Published: November 01, 2008
Gregory Cronie, Head Sales, Payments and Cash Management, ING
Welcome to this new series of features from ING on Financial Supply Chain Management and how treasurers can optimise the process to create competitive advantage and add value to the company. During this period of economic instability and depressed growth, which could extend for months or years, every company needs to make the most of its resources and adopt creative solutions to weather the crisis and position itself for short term survival and long term success. Over the next three editions of TMI, we look at financial supply chain management from end to end. What is it? What are the components which make it up? Where are opportunities to address inefficiencies and create value typically found? What solutions can be implemented to take advantage of these opportunities?
Since the discipline of Treasury, as we understand it today, originated in the 1970s, treasurers have typically managed the company’s financial assets at a macro level, focusing on overall liquidity and risk. Cash pooling, cash positioning and forecasting typically take place at a group or at least business unit level. While these activities continue to create substantial benefits for their firm, treasurers can further enhance the value they deliver by influencing the elements which contribute to working capital, and increasing the efficiency of the financial supply chain. In this way, treasurers can optimise liquidity, preserve margins and minimize the amount of working capital, which the company requires, whilst contributing to a better experience for customers and suppliers.
Treasurers can further enhance the value they deliver by influencing the elements which contribute to working capital, and increasing the efficiency of the financial supply chain.
A question, which our clients frequently ask, is how to justify investment in the financial supply chain. For too long, it has been considered that the financial supply chain facilitates the physical supply chain i.e. the process of payments and collections supports the exchange of goods and services. In fact, the opposite is true. Companies’ overriding responsibility is to deliver stable returns to its stakeholders, and the goods and services, which it provides, are the mechanisms to do this, not the other way round. Consequently, investment in the financial supply chain is key to a well-managed business with consistent returns and a competitive margin, and equally important as the investment in production processes.
To enable companies to leverage opportunities for improvement in the financial supply chain, ING has invested heavily in developing its international scope and solutions to become a leading bank in many of the disciplines which comprise effective financial supply chain management, from trade services and trade finance, through to cash and liquidity management. In this series, we look at each step in the financial supply chain, from explaining the basics to addressing the complexities of global supply chains.
This innovative ING Guide will be presented in three parts. In this first part, ING introduces the financial supply chain and outlines the order-to-cash and purchase-to-pay processes. In the second part, which will appear in the next edition of TMI, we look at supply chain financing alternatives and how these can be used to unlock working capital. In the final part, we look at financial supply chain optimisation from a strategic perspective, including some of the industry initiatives of which corporate treasurers can take advantage to maximise liquidity and reduce costs.
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Physical Supply Chain
Financial supply chain management is an expression which has become de rigeur but the concept is by no means new. The financial supply chain is a parallel, but opposite process to the physical supply chain, which is the supply and demand of goods and services. Company A which supplies goods will collect money in return, Company B which requires the goods will pay money in return.
ING has invested heavily in developing its international scope and solutions to become a leading bank in many of the disciplines which comprise effective financial supply chain management, from trade services and trade finance, through to cash and liquidity management.
Every company’s supply chain is different, from the rudimentary to the highly complex, not least according to industry, business model, diversification, degree of centralisation, sourcing and consumer markets. Over the past 50 years, international trade has doubled every five years - an increase of 1,000% over this period. Furthermore, the physical supply chain has become substantially more complex in terms of the volumes involved and the number of participants to a transaction. The increase in volumes is not only due to the overall growth in trade but the average size of transactions has reduced to around 42% of transaction value in relative terms since the 1970’s. More transactions, more customers, more suppliers and more participants in the chain.
Information Supply Chain
To respond to these changes and maintain a competitive position, companies have made substantial progress in automating the physical supply chain, with highly sophisticated sourcing, production and distribution. ‘Just in time’ (JIT) production, originally a Japanese phenomenon, is common in many firms as a way of reducing cash tied up in surplus stock. Companies in all industries, both goods and services, invest a great deal of time and resource in forecasting demand to ensure appropriate levels of supply. To facilitate this process, a parallel strand to the physical supply chain has developed - the information supply chain - to ensure effective communication between each stage of production and distribution, particularly through the use of enterprise resource planning (ERP) tools.
