Managing non-evident Capital Costs with SAP Bank Analyzer. Chapter IV

Dear,
As we commented in the previous post, the difficulties of integrating Bank Analyzer as a sub-ledger of non-financial processes are more related to marketing reasons and perceptions than real technical constrains.

I will try to make a simple description on this post.
The main objects for modelling a business deal in the Accounting for Financial Instruments module (sub-ledger scenario) of Bank Analyzer are the following.

- Business Partner. It’s the Physical or Legal Person with whom our company is having a business relationship.

- Financial Transaction (or Financial Instrument). It’s the representation of the financial contract that our company has with the business partner.

- Business Transaction. It’s an event of the real world, relevant for accounting which can potentially trigger a flow in a GL Account.

The objects above are not specific of a financial deal, but in fact to most, if not all, business deals.

All business deals have a counterparty with which our company is having the business relationship, the business agreement is represented by a contract (Financial Transaction), and a number of events happen in the real world, in relation to the contract, and can trigger flows in GL Accounts (Business Transactions).

For instance, let’s look at typical sales business deal, represented in SAP by a Sales Order, a Delivery (with Post Goods Issue) and an Invoice.

Every Item of the Sales Order represents the commitment of delivering a number of goods (or services), at a delivery date for an agreed price.

The Item of the Sales Order also represents the conclusion of a forward contract for delivering an underline (goods or services) at an agreed date (forward date) and price, with a Payment Date which is determined by the Delivery Date and the Payment Term.

On forward date we will create a logistics delivery (actually some days in advance as for fulfilling the delivery date we also must consider the picking, packing, transportation times, etc.) and the correspondent accounting entry as the forward contract has been settled. 

At that moment our Sales Order Item (Forward Contract) has become an Account Receivable that will be cleared (if the counterparty fulfils his obligations) at Payment Date.
As you can see, there’s a parallelism in the business flow of a standard Sales and Distribution process with the events of a Derivatives Trading business flow.

The main difference between these two modelizations of the business deal is that the Sales and Distribution modelization puts the focus in the logistics process, while the derivatives trading modelization puts the focus in the Capital consumption (Market and Credit Risk).

Modeling the Sales and Distributions Process as a Forward Contract in Bank Analyzer gives us the opportunity of determining:

- The Capital Consumption due to Credit Risk, by determining the Exposure at Default from the Credit equivalent amount of the derivative and the Probability of Default of the counterparty (business partner on the deal). 

- The Capital Consumption due to Market Risk by running a Value at Risk calculation (in future Bank Analyzer releases). 

For years, capital was abundant and it was not necessary to estimate the Capital consumption due to Credit and Market Risk of most of business deals; that’s why we could afford modelling the business processes neglecting its importance. 

But today, we’re in the middle of a systemic crisis generated by the new environment of capital scarcity. In this new environment, we can’t afford neglecting the cost of the capital that we consume in a business deal. 

Consequently we’ll have to build information systems which include accurate measurements of the cost of capital of the business deal, and include them in the calculation of its contribution margin.

In my opinion, SAP Bank Analyzer technology is the answer to this requirement.

Looking forward to read your opinions.
K. Regards,
Ferran.

Managing non-evident Capital Costs with SAP Bank Analyzer. Chapter III

Dear,
In the last posts, we’ve discussed the importance of managing Credit Risk and Capital Costs in non-financial processes.

https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-chapter-frances?trk=object-title

https://www.linkedin.com/pulse/managing-non-evident-capital-costs-sap-bank-analyzer-ferran-frances?trk=object-title

The necessity of managing capital costs is nothing new; it’s the natural consequence of managing the risks associated to an economic activity. What is new is the relative importance of the capital costs in the economic analysis of a business event.

During most of the 20th Century, and particularly since the end of the Second World War (including the plans for reconstructing Europe and Japan) and the implementation of the Breton Woods Agreements, capital was abundant and inexpensive.

In this environment of capital abundance, costs of capital were easily covered by high margins and strong economic growth. Consequently there was no incentive in managing capital efficiently. For decades, the economic world chose to believe that resources were unlimited and wasting capital not an issue.

http://en.wikipedia.org/wiki/Bretton_Woods_system

With the Oil crisis of the 70’s, we discovered that natural resources were limited, challenging the economic growth.

http://en.wikipedia.org/wiki/1973_oil_crisis

At the same time that some initiatives were implemented for managing resources more efficiently, world’s leaders looked for another resource which could be wasted for feeding economic growth.

The alternative was consuming solvency by increasing debt, in other words, replacing cheap oil by solvency as a resource for feeding economic growth.

http://www.imf.org/external/pubs/ft/fandd/2011/03/picture.htm

This is the starting point in the deregulation of the financial system.

www.cepr.net/documents/publications/dereg-timeline-2009-07.pdf

Analyzing what´s the alternative for sustaining economic growth goes far beyond the objectives of this post, I just want to highlight two points.

• Sustaining economic growth on increasing debt is not possible anymore.

• Capital requirements are a percentage of Risk Weighted Assets (Percentage of Debt Weighted by the Risk of the Counterparty + Leverage Ratio); consequently as global debt is historically high, capital requirements should be historically high.

The two points above describe why the financial system is operating in a new environment of Capital Scarcity; and this is serious because Capital is the main resource of the Financial System.

In economy, when a critical resource becomes scarce we recognize it criticality and scarcity by increasing its price. These are the increasing capital costs that we’re discussing here. Higher costs of capital start in the financial system, and then they are spread by investing and lending through the whole economic system.

In the new environment, managing capital costs becomes mandatory, and particularly we must include them as part of the contribution margin of any business deal, obviously this necessity depends on the weight of capital consumption in the contribution margin.

For instance, the capital costs involved in the trade of 20.000 Barrels of Brent Oil for being delivered in 12 months, and paid in foreign currency, are not even close to the capital costs of buying 20 cans of beer in the local Walmart. But in both cases, the weight of capital costs involved in contribution margin of the deal are much higher than 30 years ago.

We have an excellent tool in the SAP Business Suite, Bank Analyzer, for determining Capital Costs (on the current releases only Credit Risk Capital Costs) and include them in the calculation of the contribution margin.

The difficulty seems to be integrating Bank Analyzer in the management of non-financial business processes; and judging by the emails I’ve received in the last weeks, this is an extended concern amongst the readers of this blog.

In my opinion, the difficulties have more to do with marketing reasons and perceptions than with technical constraints. We’ll talk about them in the next post.

Looking forward to read your opinions.
K. Regards,
Ferran.