Cash & Liquidity ManagementCash ManagementFrom Collections to Excess Liquidity – Risk in the Supply Chain

From Collections to Excess Liquidity - Risk in the Supply Chain

Trade in Europe and the US is increasingly conducted on open account, which has the advantage for corporates that they can collect their payables more quickly. However, as companies move away from traditional trade instruments such as letters of credit (LCs), which provide some guarantee of payment, they are finding themselves without the appropriate risk mitigation instruments in place to protect against customer default. It is increasingly important for corporates to do their own research into their customers’ credit history and reliability. Although most companies do not currently have the necessary information available to assess this, it is important that they focus on risk mitigation on the collections side.

Regulatory Developments on Risk in Customer Collections

There has been a wave of regulations in the market that affect the way companies deal with customer risk. Companies need to know who they are dealing with so know-your-customer (KYC) principles, although traditionally the focus of banks, should also be a priority for corporates. Sarbanes-Oxley has also been important in forcing companies based in the US, or with a listing on the Securities and Exchange Commission (SEC), to assess their exposures and gain a global view of collections and the international financial reporting standards (IFRS) require every hedging instrument to be assessed in terms of the risk it’s hedging.

Centralising Collections

Another way of gaining a better view of accounts receivable is by centralising this process. Although this is difficult and complex, it is something that companies should consider if they want to successfully mitigate risk in collections. The accounts payable department in many companies has been centralised for some time, usually by means of a shared service centre (SSC) or a payments factory. Some companies have already taken the step of centralising their trade finance and LC issuance functions. Rabobank, along with two other banks, recently worked with a large company that wanted to centralise its trade finance function and the company found that processing incoming LCs through the centralised group of banks was more efficient from a risk management perspective.

Centralisation brings significant cost benefits to the corporate and it also means that information on the issuance of LCs or the bank guarantees is centralised. The corporate is therefore able to monitor the collections process end-to-end, whereas previously collections were done on a local level and central treasury did not have a good view of the process. This improves the mitigation of associated risks in the collections process because the company can establish effective policies, rather than having local entities conducting the trade transaction and funding these through their local banks. There are many risk issues surrounding trade finance, such as counter-party credit risk and, by centralising the process, companies have much better control over the acceptable level of counter-party credit, the funding of the trades and also the execution of all these instruments.

More companies will focus on the collections side in future and this will be helped by the pan-European direct debit system (PEDD), which is due to be introduced in 2008, the first deadline for the creation of the single euro payments area (SEPA). But the industry will probably focus on finding a simpler solution for other payment instruments. In 2010, as a result of SEPA, customers will probably be able to pay from one account in Europe and this will simplify the collections process.

Establish a Customer Credit Scoring System

Companies need to assess the exposure of the customers they are dealing with and how credit-worthy they are. Ratings agencies can be used, but another option is for the corporate to establish its own customer credit scoring system, similar to the system used by banks to carry out credit checks on their clients. Some companies are looking at establishing their own customer rating system based on information about the customer’s payments history and performance and also at practical information about day’s sales outstanding and what kinds of instruments are used by the customer to mitigate the risk. Once the corporate has an overview of the payables outstanding from its customers, it can then look at how to mitigate the risks surrounding retrieving the debt.

In establishing a credit scoring system to assess risks associated with customer payments, companies should consider:

  • Where is the client located?
  • What are the exposures of the customer and its accounts payable? For example, country, currency or market risk, etc.
  • In what currency is the receivable?
  • What are the payment terms?
  • What instruments are used to get the receivables in? (i.e. factoring, trade instruments, etc.)
  • How are payments structured by the customer – is it done on a local basis, or is there already an in-house bank?
  • What is the company’s track record?

Most companies haven’t yet established this kind of system because it has not been a priority for them, rather than because they don’t have the right technology to obtain the necessary data. On the collections side, many companies haven’t yet got an adequate grasp of what is going on in their organisation, which increases risk and could have an impact on the final liquidity position.

Instruments for Risk Mitigation in Collections

There is a wide variety of options open to corporates who want to mitigate risk in their collections, such as lockboxes, factoring, receivables securitisation programmes, foreign exchange instruments and trade finance instruments. Here is a brief overview of some of the main ones:

Lockboxes. These are usually used by larger companies with a lot of cheque receivables who want to optimise their day’s sales outstanding. The cheque is collected much more quickly and the company has a centralised view of the flows and a better overview of the information, so it is better equipped to deal with any associated risks.