Financial Supply Chain
People often associate the physical supply chain with a “one way” flow of goods and services i.e. those that the company produces. In reality, this only tells half the story, as companies will be sourcing goods and services as well as producing them. This is a crucial distinction when it comes to understanding the financial supply chain and its relationship between working capital and liquidity management. In many respects, it is useful to think of the financial supply chain as being a parallel, but reverse process to the physical supply chain. As goods and services pass through the chain from production to customer, cash flows from customer to the company. Similarly, as a company imports or demands goods and services, cash passes from the company to its suppliers. [[[PAGE]]]
The process illustrated in fig 2, although a simplified version, is replicated on the left of the diagram for every order from every supplier (purchase-to-pay) and similarly for every order given to every customer on the right (order-of-cash). We will come back to each of these two sets of processes, and the relationship between them, which creates the company’s working capital requirement. It will already be obvious, however, of the need to ensure efficiency in the financial supply chain, not least to ensure that various elements of the process, such as purchase order, invoice and payment can be integrated and reconciled easily. Furthermore, given the multiple exchanges of information between supplier and Company A, and Company A and customer, the more effective this communication process, and the more consistent the information used by each party, the better the process will be. This becomes even more significant when there are queries or late payments. In many ways, developments in the financial supply chain have lagged behind those of the physical supply chain. As we will see later in this series, while companies have made significant progress in automating events in the financial supply chain within their own organization, there is still a great deal of potential to connect the parties in the chain, including the banks, more closely.
The use of cash to pay for these goods and services i.e. payment and collection, was probably first introduced in China in around 2700 BC. The bank notes with which we are familiar originated in the Bank of England in the late seventeenth century, and cheques were also first issued by the Bank at around the same time, becoming a popular method of facilitating trade by the late eighteenth century.
However, the use of cash or cash equivalent instruments alone was not sufficient for many exporters and importers. In particular, difficulties arose when there was a difference in the credit standing of the seller and purchaser, especially when conducting trade cross-border. A stronger seller would be concerned that a weaker purchaser, particularly overseas, could default on payment. To reduce this risk, the seller might demand upfront payment. On the other hand, the purchaser would be concerned about advance payment without the opportunity to assess the goods first. This has had a variety of consequences, not least a wide spectrum of different payment terms which a company may require, or be obliged to adhere to, creating difficulties in the payments process when large volumes of payments are involved. [[[PAGE]]]
Another result is that banks developed an intermediary role to help exporters and importers manage their respective risks. The trade instruments with which we are familiar today, such as letters of credit and other documentary credits, were first commonly used in the late nineteenth century. A letter of credit, or LC, is a guarantee issued by the buyer’s bank to the seller which guarantees payment on presentation of the correct trade documentation (fig 3). The bank mitigates its own risk by taking ownership of the goods until it has received payment by the buyer, but as banks cannot physically take delivery of goods, the trade documentation which relates to legal title to the goods is used instead.
The process from stage 1 to stage 13 can frequently take many weeks, hindering companies’ efforts to restrict the amount of stock tied up and delaying payment. This is often due to inaccuracies in the trade documentation which then needs to be corrected and resubmitted - frequently more than once - prolonging an already lengthy process. Consequently, increasing the efficiency of trade processes as far as possible is an important priority for companies’ finance departments to avoid interrupting the physical supply chain and ensuring earlier payment. This applies too to the buyers who use letters of credit. While it may appear that buyers would prefer to pay later, the delay in gaining legal title to the goods can impact substantially on the firm’s business and the payment timing becomes unpredictable, requiring large amounts of working capital to be held pending payment.
During the current economic recession, companies are more focused on customer payment risk and therefore letters of credit are likely to be more important than during more favourable ecnomic conditions.
Over recent years, there has been a substantial growth in ‘open account’ i.e. transactions paid directly rather than using trade instruments such as letters of credit. However, although open account now represents the majority of transactions, the growth of international trade over the past half-decade which we referred to earlier means that trade services are still increasing. Furthermore, although transactions conducted under open account are increasing, the risks of unequal trading partners, particularly internationally, still remain. During the current economic recession, companies are more focused on customer payment risk and therefore letters of credit are likely to be more important than during more favourable economic conditions.
The letter of credit process is a form of financing for sellers, the beginnings of an important trend in the services which banks are increasingly offering, namely using different elements of the financial supply chain, such as receivables, invoices or even purchase orders as collateral for financing. In credit-strapped times, this type of financing is becoming increasingly important to treasurers, as we will discuss further in the next edition of TMI. These innovations include mechanisms such as supplier financing which uses a customer’s higher credit rating as a means of securing financing for lower-rated suppliers. [[[PAGE]]]
Fundamental to treasurers’ role is maintaining liquidity to ensure that the company has sufficient levels of working capital to finance its regular activities. Working capital is the amount of cash which a company requires to fund the difference (both in amounts and timing) between payment and collection.
