Published: October 01, 2009
Since the onset of the economic crisis that engulfed most of the world beginning in mid-2007, liquidity has become more important than earnings growth to creditors and investors alike. As a result, treasurers and CFOs have heightened their focus on working capital as an effective lever of liquidity.
As access to capital markets dried up, banks began to retool and shrink their balance sheets. With traditional funding sources becoming scarcer and more expensive and impact of forecasting errors more significant, companies turned to self-funding. Even many highly rated companies which retained some access to external credit sources during the financial crisis have been opting to fund internally where feasible and fortifying their efforts to improve working capital efficiency.
Investors have been rewarding this behaviour. Studies show that firms with high cash-to-asset ratios are attracting a 12% equity valuation premium over less liquid companies. Consequently, treasurers are focused more on optimising working capital and extracting liquidity otherwise trapped within their cash conversion cycles than ever before, and recognise that actively managing working capital provides flexibility when alternative funding is not available and access to markets is limited. The benefits of working capital improvements are measurable and substantial. At Citi, we have supported large multinationals in reducing their working capital requirements by up to 30%, translating to an accretion of 2% to 3% earnings per share.
Holistic approach yields greatest rewards Despite the potential advantages, many companies miss opportunities to release liquidity by failing to take a holistic view of how initiatives to improve working capital will impact their cash conversion cycle. For example, an exclusive focus on payments efficiency fails to address wider liquidity implications or supply chain risk, while a change in pricing strategy, even if supported by the procurement department, might impact on foreign exchange risk and liquidity.
Once a company starts along a path towards improving working capital efficiency, however, it should choose its relationship bankers wisely. As financial intermediaries, banks help their clients to collect, invest and pay out cash, thereby providing the means to improve processes across the financial supply chain in three broad areas:
By addressing all of these areas on a holistic basis, relationship bankers can provide critical insights into accelerating the cash conversion cycles and enhancing working capital. Looking at each of these in turn, in procure-to-pay there are substantial benefits to be gained by centralising internal processes, technology, and banking arrangements through shared service centres or payment factories. For example, payment cycles can be co-ordinated to improve cash forecasting and liquidity management. By automating payment processing and gaining access to real-time information and analytics, the quality and timeliness of decision-making is also enhanced. For companies with a stronger credit rating than their suppliers, which may be concerned about maintaining the resilience of their supply chain, banking partners can help to establish supplier financing programmes whereby suppliers can access relatively cheap financing through the bank to ease working capital constraints, and secure relationships between suppliers and buyers.
On the order-to-cash side, there are opportunities to centralise and automate processes from the point of receipt of purchase orders to reconciling inbound payments with outstanding receivables. By doing so, companies enable more rapid, predictable cash collection, eliminate float from internal processes and banking procedures and reduce internal process costs and banking fees. Furthermore, by having access to more timely and reliable transaction data, cash management decision-making is enhanced.
Companies that can establish receivables and distribution financing programmes with their banks can support sales growth without extending their cash conversion cycles. With such a programme, the bank purchases selected accounts receivable on an ongoing basis from a company. The company can then offer its customers more advantageous payment terms, which potentially increases the volume of sales, as well as extending their days payable outstanding (DPO). This use of financial intermediaries creates benefits for suppliers and customers alike, helping to strengthen relationships and resilience in the supply chain. For the selling company, it can lead to more sales with satisfied customers, without the working capital strain of maintaining and financing additional on-balance-sheet receivables. Buyers benefit from more competitive payment terms and the ability to continue buying using the liquidity gained between their purchases and payments. [[[PAGE]]]
From a treasury and cash management perspective, companies need to focus on working capital by firstly embedding cash flow and liquidity risk into their treasury policies and procedures, and secondly reviewing the adequacy of their internal operations. Increasingly companies are finding that by moving to a centralised cash management structure they can eliminate persistent sub-optimal practices, such as rationalising operating banks. Two years ago, many treasurers were striving for a single regional, or even global cash management bank. Today, treasurers’ objectives are rarely to rationalise banking partners to such a degree; however, despite the need to manage different forms of counterparty risk, which diversification of cash management banks can help to mitigate, there are substantial benefits to a single banking model. Treasurers should not fear consolidating their activities within a single banking infrastructure; after all, in many ways it is no different from concentrating business processes through a single ERP. Working with too many banks limits purchasing power, fragments internal liquidity and makes it difficult to achieve global visibility over cash positions and flows. This in turn complicates cash forecasting, liquidity planning and risk mitigation. Other important objectives often include reducing ad hoc funding at a local level, minimising external cash flows between subsidiaries and maximising cash available for investment. By focusing on these areas, companies can eliminate unnecessary external funding costs, boost investment yields and reduce transaction costs across the group.
