Cash Management for the 21st Century

Cash Management for 21st century

In the past, finance managers of the multinational companies could apply lagging and leading and facilitate the subsidiaries’ local borrowing with guarantees or letters of goodwill. If the devaluation of an export market’s currency was feared, then the finance manager could instruct the subsidiary to pay earlier. He could also consider a forward hedge but, if a devaluation is expected, the forward discount already anticipates the possible devaluation. Discounts for short periods of over 100 per cent or even 1000 per cent happened repeatedly in the Euro Monetary System (EMS), when realignment was expected. Global cash and currency management was only possible in some circumstances and usually the treasury departments of a multinational company had to repeat the same work in every country.

The international landscape had changed totally by the end of the eighties and the beginning of the nineties. In the past, few countries, e.g. Germany, Switzerland, the US have had a full capital convertibility. The capital liberalization has now extended to the whole industrial world.

Organising Central Treasury Like a Bank

The central treasury department can now be organised like a bank. The corporate treasury maintains an interest bearing account with every foreign subsidiary or domestic subsidiary, and all transactions can easily be processed using these accounts. In the past, leading or lagging could cause a long discussion about interest rates and procedure among the financial managers of the same group. This was not productive but was necessary to reach a consensus and support for corporate goals. With the money market type accounts this is not necessary any more. Every subsidiary knows the interest, which it will receive or has to pay in advance. This simple concept offers an enormous savings potential.

In the past, every exchange transaction had to be accompanied by receipts to prove that the basis transaction was an export or import, and sometimes permission was necessary to execute foreign currency transactions. It has happened fairly often at many multinational companies that transactions turned virtually in a circle: the American parent company pays $10m to the subsidiary in Germany for due invoices from Germany. An exchange transaction has to be closed with a bank. Several banks are called first to get the best market quotation. The German affiliate uses these proceeds to pay its obligations versus an affiliate in UK. Euro is converted into pounds. The English subsidiary, which also obtains goods from the USA, uses the proceeds to buy US dollar. Assuming that the rates haven’t changed, the group then has, without taking into account the possible value losses or mistakes, paid $20,000 to $40,000 for the round trip because of bid and offer spread alone.

When the treasury is organized like a bank with interest bearing accounts with every affiliate company then we can separate movement of cash through third-party banks from the settlement of liabilities resulting from goods deliveries and services provided. The costly round trips, as described above, can be then avoided. To capture all transactions correctly and manage currency positions, one can buy a software package or attempt to develop an internal solution with e.g. Access or Excel.

The Interest-bearing Account

The base of the concept is the interest bearing account. Such an account could look like illustration 1. It contains all relevant information. The deposits and overdrafts on the account carry interest close to the market rates. Altogether, every member of the group is in a better position because it couldn’t finance or invest in the market with such a small margin. The earlier discussed round trip is simply booked into the interest bearing accounts with the corporate treasury. No exchange transactions are needed now, no sending of conformations to banks, no comparisons of quotations, no disposition of the bank accounts, no control of the exchange transactions, and primarily no expenses and charges; only two entries are carried out on the account. A $10m credit note from the goods delivery to the UK and a $10m debit for the goods delivery from Germany. The bookkeeper uses this receipt like he would use a bank account statement to book accounting entries. He is not booking against bank account but against the group account with corporate treasury.

Single big settlements of inter-company liabilities can be booked directly into the inter-company money market accounts. However if we want to settle hundreds or thousands of inter-company invoices then we need more automatic processes. We input at first the due invoices in a table. Such a table could look like illustration 2. The information about the due invoices is transmitted electronically to the corporate treasury. The Internet is the most efficient way for exchanging information among various members of the international group. How shall we now execute netting? You can use special netting software, ask the bank or other third party to do this, or write a netting programme.

Illustration 1: Group account

Netting Techniques

Independently which way we choose the principle of netting procedure will remain the same. Our table with inter-company payables has to be sorted. At first we sort the table according to paying units. We sort according to the field remittance from. Illustration 3 shows the results of this sort. We see immediately from Illustration 3 how much the Argentinean, Australian etc. subsidiary has to pay. The due amounts are shown in the invoicing currencies but they have to be booked into the money market accounts in the currency of the money market account. Normally each subsidiary has at least a money market account with the corporate treasury in its own local currency. Therefore based on the information in the illustration 3 we have to prepare a debit note.

If we want to debit for example the account of the American subsidiary with the netting amounts, then we shall make a debit note for this subsidiary. The debit note could look like illustration 4. The debit note contains all relevant information, which is necessary for the recording of the transactions. The affiliate companies that get a credit note are listed there. The invoices in different currencies are listed there but the debit into account occurs in the local currency of the subsidiary. The total amount of all settled invoices converted into local currency of the owner of the money market account will be now according to the amount on the debit note debited into money market account.