There are a range of risks and scope for delay in both the order-to-cash and purchase-to-pay processes. The effect of this is to postpone collection of cash and make both payment and collection timing unpredictable. This means that even if the payment and collection amounts each month are similar, the company needs to maintain a “float” or working capital amount to finance cash flow volatility and timing mismatches. A frequent metric used for calculating working capital requirements is ‘cash days’. This is calculated by adding the number of days sales outstanding (DSO) to the number of days inventory outstanding (DIO) and subtracting days payables outstanding (DPO).
i.e. (DSO + DIO) - DPO = Cash Days
For example, if DSO = 45 days, DIO is 25 days and DPO is 20 days, the total number of cash days is 50 days (45 + 25 - 20 days). Therefore, if Company A’s sales are €1bn a year, daily sales average €4m. The cash required to run the business is the daily sales figure multiplied by the number of cash days = €200m. For Company A, the working capital requirement represents 20% of annual revenue which cannot be used for strategic investment or other business purposes which could otherwise contribute to its competitive position. Consequently, in this example, for every day’s reduction in the number of cash days, the working capital requirement can be reduced by €4m, an immediate contribution to the bottom line. Working capital levels differ between industries but there are few companies which have delivered the maximum possible efficiency in this area.
Many treasurers have already achieved significant treasury centralisation, and automation and efficiency in treasury operations, the skills which are also required to develop efficiency in the business functions which contribute to the number of cash days, particularly order-to-cash and purchase-to-pay. Focusing on one of these areas alone will deliver some benefit but less than a cohesive working capital optimisation initiative with a closer connection established between the two sets of processes, with the results apparent in treasury through greater liquidity and lower working capital requirements.
In some cases, treasurers are taking an advisory role in these areas; in others, payment and/or collection factories are falling under treasurers’ remit. In this way, treasurers have a greater ability not only to manage liquidity and ensure that the required level of working capital is available, but to minimize the actual amount of working capital which is necessary. This has a direct value to the business and therefore is an important way in which treasurers can elevate their influence and profile within the company
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Order-to-cash and purchase-to-pay processes are closely aligned - after all, every company will be both a buyer and seller of services. In this Guide, brought to you by ING, we focus first on order-to-cash. This is deliberate - while CFOs are rarely kept awake at night worrying whether a payment has been made, worrying whether money has been received is quite a different matter. Many cash management and financial supply chain projects focus initially on payments, particularly international payments, as these can be costly unless managed effectively and there is a fear of fraudulent payments, unless adequate controls are in place. Although payments is an important area on which to focus, it may be more valuable to prioritise collections in many companies as the benefits are more tangible, to ensure that cash is collected earlier, creating cash flow to fund the company’s activities. After all, for many firms, receivables are the largest or second largest asset on their balance sheets.
Fig 4 below exemplifies a possible order-to-cash process, with the buyer to the left and seller to the right. For the purposes of this order-to-cash section, Company A is the seller; however, as we will see when we move on to purchase-to-pay, many of the techniques for automating order-to-cash processes are, of course, relevant when Company A becomes the buyer.
Treasurers frequently consider the description of ‘order-to-cash’ to be synonymous with ‘collections,’ but this does not take into account the complexity in the processes which precede cash receipt. From the perspective of Company A, the order-to-cash processes - and the challenges surrounding them include:
Although payments is an important area on which to focus, it may be more valuable to prioritise collections in many companies as the benefits are more tangible.
A. Agree order details, including pricing and payment terms. Depending on the scale of the order, type of customer and type of goods/services, companies may apply different payment terms to different customers eg. payment in advance; payment on receipt of goods; payment 30 days from invoice or 30 days from receipt of goods. Applying different payment terms helps the company to manage risk but can also make it more difficult to monitor and follow up on receipts.
B. Orders can be received in a variety of ways depending on the industry and type of goods etc. but a frequent problem is transferring details of the order into the company’s systems to be passed on through finance for invoicing and production/services for order fulfillment. Manual input of purchase orders can result in errors and a great deal of resource.
C. When receiving invoices, many customers will require their original purchase order number so they can reconcile the invoice with the original order details. As well as details of the order, payment terms etc. this information therefore needs to be held on the company’s system to be passed through to the customer. Without this, a customer’s reconciliation process, and therefore payment, can be delayed. [[[PAGE]]]
Invoices are frequently sent by post, which is expensive and, can lose a few days, which can result in late payment. On the other hand, often customers will not accept invoices received unless in hard copy.
D. With payment terms often extending to 30, 60 days or beyond, and payments frequently received on a date other than the due date, depending on customers’ payment run etc. unpredictability of collection timing is a significant problem for companies, making it difficult to forecast accurately.