Receivables securitisation programmes. Large companies with high levels of receivables outstanding, and good customer credit ratings, can sell their receivables to a bank, which will securitise them using a special purpose vehicle. This eliminates some risk because the company receives a guaranteed amount of money (although it is not the full value of the receivables). It is mostly used as a financing tool but it does change the risks within the company.

Factoring. If a company is not large enough to set up a securitisation programme, it may use factoring, in which the company sells its receivables to a factoring firm, which pays a specific amount for the receivables and then collects the receivables on the company’s behalf. This can be with or without recourse.

In-house bank/central treasury. In some companies, the central treasury or the in-house bank is taking over the receivables function, funding the subsidiaries and controlling the whole funding portfolio.

FX instruments. To mitigate FX risk, corporates need to know how many of their subsidiaries are operating in which countries, which suppliers they deal with, if they trade on open account and if they have mitigated their FX currency exposures.

Derivatives. The derivatives side is interesting and includes credit default swaps. It still has room to grow, especially on simple collection structures, which have been largely overlooked. Corporates and banks tend to use derivatives for large complex transactions and this market will become more commoditised in future.


From a liquidity point of view, the payments side is much easier to manage, but supplier risk is an issue and, in the case of a manufacturer, if a supplier does not deliver a component, then the product will be delayed, which leads to a delay in payment from the customer. Some companies are seeking to diversify their supplier risk by using different suppliers in different regions and back-up suppliers. It is also possible to have a scoring system for your suppliers, which can feed into the data in the customer credit scoring system.

Excess Liquidity – Investment Strategies and Risk Mitigation

The amount of excess cash on company balance sheets has increased in the past few years. The majority of Rabobank’s corporate clients now have excess liquidity. This has led to many companies doing share buy-back programmes. Part of the reason for this is that there has been an economic downturn and corporates have been seeking to economise and stop excess spending. On the investment side, there has been a reluctance to invest heavily in new equipment and materials. In future, people will invest more in their companies, especially in fast-growing markets such as China.

Treasury has a number of options for investing excess liquidity – money market funds, asset managers, investment in the company (equipment, products), bank deposits, yield-enhanced funds – but it is most important first of all to establish a good view of the incoming cash flows. As mentioned before, accounts receivable are unpredictable and it is vital to stabilise this incoming cash flow as much as possible through risk mitigation. Treasury also needs to look at the company’s future plans, such as investment in the company and the possibility of any merger or acquisition activity. These plans, and their time scale, will affect the investment of the excess liquidity position and the structure and terms of the investment instruments.

In large MNCs, investment options are heavily dictated by performance criteria, or investment policy and some companies have very strict criteria about how much they can invest in a certain type of fund or the counter-party’s rating, etc. The investment policy is usually set by the executive board of the company and it mitigates the risk around investment programmes, for example a common criteria is that no more than a certain amount (eg 5-10 per cent) of liquid assets can be invested in a certain asset, or that investments in some assets are prohibited, for example hedge funds.

Companies are very familiar with the processes involved in investing their excess liquidity and mitigating the risks associated with this. However, not many companies have a good overview of their supply chain and the dynamics of the incoming receivables, which feed into the excess cash on the balance sheet.

Large corporates, in particular, are restricted by investment policies. However, in mid-sized companies the situation is completely different because there is often no policy and investment and risk mitigation decisions are taken by the finance and treasury departments.

Excess liquidity is often invested in current accounts or banks deposits with their main relationship bank. However, these do not give the best returns and the cash deposits are often just an added service that the bank provides in addition to other services, such as payments services. It should have more importance for corporate treasury and it should be integrated with the company’s risk profile.

Moreover, liquidity management is increasingly combined with risk management. The most important reason is that these areas are closely related and in most companies, CFOs are responsible for both areas of expertise. It is important for banks to follow the corporates’ needs, monitor the developments in the market and new regulations. For instance, Rabobank has developed the concept Financial Logistics, which offers an integrated solution for optimising risk and liquidity positions.

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