Time to Reassess Accounts Receivable?
As the recent credit crisis in the financial markets starts to affect business credit, the coming year looks set to be one in which the thoughts of finance directors and chief financial officers turn to improving their cash and working capital management. Many pundits have claimed that European business fundamentals are sound, and that the liquidity crisis is likely to prove one that only affects players in the capital markets. While the point about business performance is valid, to pretend that the freezing temperatures in the financial markets will not induce a few sneezes in business would be naïve.
Commercial banks have already corrected the risk-rate spread to better reflect real risk among corporate borrowers. That immediately means that the price of credit, or indeed its availability at all, has tightened for the more leveraged sector of the business community. From a fiscal point of view, Britain is particularly exposed to downturn in the financial markets, in that a substantial proportion of the UK’s profits now come from financial services firms. So if those profits take a downturn, so do taxation receipts for the Exchequer, affecting public services and spending, and in turn pressurising overall economic performance.
Mark Twain aptly described the attitude of banks when he defined the typical banker as “someone who lends you his umbrella when the sun is shining, only to ask for it back when it begins to rain.”This is particularly relevant to the current situation, when the credit squeeze is arriving at a time when fiscal policies have bitten deeper than expected, and GDP forecasts have been steeply downgraded (2.3% in 2008 – source: IMF). In other words, just at the moment when favourable business credit is most needed – from an economic point of view – it is becoming less available, at least for firms carrying high debt levels, or who are in pressurised sectors.
When lines of credit are easy to obtain, and inexpensive, then the FD does not lose sleep over his or her working capital efficiency. When those lines of credit dry up, get capped, become more expensive, or carry insupportable covenants, then working capital and cash management techniques suddenly gain priority attention from the finance department.
The best barometer for how well a firm is managing its cash flow and working capital is the measure known as day’s sales outstanding (DSO). It is not the only such measure, and in different industries there will be other key metrics (such as day’s inventory outstanding for the manufacturing sector). However, as a universal thermometer for getting a grasp of whether business is ailing or prospering, it provides a consistent picture across all non-financial business sectors.
A recent study1 showed that whilst DSO for large firms has remained fairly constant over the last few years, the same metric for small to medium-sized enterprises (SMEs) – defined as having 11-249 employees – has risen 6% since 2004. Even more importantly, whereas large firms have got their DSO significantly below 50 days, the same measure among SMEs is almost 70 days. Given that the most prevalent cause of failure among SMEs is cash flow problems, this statistics reveals not only the urgency of SME cash management improvements, but also the extent of its potential.
A further aspect of the practical imperatives of SME cash management lies in the reality of bank credit assessment systems. The models employed to set rates for SME lines of credit are fairly simplistic, with a few key factors used to arrive at rates and terms for SME borrowers. The simplicity of banks’ credit rating models lies in the fact that it is only certain fundamental factors that can be consistently validated by official sources such as Companies House. So, such models tend not to discriminate between low and high risk companies, with the result that, in a credit squeeze, higher and lower risk companies tend to find their cost and availability of credit rising. Only when it comes to larger firms can financiers afford to conduct detailed analyses and come to truly individualised credit ratings. Among SMEs, the current need to improve cash flow management is a universal requirement, and is not simply restricted to firms with higher leverage or in lower margin industries.
To give an idea of the scale of the problem, consultancy REL released a report in 2007 that claimed the top 1,000 European companies could generate an additional €407bn-worth of cash flow annually if all companies matched the cash conversion performance of top performers in their industries. According to this report, despite a booming economy and record sales figures, top companies in Europe lost ground in the battle to generate and manage cash in 2006. The annual study examines how effectively major corporations are turning sales into free cash flow and how much cushion they have in their operations, identifying the companies that excel in this area – ‘Cash Masters’ – as well as those who lag behind. While European companies appear flush with cash, the reality is that the ratio of cash on-hand as a percent of sales is at its lowest level in three years.
What of the SME community, as opposed to major listed companies? This section of the business community, according to official statistics from the Department for Business, Enterprise and Regulatory Reform (BERR), accounts for almost 30% of the UK business revenue, compared with around 50% for large firms. However, in terms of trapped cash, the vast majority (four-fifths) is frozen in the accounts of SMEs.
