Cash & Liquidity ManagementPaymentsClearing & SettlementSettlement-Slot Delays Causing Working Capital Problems

Settlement-Slot Delays Causing Working Capital Problems

For several years now, low-cost airlines may have shown the way in lean operations and how to sweat an airline’s asset base, but they are not done yet. Ray Webster, CEO of one the low-cost stars, EasyJet, spoke of his company’s strategy to make their business model even slicker and to “squeeze the lemon” (FT, 8 Oct. 2003).

REL Consultancy Group’s recent ‘European Airline Industry Survey’ highlights that a key area where EasyJet and a number of other airlines might look to further “squeeze the lemon” is in operating working capital – essentially the large amounts of cash that airlines have tied up in collections, inventory and uneven payment practices.

Indeed, for those in the industry who believe that the route to ever greater efficiency is through consolidation, the industry constraints that have limited the likes of Air France and KLM in their efforts to consolidate operations would suggest that reducing working capital may be one of the few areas left for finding substantial savings that can be delivered quickly.

Wide Variation in Working Capital

REL’s survey found wide variations in the airline industry’s levels of net operating working capital, with surprises for both low-cost operators and the traditional flag-carriers. For example, in 2002 net operating working capital in Alitalia locked up financial resources equivalent to an astonishing 8.1 per cent of sales, whereas Air France operated with a creditable working capital level of just 2.2 per cent of sales and Ryanair ran an even tighter ship with negative working capital of -2.8 per cent of sales – an admirable attribute hitherto rarely seen outside the world of high street retailers. What this means is quite simple – Ryanair collected cash from its customers faster than it had to pay its suppliers, so financing its operations in part through its trading terms.

However, a common theme appears to be an increase in levels of working capital across many of Europe’s leading airlines, whether they are low-cost or not. Notwithstanding the general drive across the industry for efficiencies, only BA, SAS and KLM reduced their levels of working capital as a percentage of sales in 2002 from those seen in 2001, with KLM achieving the biggest reduction. It must be said, however, that KLM remained far from best in class with a net operating working capital still 6.7 per cent of sales, just ahead of bottom placed Alitalia.

Good working capital management not only drives balance sheet strength – an essential element in determining an airline’s credit rating – but also revenue, expenditure, cash flow and perhaps most importantly, customer service. For, example, improving collections often involves addressing the root causes for delays in customer payments, which can mean eliminating errors in pricing, invoicing and general service delivery. Fix these things, and companies make life simpler for both themselves and their customers.

Working capital improvements are nothing new and do not apply only to the airline industry. Across many different sectors, companies are appreciating the near and long-term benefits of instituting working capital management programmes as investors demand more efficient use of what is, after all, their capital.

The amount of money involved can be significant. In a recent REL project, a leading European chemicals company freed up more than $1bn in cash in just four months, with minimum investment, through working capital reduction programme and a US technology company generated $2.6bn in cash plus $200m of process cost savings, through a similar programme.

Timing Settlements is Key

A response we often hear is “This is all very fine for other industries but the airlines business is unique and what works elsewhere won’t work here”. So what then are the industry’s constraints and, more interestingly, what are the areas that provide opportunities for improvement?

A key issue for many airline operators is that the timing of cash-flows is often determined by standard industry ‘clearing houses’ each with their own formats, processes and cut-off times. In Europe, inter-airline settlement of passenger sales is processed by IATA on a monthly basis with a 19-day settlement period, cargo business is settled through CASS (again on a monthly basis, but with a 31-day settlement period), and travel agency sales are often settled through BSP on a weekly basis, with a ’15-days from end-of-month’ settlement period.

So what do these settlement cycles mean for actual industry cashflows? Airlines that depend for a large part of their passenger revenues on sales transferred through from other airlines will have their monthly sales settled at best within 34 days (an average of 15 days-to-bill up to the monthly IATA cut-off point, plus the 19 day settlement period). Similarly, best average settlement through CASS for transferred through cargo revenues would be 46 days.

