Cash Management Best Practice - Unlocking Working Capital - The Global Treasurer

5/28/2019 Cash Management Best Practice: Unlocking Working Capital - The Global Treasurer
Cash Management Best Practice:

Unlocking Working Capital
Author
Joost Bergen August 29, 2006
Date published Categories
Cash Management
Practice
Many sectors and European economies are experiencing slow growth, while high oil and energy costs
are putting profit margins under pressure. In this environment, improving operational processes and
ensuring an efficient supply chain can help to improve profitability and safeguard it for the future. And,
with senior management more and more aware of the benefits of self-financing, treasurers and finance
professionals are under pressure to unlock working capital tied up in the supply chain for operational
use or investment.
CFOs and their treasury staff are achieving this mainly through an enterprise-wide tightening up of the
‘working capital value chain’. This involves operational improvements in diverse areas ranging from
sales and accounts to warehouse managers and logistics. Treasury has a key part to play in reducing
working capital requirements through best practice cash management, including centralising cash flow
and liquidity management, and making the business more cash aware.
In the quest for competitive advantage, multinationals have great scope to unlock capital trapped in
physical and financial supply chains. A recent study1 calculated that the top 100 Western European
companies alone have around EUR480bn trapped in inefficient management of working capital.
Similarly, the survey indicated that there are huge amounts of capital held captive in the working
capital chains of companies in the Americas and Asia. Another study, conducted by BDRC on behalf of
ABN AMRO2, found that 48% of companies have centralised their liquidity management, which means
that large numbers still have the opportunity to do so, if it fits their business model.
Driving forces that are encouraging multinationals down the path of reducing working capital
requirements include, not only the return of growth to the agenda, but also the current determination of
boards and shareholders to impose more disciplined management of capital. The emphasis on cash
flow as a yardstick of performance is symptomatic of this, as is the importance shareholders place on
return on capital employed. In addition, a natural trend towards late payment in the recent period of
https://www.theglobaltreasurer.com/2006/08/29/cash-management-best-practice-unlocking-working-capital/ 1/9
slow growth lead to increasing focus on payment terms and reasons for late payment. Often failure to
pay or late payment, are the result of poor client service or disputes on delivery, for example, non-
delivery or delivery errors.
Just as the exercise of reducing working capital requirements has implications for many of the areas of
the business, its benefits spread beyond improved working capital ratios. Most importantly, the
improvements in operational processes that lead to a reduction in working capital additionally tend to
decrease costs. Consequently, there is an increase in profit. Therefore, there are multiple benefits in
terms of value creation for shareholders.
For the treasurer, there is a role to play in reducing working capital requirements, even though
implementation stretches across other areas of the organisation. Cash management is a prime
responsibility of treasury and the starting point for building a broad working capital improvement
programme.
Achieving Operational Reductions in Working Capital
For each multinational, the route chosen to reduce the working capital tied up in its operational supply
chain will depend on its unique characteristics. Much depends upon the industry in which a company
operates, and its power in relation to the entities with which it trades. For example, a large retailer may
have the power to improve the terms under which it pays its suppliers.
Other types of companies may not have such power, and may have to seek efficiencies in operational
processes, or inventory reductions and efficiencies. This is particularly the case in the commodity-
based businesses, where continuing pressure on margins can only be compensated if operational cost
can be reduced (particularly if cost cannot be fully incorporated within the market price).
Analysing where the opportunity for improvement lies requires detailed information regarding the flow
of funds and goods in all areas of the business – it reaches to the core of a company’s business
processes.
When seeking operational reductions in working capital, there are three key areas: days sales
outstanding (DSO), days payables outstanding (DPO) and days inventories outstanding (DIO).
In the case of both sales (DSO) and payments (DPO), one of the opportunities for improvement lies in
negotiation of more favourable terms, and – as mentioned earlier – this depends on who has the
power in the business relationship.
The first step is to

analyse why some
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clients are paying
later than others

