Cash & Liquidity ManagementCash ManagementPracticeBack to Basics – Reviving Cash and Working Capital Management

Back to Basics - Reviving Cash and Working Capital Management

During the past year, the world has clearly seen the downside of a globalised financial system. No organisation has been left untouched by the ongoing turmoil in the capital markets and the knock-on effects on business. Risk mitigation – whether liquidity risk, counterparty risk, credit risk, etc – has become the top priority for corporate treasurers and the focus has changed from a solely cost-based process efficiency to include a working capital process efficiency.

As banks de-leverage their balance sheets and join the flight to higher quality investments, many corporates are finding it more difficult to access funding and re-funding, which has also become much more expensive. To reduce reliance on their banks and capital markets, corporates are trying to free up capital within the company, looking to unlock cash trapped in accounts receivable (A/R) and accounts payable (A/P) processes and from regional operations where idle cash cannot be easily accessed because of regulatory restrictions. Active working capital management and improved inter-company funding through cash pooling are attractive components in the struggle to access more liquidity.

The current financial turmoil has also resulted in some positive developments, such as a higher business awareness and adaptability, and has led to some corporates being more willing to implement the necessary changes to their operations to withstand additional upcoming challenges. When it comes to managing global liquidity, tools/solutions are available for treasuries and can be demanded from the banks that want to live up to their role as client partners. Now is the time for a corporate to take an even firmer grip on its cash positions by leveraging these tools.

Cash Management: Control, Access and Forecasting

In order for treasury to mitigate risk in terms of cash shortage and liquidity, it is vital to get the basics right: control, access and forecasting. The main goal is to achieve visibility of cash across the enterprise because a firm needs to know where its cash is, how to get its hands on it, and also be prepared for future credit or cash flow problems.

Therefore, treasurers realise that it is now more important than ever to secure availability and allocation of future liquidity. This was reflected in SEB’s survey ( Cash Management Survey 2008 Reveals Liquidity is Corporate Priority), which found that liquidity management topped the list in terms of areas for improving cash management within an organisation, according to 34% of the corporates surveyed.

Figure 1. Highest Potential for Improvement in Cash Managment

Source: SEB Cash Management Survey 2008

This result differed from 2006 and 2007 survey results, when respondents chose cash flow forecasting as their top area of improvement. However, the difference is not as great as it would first appear because liquidity management and cash flow forecasting are closely interlinked, making it difficult to focus on one without reference to the other.

The 2008 results highlighted the main barriers to accurate cash flow forecasting as inaccurate sales projections and lack of internal systems integration. Both of these hurdles were selected by 51% of the respondents. Corporate respondents also highlighted limited availability of resources, such as staff and investment (41%), lack of inter-department communication (41%) and lack of effort/priority within the business unit (39%), as hurdles obstructing efficient forecasting.

As stated above, corporates need to get visibility into their cash flows and be able to concentrate cash where they need it. Many companies are scrutinising market regions and currencies that they haven’t paid much attention to before in order to get control over all their available cash, even the smaller currencies, whereas previously there was no problem leaving funds in a certain country or a certain currency and allowing that amount to fluctuate. Looking at the target balances, most firms will aim to keep these in the subsidiary’s country, but will sweep and concentrate any excess cash over that target band. Today, most corporates are putting a tighter target balance for different countries and different subsidiaries.

All of these problems highlight the need for cash management centralisation. In the cash management survey, when asked what structure best described their current cash management organisation, 28% of the corporate respondents selected a decentralised structure. But the trend is towards centralisation – corporates are working towards creating global and regional cash concentration centres, with 29% moving towards global cash concentration.