So with standardised settlements systems why are some winning and some losing? Firstly, airlines that capture a significant proportion of their revenues outside of these clearing systems (e.g. web-based sales) have the potential to achieve better performance. For example, BA closed 2002 with a trade receivables balance equivalent to just 29 days of sales (Days Sales Outstanding or DSO), yet KLM closed with a DSO of 42 days and Alitalia with a DSO of 52 days.

The Problems

Yet this is clearly not the whole answer. Airline revenues are still heavily dependent on industry settlement systems, and getting internal processes right and eliminating disputes (or at least resolving them quickly) is critical to ensuring all eligible claims are ‘readied’ for each settlement slot.

Too often, transactions in the days prior to these settlement slots are not readied in time for processing. As a result, slots are missed and claims submission is delayed for up to a month, generating a significant “kicker” effect in the take-off of working capital levels. For an industry that would not dream of missing a take off or landing slot through lack of planning it is perhaps surprising that relatively little attention is paid to these equally important slots!

Claims errors, ineffective dispute management and lack of clarity of internal responsibilities result in further collection delays as issues fail to get addressed or resolved as quickly as they should be.

For example, a medium-sized European airline identified significant working capital improvements it could achieve through modifications to its internal processes in Accounts Receivable, particularly through eliminating the delays and errors in readying transactions for IATA and CASS cut-offs.

So much for the cash receivables. Are the payments made by airlines the flip side of the same coin? As you might expect, airlines that hold a dominant position in a major alliance, or pay for a significant proportion of contracted services through these clearing systems, may find that they can take advantage of the long settlement periods of these systems. For example, BA closed 2002 with a trade payables balance equivalent to 47 days of sales (Days Payable Outstanding or DPO), whereas KLM found it had to operate at just 30 days DPO.

However, a north-south regional divide in general payment practices, found in many industries, is also reflected across the airline business. Overall, the southern European carriers achieve longer payment periods (over 38 days DPO) than their northern European counterparts (30 days DPO or under). The notable exceptions are the UK carriers, where BA achieves 47 days DPO whereas EasyJet has only 18 days DPO.

Clearly, payment terms cannot be considered in isolation from the prices that companies are able to negotiate with their suppliers. However, if airlines are paying suppliers faster than the competition, they need to ensure they are capturing at least the corresponding working capital ‘value’ through better prices.

The Solutions

In general, what the survey highlights is that optimising revenue and receivables management models (e.g. speeding up the readying of error-free transactions for inter-airline settlement, increasing web-based sales) to achieve low net working capital is essential, but not sufficient.

Companies need also to leverage their purchasing power and optimise controls in payables processing. Strategic sourcing and process automation are examples of several areas where companies should consider taking a second look.

Taking just these two areas in turn: strategic sourcing tends to be seen only in terms of the big spend areas – fuel, airspace & landing costs etc. Little attention is paid to non-core spend, which is often significant but fragmented. Major benefits can be achieved by eliminating duplication in many of these spend categories by identifying opportunities to consolidate into the few preferred suppliers that offer the best price, terms and service, and establish control mechanisms to enforce ‘on contract’ spend.

Companies should seek to avoid spending time on procurement and payment transactions that have very low value. Purchasing cards (P-cards), blanket purchase orders and other techniques can be used to allow purchasing to take place locally, and with little intervention whilst still preserving the necessary controls, reporting and pricing benefits.

Working capital is likely to come under increasing focus in the airline industry as a prime source for achieving the elusive operational synergies, so often promised at the time of announcement of large merger and acquisition deals.

For example, in 2002 the combined receivables balances of Air France and KLM stood at nearly €2.2bn. A 10-15 per cent reduction just in these balances, a low-end figure for many companies in other industries that have undertaken working capital reduction programmes, could yield up to €300m in cash. Add in Alitalia and the total cash prize from optimising receivables management alone reaches over €420m.

Given the constraints imposed on such merger deals in Europe (for example, various industry accords and regulations have limited the scope for KLM and Air France to consolidate their operational centres), drawing on the lessons from other industries to deliver large, sustainable benefits from rapid reductions in working capital is likely to become an industry imperative.

This article was originally published in Airlines International

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