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using benchmarking
techniques. Then,
companies need to
Netting: An Immersive Guide to Global Reconciliation ensure that the
benefits of
negotiating
extended payment
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terms are not
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outweighed by costs
in areas such as
loss of discounts,
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Threats detrimental impact
on profit.
Additionally, there
are risks to
reputation and to credibility with suppliers.
In the case of DSO, it is important to identify the root cause of any weaknesses and to take a proactive
approach to the management of receivables. Late payment may be the result of problems with
invoicing, product delivery or ambiguous payment terms. Automating the payments workflow through
electronic straight-through-processing rather than inefficient manual processes can be part of the
solution. Another possibility is to make sales and services responsible for booked revenues, instead of
mandated ones.
Once internal processes have been analysed, banks can provide automated cash management
options that can unlock working capital in the DSO cycle. But good information is essential because it
enables the identification of late payers and analysis of any reasons for payment delay.
In the case of DPO, there will likely also be improvements to be made to internal processes. Incorrect
payments are often made as a result of incorrect invoice details, missed data, ambiguous terms and so
on. These problems can be minimised by, for example, automating workflow, having a consistent
strategy and approach towards suppliers and payments, and having comprehensive and consistent
access to invoice and transaction information.
An additional strategy for reducing working capital is to take it off-balance sheet through asset
securitisation or vendor financing programmes.
Figure 1: Working capital value chain
Cash Management in Working Capital Improvement
Cash management’s role in reducing working capital requirements involves introducing the greatest
possible efficiencies in cash flow management and liquidity management.
The way treasurers go about this will depend on the nature of the organisation. Broadly speaking, the
greatest opportunities for efficiencies exist among decentralised organisations where cash
management can be centralised and a shared service centre (SSC) established. Centralised
organisations may already have highly efficient cash management practices, although this is not
always the case.
Establishing an SSC should be a catalyst for the improvement of working capital management. From a
treasury perspective this will also involve the introduction of a new treasury management system,
rationalisation of banking relationships and benchmarking initiatives.
One major benefit of such a reorganisation comes at no extra cost; the organisation as a whole will
start talking to each other about improving its working capital, affecting and energising all levels and
departments.
Figure 2: Managing working capital
Cash-flow Management
Cash flow management involves optimising transaction processes with the aim of minimising
transaction costs and maximising control while improving information flow and reporting. How this is
done depends on the company’s business model. For example, a decentralised company – with local
management and production – may approach this differently to a centralised company.
Obviously, multinationals generally achieve the greatest efficiency gains through the introduction of a
SSC. By definition, an SSC has a big impact on the company’s core processes. An SSC takes multiple
tasks, processes, general ledgers and IT infrastructures, and reduces them to one process per task in
one central location, although there are always some tasks that cannot be centralised. Harmonising
procedures by introducing uniform enterprise resource planning (ERP) systems confers real gains in
financial terms, but also in more accurate reporting. Introducing a true SSC can lead to considerable
efficiencies if it is done well; at its best, it will provide insight into a company’s ‘end-to-end’ receivables
and payables process.
For many companies, the SSC may be one step too far. Instead, they may initially focus on centralising
payment execution through a single ‘payment factory’, with local subsidiaries retaining their own
accounts payable (AP) and accounts receivable (AR) management. Additionally, the payment factory
will provide an interface to the company’s banks. While a payment factory does not attain the full
benefits of an SSC, it does lead to a reduction in transaction costs. Furthermore, centralising payments
provides a better understanding of cash flows, which helps to improve liquidity management.
Figure 3: Cash flow management
Liquidity Management
Once the maximum practicable efficiencies have been achieved in cash flow management, the
treasurer can turn to the management of liquidity. The aim is to achieve the lowest possible funding
cost on debits and the highest possible return on invested liquidity. A reliable cash-flow forecast is
crucial to enable the company’s cash balances to be managed with a longer horizon than several
days.
The daily cash flows from the operational/commercial side of the firm will result in daily balances in
different currencies within different current accounts in different jurisdictions/regions. The cash
manager’s challenge is to achieve the highest possible return on these balances.
Combining the individual account balances results in several short or long positions in different
currencies. This can be achieved by automatic concentration structures supplied by banks, or by
manual transfers, currency conversion or physical swaps. The cash manager invests these balances in
different instruments depending on the profile of the balances. We have defined three different profiles:
Daily fluctuating operational cash;