Trade Finance: Leveraging Trade Flows

Trade finance can be used to optimise working capital and cash flow forecasting, but it is something of an unknown quantity for many treasury departments. SEB’s survey (Trade Finance Survey 2009: Why Treasury Needs to Take Control of Trade Finance) exposed trade finance as an area of particular weakness, with a significant difference between how companies manage their trade finance activity and the way they manage and monitor other cash flows. Only 20% of companies manage their trade finance operations on a global basis, as compared to closer to 75% which have global control over their cash management. The centralisation of trade finance management needs to rise to this level.

As bank lines remain a scarce resource, corporates have been driven to leverage on their trade flows, rather than ‘in the good old days’ when they could request another increase of one or several of the bilateral overdraft facilities. However, leverage on incoming or outgoing funds can expose weaknesses in both the physical and the financial supply chain processes – it comes back to a company’s governance models for trade finance processing, for example identifying who takes responsibility for trade flows.

A number of internal issues need to be examined before corporates can truly leverage their trade flows. For example:

  • How efficient and accurate are the invoicing/trade document procedures?
  • What proportion of the trade flows is included in the forecasting?
  • What are the payment conditions, for example, for a Chinese supplier? Is the buyer fundamentally financing their operation as well?
  • How much political risk is the purchaser covering and has the new risk factor in the Organisation for Economic Co-operation and Development (OECD) countries horizon been strategically evaluated and a procedure developed for how to handle this risk (given the fact that many corporates lack a risk management strategy for the emerging market)?

A corporate must be comfortable with its counterparty, in the sense that they have a long-term, secure and stable relationship. However, it is now more difficult to have control over a counterparty during the credit crisis – for example a supplier’s bank credit line could be withdrawn within 24 hours if their bank has problems. Also, the political risk is quite difficult to monitor company by company.

This has meant that the trend towards open account trade is reversing because open account transactions are now seen to increase counterparty risk. Therefore many companies are returning to letters of credit (LCs) in order to mitigate this risk. The move away from open account to LCs is pushed both by the supplier, because it means they then have stronger contracts with the buyer, and also the buyer, who doesn’t have free provision of funded credit facilities from its banks any longer (i.e. overdraft facilities) and therefore needs to cut down on financing its suppliers.

For example, when finding production capacity in China was a challenging task in some product segments, the corporates that wanted to do business in the country had to agree the conditions the Chinese suppliers demanded. In payment terms, suppliers from Asia expected up to 30% up front and 70% at shipment; while the buyer – particularly if the buyer is a retailer with a tougher stock turnaround timeframe – may calculate 90 to 180 days for incoming payments from sold goods. This means that the buyer is financing its supplier during a major part of the supply chain and consequently binding the buyer’s working capital.

As long as a corporate has good margins and doesn’t have problems in terms of accessibility to funds, then it can finance its suppliers on its balance sheet. However, this is no longer the case, as many have constrained funding capabilities.

Counterparty Risk Management

Risk management is topping the agenda of all corporate treasurers. Cash shortage is a high-risk area, as well as liquidity risk, which applies further downstream in cash flow forecasting, and currency risk, which is connected to trade and cash flow.

For trade finance today, however, the main focus is on counterparty risk. It is important to examine supplier companies from myriad angles, such as:

  • What’s their day-to-day outstanding?
  • What is their process efficiency or discrepancy in handling costs?
  • How much risk are you taking on your books?
  • What do you confirm and what do you not confirm?

With open account transactions, firms in some countries stopped confirming a long time ago mainly because if a company or subsidiary was comfortable with its supplier/buyer, it could take the responsibility regarding whether or not to confirm, instead of a central credit policy decision-making process. Trade finance has traditionally been managed at a local level because people have seen it as being closely connected to the product that is being produced, for example at a factory or export/import depot.

For companies with revenues below US$10m, the most important factor is ‘preference of trading partners’, according to SEB’s 2009 trade finance survey. Companies with revenues between US$10-500m find ‘bank trade solutions offering’ the most determining factor, but larger companies with revenues over US$500m all opted for ‘internal risk policy’ as their main determining factor in determining the relevant trade finance policy/policies.

