will not deliver the product at all.

2. Risk that he doesn't comply with the terms of the purchase contract and delivers wrong goods of unacceptable quality and origin, in random quantities, too late or too early.

3. The danger of not receiving sufficient and correct set of documents that would allow you to claim the ownership.

4. Customer non-payment risk, which is always there when you give open terms, but especially if the payment is anxiously expected to come from abroad.

5. The overwhelming difficulties and costs of international litigation to recover your losses.

To mitigate these risks you need instruments that will protect you and an intermediary that will defend your trading fort. And that's when the trade finance divisions of various banks and financial institutions come into the picture with their Letters of Credits and related services. They can step in and be your guardian against the risks.

A Letter of Credit defines all conditions of purchase/sale, including documentary requirements; and only if these conditions are met, or when discrepancies are accepted, the money will exchange hands. So, the reality is that, you can have $100 million of free cash on your operating account, but if your business has an international exposure, you will end up engaging in Trade Finance relationships one way or another.

The trouble is that the banks know you need them and their benefits come with a price and many strings attached. Even if you only accept your customers' LC's, the cost of advising and processing services may be as high as 0.5% of the transactional value. If you buy product with LC's, then the costs could be as high as 2% (banks love this lucrative business). Yet, that's not the most strenuous part of the arrangement.

When a bank issues a Letter of Credit on your behalf, it takes an obligation to pay to the supplier even if your company goes bankrupt. Therefore, trade finance facility is essentially a credit line (most are utilized by LC's and advances alike). Obviously, to obtain any sizable credit line you must go through a grueling due diligence and you have to pay for it too: field exam, the bank's and your own attorneys' charges, closing fees – $10-12 million facility may end up costing around $150-$175K.

And even that is not the most painful part of the deal. The trade finance Credit Agreements are full of covenants and conditions that restrict your capital distribution, debt acquisition, treasury, operational management, and even dictate how the business is conducted. The banks demand collaterals and guarantees, including personal pledges from owners and their spouses. There are strict and voluminous reporting requirements.

And yet, we work very hard to get ourselves into the Trade Finance prison in order to facilitate our employers' commercial activities. The only thing we can do to ease the pain is to bitch and moan about the banks – a regular exercise of international-business CFO's around the world.