In order to identify a practical estimate of trapped cash that could realistically be ‘liberated’ by better cash flow management in British business, we recently commissioned research designed to follow a relatively conservative model. Average DSO for the SME and large company size bands, were then combined with total annual revenue data, in order to arrive at an amount of cash that currently lies trapped in the system. Key to this model was the realistic target for payment. Since most business-to-business payment terms vary between 20 and 50 days, the model was constructed on the basis of a realistic target of average payment at 45 days.
The resulting study identified that UK non-financial businesses could realistically have released almost £64bn based on projected 2007 turnover. Using a target of payment at 45 days, the vast majority of trapped cash – 82% – was accounted for among firms with between 11 and 249 employees.
Successful cash management is a careful balancing act between effective collection of outstanding invoices (accounts receivable) and controlled timing of suppliers invoice satisfaction (accounts payable). In the UK, legal pressure to make timely payments of invoices is largely recognised to be powerless. Nevertheless, this does not mean that large firms can afford to collect on time, but pay late, despite the popular conception that this is the case. There have been plenty of well documented cases of essential suppliers being forced into business failure through poor payment history, only for the large firms buying its goods or services to then find themselves left with major interruptions to their own output and consequentially very serious commercial and brand damage. In order to deliver modern standards of customer service, large firms need a healthy supply chain, and that requires reasonable actual payment timings – hence our research project’s realistic target of payment within 45 days.
Over the coming year, I predict that more attention will be paid to accounts receivable (A/R) and accounts payable (A/P) efficiency and effectiveness. A more systematic and automated approach to A/R and A/P is required, and a large part of the effectiveness of the workflows here concerns the underlying documentary evidence, especially for smaller firms trying to improve their payment record from larger customers.
The need to capture documents, as well as data, in the A/P process is self-evident. Most businesses receive paper invoices from their suppliers and, to implement an efficient and effective A/P operation, these need to be scanned, indexed and stored for easy retrieval in a central system. Software and service solutions to streamline the A/P process abound, and the marketplace is very crowded. For organisations with a wide range of suppliers, there is considerable scope for saving on staff costs by automating the process of generating copy statements, remittance advices and allowing suppliers to ‘self-serve’ over the Internet in terms of their queries about where an invoice is in the purchase-to-pay cycle. The major current development in this area is the creation of centralised ‘shared service centres’ for branch-based, franchised or otherwise fragmented organisations, in order to find additional economies.
Few organisations have yet invested in combined A/P and A/R solutions, despite the fact that the underlying technology support is essentially the same, combining workflow, data management and document management. In the debt collection process, organisations that can offer the buyer reliable proofs of delivery, signed purchase authority, authorisation of staff attendance, confirmations of receipt, certificates of good condition, etc, are most likely to receive prompt payment. The buyer’s accounts payable department will almost always prioritise invoices which come with good documentary support, so having this capability is likely to have a major impact in reducing average DSO, and freeing up trapped cash. Again, systems that combine workflow, documents and data are now offering web-based presentment of invoices plus supporting documents. Hybrid systems will deliver paper invoices, but quote a web-link where the supporting documentation is to be found.
In conclusion, UK business is in a position – on a conservative estimate – to free up some £64bn of cash flow annually through better A/R process management. Pressure to release some or all of this working capital is particularly topical at a time when risk-rate spreads have returned to a more normal level as a result of the credit crisis, and the price of credit has risen, while its availability has fallen, for many businesses. FDs and CFOs will be paying particular attention to working capital management in the coming year in the search for new cash sources. But this needs to be done in a way that is sensitive to the importance of maintaining health in the supply chain. Document, data and workflow automation are critical to improving the efficiency and effectiveness of A/R and A/P processes. Moreover, both applications use fundamentally the same underlying technology and services. Finally, the model on which this report is based takes a conservative and practical view, positioning the SME DSO target at a highly achievable 45 days.
1 Source: Siemens Financial Services, Q1 2007.