Factoring and Supply Chain Financing

Working capital management, which represents operating liquidity available to a business in terms of days sales outstanding (DSO), days payable outstanding (DPO), and days sales of inventory (DSI), as well as short-term financing, is a key component to cash flow forecasting and liquidity management. Although many of the respondents from the 2008 cash management survey seemed content with the quality of their working capital processes, such as purchase-to-pay, order-to-cash and inventory cycle, the main challenges preventing the improvement of working capital management were identified as cash flow forecasting, data collection, analysis and integration, cash concentration, inventory management, A/R and A/P, and internal communication.

Improving working capital has traditionally focused on receivables, for example factoring or receivables purchasing. Factoring, whereby a business sells or pledges its A/R (i.e. invoices) to a third party at a discount in exchange for immediate money, was previously considered to be a product for SMEs, however it is also being demanded by large corporates – although it’s not called factoring but receivable financing or similar. All the multinational companies are using some kind of factoring-related products because it is a very efficient way to obtain financing by using a corporate’s current assets for financing, instead of putting up other collateral.

Many smaller companies believe factoring exposes a company’s weakness, or is a product for weak companies, but that is not correct. It has proven to be an efficient way to obtain financing from the banks. It’s also a better product for the banks because it is based on the invoicing cycle and turnover of the company, i.e. the company’s development, and the bank has a stronger position with direct collateral in the invoices.

A hot topic in the past few years has been improving working capital and cash management based on a company’s A/P in the form of supply chain financing (SCF). SCF is an interesting product in these turbulent economic times when suppliers are facing more difficulty in getting funding from their banks in the normal way. As long as the bank still has a credit appetite in terms of the buyer, SCF can fund the whole supply chain from supplier to buyer. SCF has changed from the rationale of being a tool for access to cheap funding into possibly being the only way for the supplier to obtain funding.

Given the effect that can be achieved through SCF, it is surprising that it has not boomed even more than it has in the current conjuncture. Compared to refinancing a loan, it is easier to look at the A/P, for example, yet banks and corporates have not been eager to pursue the SCF option for several reasons. First, the bank must be ready to assign large amounts to the credit lines of the buyer, which automatically disqualifies many buyers. Second, setting up the SCF structure within a large buyer require some work because the firm has to adapt its purchasing and procurement organisation to the SCF programme. This work has, in these turbulent times, often had to stand aside for more urgent matters.

As banks are now responsible for capping the corporate’s overdraft facilities and in order to gain access to short-term funding, they should work with core clients on a factoring solution or SCF. This can be considered to be a flight to quality by banks, where the calculated risk they take on their clients is based on trade flows, instead of an overdraft. A factoring or SCF programme has higher credit quality and isultimately more beneficial for all three parties – buyers, suppliers and banks.

Another benefit of SCF is that when times get tough, a buyer will try to push its supplier for longer payment terms, or push them on price and trade discounts, etc. For example, a buyer may say that from tomorrow it will not accept payment terms of less than 90 days. Buyers can then offer their suppliers help to finance the extended payment term by using their creditworthiness with the bank. Otherwise that supplier will need to fix it themselves, which would increase its costs that would be passed on to the buyer in the end.

Using A/P and extending the payment terms through SCF effectively means that the buyer doesn’t need to borrow money, which has a negative impact on the debt-equity ratio. The firm needs to look at the turnaround time and make sure that the A/P, for example, is 180 days and A/R is 90 days, which would make the firm’s cash position stronger because it gets paid faster than it pays out.

Conclusion

Working capital is basic. Cash management is basic. In these turbulent times everybody wants to go back to the basics.

Liquidity management and working capital management have in many companies for the first time earned interest from board levels. This is a golden opportunity for treasurers and cash managers to get the attention they deserve. Now is the time to use that attention to establish structures and solutions for the future.

To read more from SEB, please visit their gtnews microsite.

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