Furthermore, chasing late payment is frequently a time-consuming but vital activity, made more difficult when different people are involved in collections, or the process is dispersed across different parts of the organisation. For example, the sales team (often distributed across many locations) in many companies is responsible for chasing collections but sales professionals are generally incentivized to generate revenue, so these other priorities frequently prevent collections from being managed systematically.
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E. Receiving payments in different banks, accounts, locations and via different payment methods means that finance managers do not always know when payment has been received, particularly if reconciliation is a decentralised activity. This can cause problems with customer relationships - for example, a company appears unprofessional if chasing invoices, which have already been paid, or incorrectly stops future orders. Furthermore, unidentified or unpredictable collections restrict a company’s efforts to manage liquidity and working capital.
In theory, the timing of cash received under the terms of an export letter of credit should be more predictable. However, with a large proportion of trade documentation being submitted to the bank with errors, often repeatedly, which need to be remedied before payment can be made, companies are often unnecessarily delaying inflows of cash which could be essential for liquidity management purposes.
Addressing the challenges above can be achieved in various ways, including a combination of internal initiatives, potentially with solution vendors and/or banks, and external projects working with banking partners. While every company’s order-to-cash process will differ, some of the most important solutions include:
Purchase order services
Purchase order services are closely allied with eInvoicing. By connecting these processes, buyers and sellers can share a common view of data with data imported and exported electronically from/to the respective companies’ systems. Typically, systems supporting purchase order delivery allow copies to be printed and/or the relevant data imported into the seller’s systems in the appropriate format. This avoids the need to manually input data from the purchase order and both buyer and seller record the same reference information. Some systems provide automatic notification to buyers of purchase order receipt. [[[PAGE]]]
eInvoicing
Purchase order services can be (although is not always) linked to eInvoicing by automatically creating the invoice based on the purchase order information. Data from the original purchase order is supplemented with additional information from the seller’s systems, such as payment terms, and transmitted back to the buyer. Like purchase orders, these can then be printed by the buyer, or imported in the relevant format into its internal systems.
eInvoicing is used as quite a generic expression to include different types of electronic invoicing. For example, EIPP (electronic invoice presentment and payment) and EBPP (electronic bill presentment and payment) are both acronyms frequently used to describe different types of eInvoicing solutions. EIPP is typically used to describe business-to-business (B2B) invoicing, whereas EBPP is used to refer to business-to-consumer (B2C) billing such as utility and telecoms bills.
Although more relevant to purchase-to-pay, some eInvoicing solutions also include automated purchase order and invoice reconciliation, as well as invoice approval.
One trend, which has emerged in recent years, is a purchase order/invoice exchange, such as OB10, which effectively provides an intermediary mechanism for distributing, receiving, matching and converting purchase order and invoice data.
Centralised Collections
Reducing the quantity and value of overdue collections should be a priority for every CFO, now more than ever. Clearly, the earlier payment is received, the sooner that cash flow is available to the business. Furthermore, during difficult economic conditions, many firms are scrutinizing their credit risk in more detail, resulting in shorter payment terms, lower credit limits and more stringent limitations on re-order in the event of outstanding collections.
In many companies, the accounts receivable function is distributed geographically and by business line, often aligned with the sales organization. As sales departments are primarily focused on signing new orders, monitoring collections is often a secondary activity or lacks a systematic approach. It is very difficult to ensure that collections are rigorously managed unless there is dedicated resourcing, consistent processes and management visibility over collection status. Centralising the collections function can be physical or virtual - i.e. with collections staff based in a single office or located in different sites but with a common systems infrastructure to automate processes, ensure consistency and produce standard management reporting.
There are a variety of benefits in centralising the collections function, as summarized in fig 6. However, in addition to the operational and working capital advantages, one aspect, which should be emphasized, is the ability for companies to work more effectively with their global customers. A company may engage with a customer in a variety of different locations with various payment terms, credit lines and payment currencies. By centralising the management of collections, companies can establish global credit lines, track customer activity globally and provide consistent payment terms. This avoids multiple accounts receivable communications with the same client and enables companies to give better service. [[[PAGE]]]
Early Payment Discounting
Early Payment Discounting or Dynamic Payables Discounting is a process which suppliers can use to encourage buyers to pay early based on a sliding discount scale. The discount amount is calculated dynamically based on the number of days remaining until the due date. Discounting is a more economic means of financing than factoring or asset-based lending, and by creating greater certainty around payment timing, improving cashflow forecasting.
