How Treasury Can be Better Prepared for Recession

What does recession mean?

Recessions are transient drops in economic activity across time frames of six months to several years. 

Understanding recession

From 1854 to the most recent recession in 2020, the United States has experienced 34 recessions, according to the NBER. There have been five such instances of negative economic growth since 1980 that were defined as recessions.

Most nations have experienced economic growth as their long-term macroeconomic trend since the Industrial Revolution. However, there have also been short-term fluctuations along with this long-term expansion, where important macroeconomic indicators have displayed slowdowns or even outright negative performance across time frames of six months to several years before resuming their long-term growth tendency. 

Why do recessions happen?

Many economic theories try to explain why and how the economy might deviate from its long-term growth pattern and experience a sudden recession.

According to some economists, actual developments and structural changes in the sectors best explain why and when economic recessions occur. For instance, a sudden geopolitical crisis-related, sustained rise in oil prices would simultaneously increase costs across many businesses, or a revolutionary new technology might quickly render entire industries obsolete, which would result in a widespread recession.

Impact of recession on treasury

Why is treasury yield dropping?

The term yield curve refers to the relationship between the short-term and long-term interest rates of fixed-income securities issued by the U.S. Treasury.

The yield curve usually is not inverted since longer-term debt often carries higher interest rates than short-term debt. The yield curve is inverted when short-term interest rates are higher than long-term interest rates. An inversion in the yield curve is considered a reliable predictor of a recession.

The economy is significantly affected by this yield curve. For instance, a bank can make money by borrowing money at short-term rates and lending it out at longer-term rates. When that gap is wide, they make more profit. An inverted yield curve complicates that by enlarging the gap. As a consequence, banks make lending difficult to obtain, reducing the chance of growth opportunities for companies.

What are the risks associated with treasury?

Treasury risk during a recession includes the following:

• Interest rate fluctuations:
  Throughout recession, there are multiple stages of increase and decrease in interest rates. During the period of high economic activity and spending, Feds tend to increase interest rates to balance the supply-demand gap. This suppresses buying and spending and gradually invites a recession. During a recession, economic activity slows down and the government lowers interest rates to kickstart the economy. Hence companies forecast frequently during this period of fluctuating interest rates to keep a track of their cash flows to avoid cash crunch.
• High FX risk:
  Companies of all sizes and industries are growing internationally, seeking new sales opportunities and expanding supply chains. As a result, treasurers are seeing a surge in risks spanning multiple currencies which adds to the operational and financial complexity. FX risks are difficult to assess using spreadsheets, and currency fluctuations significantly impact the profit and loss statement.
• High cash buffer:
  Companies increase their cash buffers when estimates are wrong since they aren’t well prepared for macro-level fluctuations due to the manual reports being dead on arrival and relying on assumptions. Moreover, data spread across multiple spreadsheets and disparate systems hinder treasury from being able to spot idle cash on time. This hinders confident decision-making from managing idle cash, which could otherwise be used for M&A, fixed assets, buyback stocks, etc., for improving ROI.
• High borrowing cost:
  During times of recession, late payments could cost businesses a huge amount of money, and companies could end up struggling with overheads and managing cash flow. To compensate, last-moment borrowing / overnight sweeps are done with high-interest rates.

4 tips for treasury to be better prepared for recession

Tip 1: Consider recession indicators

There is no single way to predict how and when a recession will occur. According to many economists, There are two widely recognized indicators:

• Leading indicators
  A leading indicator is any quantifiable or observable variable of interest that predicts the occurrence of a change or movement in another data series, process, trend, or other phenomena of interest. Although every business keeps an eye on its balance sheet and profit margin, the data in these reports is a lagging indicator. The past performance of an organization does not guarantee its future success. As predictors of future revenues, growth, or profitability, organizations should instead focus on performance metrics such as:
  • DSO lengthening
  • Drop in customer credit score
  • Payment terms pushback
  • Partial payments
• Lagging indicators
  An observable or measurable factor known as a lagging indicator changes sometime after the correlated economic, financial, or business variable changes. As a result, lagging indicators validate long-term trends but do not forecast them. This is helpful as a lot of leading indicators are frequently unstable, and short-term swings in them can hide turning points or produce false signals.

Tip 2: Incorporate scenario planning in cash forecasting

Scenario planning helps decision-makers anticipate possible outcomes and implications, assess actions, and manage multiple scenarios. Businesses overborrow at the last moment with high interest because of poor scenario planning with spreadsheets or sup-par technology. This may lead them into huge debts that eventually cause penalties for repaying the loans late. Automated cash forecasting helps predict customer-specific payment dates accurately by incorporating multiple customer and invoice-level variables. External factors such as raw material fluctuations can also be considered to capture trends for generating a cash flow forecast.

Having automated cash forecasting software is key to identifying the degrees of impact and mitigating the risks in advance. Accurate cash forecasts allow treasurers to anticipate cash needs, improve capital allocation, understand movements in interest rates and commodity prices, manage credit and counterparty risks and control FX risks through confident hedging and repatriation decisions.

Tip 3: Perform cash forecasting regularly

Regular forecasting refers to creating accurate and updated forecasts with all the historic and current information. It enables the treasury department to make decisions based on what’s going on in the business right now, rather than on a possible budget set months in advance. Businesses will be able to predict future cash gaps and avoid missed payments if they perform cash forecasting regularly. 

A real-time cash flow forecast gives businesses the clear vision they need to implement corrective actions such as fine-tuning payment and collection strategies, liquidating assets, or approaching lenders. It supports performing variance analysis over multiple durations across multiple regions, entities, and cash category levels. Additionally, it supports functionality to drill down into variance drivers for exercising better control over cash flows.

Tip 4: Practice better treasury management

What is included in treasury management?

Treasury management best practices include the following:

1. Keeping a record:
   Treasury management requires handling tons of documents, and these documents need to be filed up in the correct order, and a copy of the same should be stored on the company’s server, available only to the treasury team.
2. Reporting:
   The performance of a company is assessed through an efficient treasury management service. A treasury module connected with ERP or a dedicated treasury management solution provides accurate reporting needed to make executive decisions.
3. Adopting automation and AI:
   Automation reduces manual work and allows teams to concentrate on strategic tasks. AI, on the other hand, utilizing and processing more data increases forecasts’ accuracy, resulting in better liquidity & debt management. Additionally, it delivers important insights for other elements of the organization like financial planning or supply chain management. It also helps by minimizing operational risk and reducing complexity.

How HighRadius treasury solution help to stay ahead of the curve during macroeconomic fluctuation

Here are some benefits provided by AI treasury solutions:

• Gather real-time information using APIs
• Create forecasts that help in the identification of liquidity trends
• Actively manage cash across multiple entities, currencies, and regions
• Get real-time visibility into cash flows with the help of dashboards
• Manage various risks such as currency and interest rate volatility
• Automate bank data reconciliation and perform cash positioning
• Track scenarios effectively to manage loans and investments
• Improve signatory tracking and bank administration
• Manage in-house banking, sweeps, and intercompany transfers
• Prepare different versions of reports for different stakeholders