Short-term cash, which is not required for between a few days and three months; and
Long-term cash, which is not required for three months or more.
Daily fluctuating cash is traditionally invested in deposit accounts, but a high-yield current account
might provide a more convenient option in some situations. Short-term cash can be invested for a
longer period in weekly deposits or money market funds. Long-term cash can be invested in
management funds or commercial paper or other structured products with a longer investment horizon.
The selection of investment instruments depends, on the one hand, on treasury policy. A treasurer
might, for example, be authorised to invest in deposits with an AA-rated bank but might not be allowed
to invest in an AAA-rated money market fund.
On the other hand, liquidity investment is a trade-off between risk, return and liquidity. In general terms,
a firm can only achieve a higher return than the inter-bank rate if more risk is taken. If invested funds
are required to be liquid, which is mostly the case for operational cash balances, longer term
instruments are not an option and yield enhancement cannot be achieved.
The Four Basic Cash Management Structures
How much opportunity a treasurer has for achieving efficiencies depends on the company’s existing
cash management structure.
We have identified four stages in a company’s evolution from a very decentralised organisation to a
centralised cash management organisation. Broadly speaking, the less centralised the cash
management model, the greater the gains the company can achieve. If a company already has a
highly centralised model then it is likely there are few further gains to be made.
1. Decentralised liquidity and cash-flow management – If the cash management function is fully
decentralised, every individual entity or branch of sufficient size manages its own cash positions
without taking other operating companies cash position into consideration. This contrasts with the
more centralised approach, where the regional cash manager is striving for synergies and economies
of scale across several countries.
2. Centralised liquidity and decentralised cash-flow management – Under this model, liquidity is
managed centrally. The centralised cash management function operates with or without delegation to a
local financial representative. The central cash manager manages the pot of liquidity in one currency
from one centralised position. He/she gathers information on cash positions from the banks and the
cash-flow forecasts of local operations. This kind of structure is seen mostly in single currency
environments, for example Europe and the US. In multi-currency environments, such as Asia or
Central and Eastern Europe, the cash manager may manage liquidity from a central location but invest
the funds locally due to legal and FX restrictions. This, additionally, follows the single currency centre
concept, meaning the funds remain in the home country of the currency. Organisations with this type of
arrangement can gain further efficiencies by centralising their cash-flow management functions.
3. Decentralised liquidity and centralised cash-flow management – Cash-flow management is

handled by a transaction centre, which has a single pipeline to the bank for settlement by way of the
appropriate local clearing mechanism. Liquidity management is conducted on a local level without
taking the liquidity positions of other countries into account. Theoretically, this type of structure is
feasible in multi-currency environments, but it is unlikely to be used in the eurozone. The aim of this
model is to achieve a major reduction in transaction fees, while leaving liquidity management in the
hands of the local operating companies. A payment factory is an example of such a structure. Many
companies with the objective of reducing internal and external transaction costs, but with structural
long cash positions, prefer a payment factory. For these companies, centralising operational liquidity
balances on a daily basis would not provide major financial gains.
4. Centralised liquidity and centralised cash-flow management – Here all activities are centralised.
The SSC acts on behalf of the local operating companies, and provides full administration of both
liquidity and cash flow. The SSC maintains a single pipeline to a pan-European bank, and agrees to
specific service levels with the individual operating companies. This is the most efficient structure for
optimising interest. Also, by handling the local operating companies transaction processing, it has a
direct and beneficial impact on the company’s working capital position.
Figure 4 : Centralised liquidity and centralised cash-flow management
Conclusion
It is clear that cash management has a vital role to play in reducing working capital requirements.
Decentralised organisations have the most to gain, as they are able to achieve considerable
efficiencies through the introduction of a more centralised approach, perhaps through an SSC.
When it comes to reducing the working capital requirement in operational processes, it is vital that this
is not attempted without regard to other costs. Less favourable treatment of trading partners can have
knock-on costs in the form of lost discounts, or erosion of reputation.
Looking forward, those multinationals with the most efficient internal processes for managing capital
will have an advantage over others. Of course, this cannot compensate for being in a stagnant
industry, or having uncompetitive products, but other things being equal the most efficient users of
capital will be looked on most favourably by the shareholders who provide that capital. At the margin,
the reward for using capital efficiently will, logically, be a lower cost of equity capital.
***
1
Source: REL Consultancy Group, August 2005.
2 BDRC interviewed global and regional treasurers at 101 companies in Europe, the US and Canada.
The interviews took place between April and July 2005.

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5/28/2019 Cash Management Best Practice: Unlocking Working Capital - The Global Treasurer

Cash Management Best Practice:

Achieving Operational Reductions in Working Capital

The first step is to

later than others

Figure 1: Working capital value chain

Cash Management in Working Capital Improvement

Figure 2: Managing working capital

Figure 3: Cash flow management

Daily fluctuating operational cash;

The Four Basic Cash Management Structures

3. Decentralised liquidity and centralised cash-flow management – Cash-flow management is

Figure 4 : Centralised liquidity and centralised cash-flow management

The interviews took place between April and July 2005.

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