Which rates should be used to convert invoices in various currencies into local currency of accounts holders? From a group point of view it may not create any difference but tax authorities in various jurisdictions could question the procedure, if conversion rates are set arbitrarily. We need a valid procedure. If we use the rates as published in newspapers such as The Wall Street Journal, nobody can question them. Other rates like budget rates or forward rates could also be possible. The five invoices in the debit note as per illustration 4 add up to $2,391,187.78. This amount can also be seen in the account statement of the subsidiary, seen in illustration 1. The account of the subsidiary was debited here with $2,391,187.78, as per debit note.

Calculating Amounts

Next we have to calculate the amounts, which every subsidiary receives from other subsidiaries. We use the same table as per illustration 2 and just sort them according to the receiving unit. Each subsidiary that receives payments through inter-company netting procedure must get credit notes as well.

CONFIRMATION OF EXECUTED PAYMENT

Illustration 4: Debit note for inter-company netting

The netting procedure described here can help a multinational company to save millions of dollars in unnecessary conversion bids and offer spreads, float, disposition of accounts, dealing time, etc. In our opinion these savings are much higher than savings resulting from the introduction of the euro.

To obtain full benefit netting must run fully automatically, otherwise it would often be faulty and erratic when a large number of booking transactions are involved. This is easily attainable with many treasury workstations or self-programmed macro controlled programmes based on a spreadsheet software, e.g. Excel.

If we introduce the concept of interest bearing inter-company accounts and understand corporate treasury as in-house bank, then we can easily use the accounts also for other transactions. We cannot only use this concept for netting within the group but also for foreign currency payments to third parties.

Every affiliate is now instructed to conduct the cross-border payments through the treasury department or better to say through the in-house bank. The treasury then decides on the most favourable way of the payment and in the internal relationship debits the account of the subsidiary, see again illustration 1.

Defining Group Liquidity

The work of the in-house bank does not stop here. The local liquidity in many currencies can be managed globally now. The in-house bank enters into pooling arrangements with one bank per country, where more than one subsidiary is located. The in-house bank becomes the pooling leader of each pooling agreement. Every day all bank accounts of all subsidiaries are balanced to nil through the zero balancing procedure. The bank liquidity appears only on the pool leader bank account. This account belongs to the corporate treasury and is globally managed. The bank transmits an electronic account statement. The corporate treasury uses this information to automatically update the inter-company interest bearing accounts. The subsidiaries do not have any bank balances now. The bank accounts are always zero. All liquidity is shown on the inter-company interest bearing accounts. The accounts with local banks are used now only for transaction activities. The liquidity management is now processed through the account of the pool leader. The subsidiaries are informed through the account statements of the inter-company interest bearing accounts about the zero balancing activities, see also illustration 1 and look for zero balancing.

The group liquidity can now be managed more effectively. If the in-house bank can negotiate narrow spread between bid and offer interest on the pool leader bank accounts then the opportunity costs of disposition of the accounts based on the actual information is very low. The group can manage liquidity without any short term planning. At first the short-term cash needs of some pool member will be offset by short-term cash surplus of other member of the same pool agreement. The residual liquidity can now be borrowed or invested for a short period of time at the bank account of the pool leader. Knowing that any short-term cash planning exercise is very error-prone and that it requires a vast amount of resources, we can save a lot with the procedure described here.

Should balances of the inter-company interest bearing accounts reach a certain level then they can be reduced with the help of inter-company loans, which offer even more attractive interest rates to the subsidiaries – see illustration 1 and look for entry loan repayment.

Making Group Liquidity More Efficient

The netting of inter-company invoices can be carried out on the same day for all subsidiaries. Various dates, or daily netting of inter-company invoices is possible as well. The affiliates can also have foreign currency receivables with third parties. One can open up the possibility for the affiliates to close forward contracts with the corporate treasury. The corporate treasury is then informed about the exposure and can close hedging transactions with the banks. Instead of closing inter-company forward contracts we could also apply factoring with the affiliates. The affiliates sell immediately or later all currency positions resulting from sales to third parties to the corporate treasury. The discounted amounts converted into local currency are now credited to their interest bearing inter-company accounts. It is no longer necessary to manage the inter-company forward contracts portfolio as the exposure is immediately booked into interest bearing inter-company accounts and corporate treasury can easily manage the group exposure.

We can further facilitate the work of various subsidiaries and advise the customers to pay directly to the bank accounts of the corporate treasury. With such procedure treasury always knows the currency position of the entire group. We can implement factoring of receivables with third parties, inter-company settlement and cross-border payments to third parties in such a way that no transaction exposure arises in subsidiaries’ books. If somebody uses re-invoicing as a vehicle for foreign exchange management, he should change to the interest bearing account and manage the foreign exchange risk with the here-described netting procedure. If re-invoicing is used as an instrument to manage taxable income, then it cannot be replaced by the concept of the interest bearing inter-company accounts. The corporate treasury can be established in a low tax country and contribute not only operatively but also from a taxation point of view to the results of the group. A treasury vehicle in Switzerland could prove to be very attractive.

This article is an abbreviated translation from the book Strategien an den Devisenmaerkten by Walter Ochynski, published in the German language by Wiesbaden, 2004, pp 131-140