By having access to more timely and reliable transaction data, cash management decision-making is enhanced.
There are many consequences of sub-optimal performance. Liquidity can be difficult to deploy if held in local accounts which are inaccessible to treasury, and foreign exchange, interest rate, and counterparty risk can be difficult to monitor and mitigate. These challenges, however, can be overcome. Choosing a global banking partner that can help consolidate operating relationships and accounts, rationalise processes and provide technology platforms that facilitate visibility and support centralisation is a vital step towards improving working capital efficiency. Visibility is key, both over the short-term cash position and longer-term forecasts. Without access to timely, accurate, detailed information, treasurers are not able to manage their activities in a strategic way, and cannot create cash flow or finance tranches for optimal working capital, financing and investment purposes. At Citi, we have emphasised the importance of cash positioning and forecasting for a number of years, and we have invested heavily in the cash flow forecasting capabilities in our Treasury Vision solution.
At Citi, we have built our cash management business to help organisations realise potential opportunities for improvement. We do this by working with companies to analyse their practices and processes across both treasury and commercial activities to identify both potential risks and areas of inefficiency. Once sources of risk and areas of sub-optimal performance have been identified, we can recommend solutions for mitigating, offsetting and negating risk and for improving performance. The solution may involve changes to internal structures, processes or technology platforms, or the application of Citi capabilities to optimise liquidity and working capital management in an integrated way. The approach to cash and liquidity optimisation needs to be tailored carefully to the needs of each company. For example, both prior to and during the financial crisis, treasurers sought to centralise cash flow as far as possible to avoid ‘trapped’ cash in local entities. For cash-poor companies, such an approach is entirely understandable. However, in today’s business environment, there is an advantage to holding cash on the balance sheet. If this cash is not required for another business purpose, then it may be more advantageous to leave it on local accounts, and reap the balance sheet advantage, rather than incurring the cost and management time of extracting it. While this is likely to be a relatively short-term situation, it is important for treasurers to maintain a close dialogue with their relationship bankers to understand the opportunities for optimising liquidity, income and balance sheet efficiency. [[[PAGE]]]
One of the challenges when implementing a cash and liquidity optimisation strategy is measuring the benefits not only when first implementing a strategy, but on an ongoing basis. To help treasurers and finance managers to quantify the advantages more easily, we have developed Citi Treasury Diagnostics, which is a metrics-based approach, providing key performance indicators in income statement, balance sheet and other terms. For example, from an income statement point of view, we consider areas such as interest income and investment returns against defined benchmarks, taking into account different currencies and tenors. We look at the cost of both short- and long-term debt, based on fixed/floating rate benchmarks, assess bank fees against internal budgets and evaluation of realised and unrealised FX gains and losses. A more comprehensive list of metrics is provided in Figure 1. Citi’s Treasury Diagnostics approach assists treasurers and finance managers not only to measure cash and liquidity management performance within the business but also to provide a benchmark against comparable firms, so they are better able to position the company according to best-in-class for the relevant industry.
Implementing solutions that are specific to the needs of the organisation that encompass global working capital management, liquidity management and a range of short-term investment services can be a vital way for companies to minimise the cost of borrowing, maximise yields and mitigate risk. To achieve this, treasurers need to work with relationship bankers who bring the necessary breadth and depth of expertise, together with the right technology to provide the necessary visibility over global cash positions and forecasting.
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