Automated Collections Solution
Whether collections are centralised physically or virtually, using a collections solution to provide systematic receivables management is essential. It is also worth noting in anticipation of Part Two of this Guide that the more discipline in this process, the greater the proportion of receivables that can be financed. Furthermore, credit insurance is often cheaper and better pricing for receivables financing can be achieved.
Centralised Cash Management
Even if internal processes have been centralised, it is very difficult to manage collections if incoming cash is fragmented across different accounts and different regions. As we will see in more detail in Part Three of this Guide, establishing a regional approach to cash management can address many of the difficulties of achieving visibility, reconciliation and managing liquidity across different countries. Furthermore, with the Single Euro Payments Area (SEPA) payment methods now available, in which ING has established itself as an industry leader, companies can make it easier for their customers to pay them quickly and cost-effectively, wherever they are in the Eurozone.
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Making payments efficiently, cost-effectively and securely is pivotal to every well-managed finance function. Many of the discussions on payments in banks’ brochures and media articles surround payments processing, particularly straight-through-processing, security and bank connectivity. These issues are, of course, very important in achieving a best-in-class payments operation. However, in addition to processing, managing payments is also a strategic element of working capital to ensure that the company is able to take advantage of early payment discounts offered by suppliers where these are beneficial, manage FX risk created by foreign currency payment obligations and time payments with cash inflows to avoid liquidity issues. Furthermore, the cash management organisation needs to be structured to minimize the number of cross-border payments to manage payment costs.
As fig 6 illustrates, this time with Company A on the left and the supplier on the right, the purchase-to-pay process mirrors the order-to-cash process, typically including the following steps (and challenges):
A. Company A receives the invoice from the supplier and needs to reconcile these against the order details before authorisation and payment. This is time-consuming if the original purchase order number is not shown on the invoice.
Managing payments is a strategic element of working capital to take advantage of early payments discounts, manage FX risk created by foreign currency payment obligations and time payments with cash inflows to avoid liquidity issues.
B. The company may wish to query the invoice and again, the better aligned the information between itself and the supplier, the quicker this is to resolve.
C. Once approved, which may need to be done by one or more business managers, the payment can be processed. This can be an involved process internally, particularly in the case of multiple payment origination systems, large numbers of “one off” supplier payments when supplier bank account instructions need to be set up and approved, if there are frequent changes to payments or if a variety of different payment methods are used. If a company operating internationally empowers its business units to make its own payments, the payments infrastructure and processes can often be fragmented, with connections to multiple banks in different locations. This makes it almost impossible to ensure that consistent security standards are being adhered to, and treasury does not always have a clear picture of the company’s cash requirements. Even when Accounts Payable is centralised, the payments process itself can be cumbersome if the integration between internal systems and the banking electronic banking system is inadequate or there are multiple banking systems in place, necessitating a variety of different interfaces in various formats. [[[PAGE]]]
Remedies to Purchase-to-Pay Challenges
As with order-to-cash processes, there are various ways of addressing these challenges, combining internal processes and technology with external banking, cash management and connectivity arrangements.
The potential remedies for many of the challenges are similar to those of order-to-cash, such as purchase order services and eInvoicing, so we will not repeat them here. It is important to emphasise however, the benefits of a collaborative approach between suppliers, customers and their banks to ensure that information is universally understood and exchanged in a consistent way between systems. One of the implications of this is the need to standardise the way in which data is communicated to avoid the need to set up different formats for interfacing data between various counterparties. Standardisation, including some of the industry developments in this area, is covered in Part Three of this Guide.
Payments Factory
Many companies are increasingly discouraging local payments wherever possible, preferring instead a centralised payments function - often described as a payments factory or payments hub. This may be held within a shared services centre, be part of treasury or an independent function. As the case study below describes, there are a variety of benefits in channeling payments originating from different systems through to a central payments system where authorisation, validation and formatting can be done before transmission to the banks. Banking interfaces can be managed centrally including (where appropriate) multi-bank connectivity channels such as SWIFTNet, as described further in Part Three of this Guide. [[[PAGE]]]
Single Payments Bank
Companies making payments in different countries and currencies will often use different banks, particularly where payments are decentralised. This is more expensive and means that unless using a multi-bank platform such as SWIFTNet, payments need to be transmitted through different electronic banking systems. Working with a single bank regionally enables companies to channel payments through to a single bank, even if payments are then made through local accounts/entities. In Europe, SEPA (the Single Euro Payments Area) will enable payments to be made anywhere in the Eurozone, as a local payment, irrespective of source and destination, reducing the number of cross-border payments. Again, this is covered more fully in Part Three of this Guide.
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