Cash & Liquidity Management

Unlocking the ties in working capital

Published: Apr 2016

Close up of combination lock

Not to be confused with simply releasing trapped cash, working capital optimisation is a dynamic process that can add value to the whole supply chain. With shrinking profit margins across Asia, corporates are focusing on the bottom line and looking at ways in which they can manage the cash conversion cycle to optimal effect.

Working capital (short-term current assets minus short-term current liabilities) is essential for a company to meet its obligations. Should the calculation result in a negative number, this could mean the company is illiquid – in other words, it has insufficient short-term assets to meet its obligations. Some organisations do operate with negative working capital where the business model means cash can be generated quickly because customers pay upfront, for instance. This enables these companies to collect cash normally but delay payment to suppliers. Dell Computers and Walmart are well-known examples of this model.

Generally speaking though, corporates want to optimise their working capital. This means that an excess of working capital could represent a wasted investment opportunity and the cost of carry may even be detrimental. Whilst holding onto cash certainly may increase a company’s flexibility in dealing with ‘stress’ events, it is a short-term strategy.

However, treasurers can extend their sights further by bolstering their supply chains with prudent investment in supply chain finance (SCF) programmes. By doing so, both short-term and long-term benefits can be felt, for example by unlocking trapped cash in emerging markets and securing the financial supply chain.

In order to enable the optimisation of working capital in this way, it is necessary for a business to measure the efficiency of its processes across the supply chain. This performance is typically measured by the number of days its cash is tied up in the different elements of the cash conversion cycle (CCC). There are three main metrics for treasurers to manage:

  • Days sales outstanding (DSO).

    The average number of days taken by a company to collect payment from a sale.

  • Days payables outstanding (DPO).

    The number of days a company takes to pay its creditors.

  • Days inventory outstanding (DIO).

    The number of days a company takes to convert inventory into sales.

With a solid understanding of these metrics, treasurers can hope to measure their working capital processes. As Percy Batliwalla, Global Head of Trade and Supply Chain Finance, Bank of America Merrill Lynch (BofAML) says: “Although we hear a lot in the market around shrinking trade volumes and how we are moving out of a benign credit environment, there are significant opportunities for working capital optimisation ahead.”

Technology, for instance, brings numerous efficiencies to working capital management, says BofAML’s Rakshith Kundha, Managing Director, Trade and Supply Chain Finance, South East Asia. “If you look at the impact of technology on the working capital cycle in a holistic manner, the benefits include efficiencies across processing, management and balance sheet.”

Indeed, in recent years specialist financial technology (fintech) companies have been increasing their presence in the traditional bank-dominated SCF space, offering platforms and software-based services. For treasurers, success in working capital optimisation will partly depend on their ability to determine which solutions are fit for their individual companies’ purpose.

First and foremost: the key stages

As part of any review of working capital management, business consultancy The Hackett Group identified five areas on which to focus. Firstly, key stakeholders must be identified. These include local and corporate stakeholders including finance, procurement, accounts payable, supply chain, customer credit, order placement and billing, cash collection and dispute management.

Appointing working capital strategy leaders can help the organisation address the impacts of shared working capital issues. “Getting in front of all the stakeholders, explaining the value proposition to them – along with their suppliers – is critical because everybody needs to know what the end objective is,” Batliwalla says. “They need to know that any implementation is not something that is going to disrupt their business but increase the efficiency for them as well.”

Having this collaborative dialogue, more often than not, is the key to implementation of a successful working capital programme. Consideration should also be given to suppliers: every action is met with an opposite reaction thus it is not advisable to artificially adjust working capital levels by simply delaying payments to suppliers, for example, because whilst it may drive improvements over the short term, this practice is likely to damage price and relationships over the long term. Dynamic discounting, explored later, is one solution to this.

Next up in any review, treasurers should benchmark their current performance. The Hackett Group advises going back five years to benchmark working capital performance against a shortlist of appropriate industry peer organisations. Meanwhile, understanding which best practices and capabilities are making the difference in performance, in both your company and peers, is critical.

Aptly, the third of The Hackett Group’s key priorities is to understand your company’s environment – the processes, management framework and board objectives, for instance. “At the end of the day, different corporates are driven by different objectives,” says Batliwalla. There is “no one-size-fits-all solution” to optimising working capital and a lot will depend on the nature of the business model and the profile of the company’s cash flows.

This exploration should lead treasurers to determine the potential for improvement – The Hackett Group’s fourth stage. At this point, accurate and real-time information is essential to ensure that treasury is focused on the right actions.

The fifth process to focus on is for key outputs and the next steps to be identified using all of the knowledge that has been assembled. Again, it is important that the desired outcomes are articulated to all stakeholders. This allows the company to begin making informed – and tailored – choices about what strategies to implement next, which providers to contact and how much effort will be required to embed the changes throughout the supply chain.

The banks’ role

Banks, of course, can provide some support here. BofAML’s Batliwalla emphasises the importance of “ensuring solutions are not concepts thrown at corporates but clearly something that meets their value expectations”. This means the bank elicits feedback from clients in terms of product development and how they would like to see the product evolve. “It always helps to understand, one, where the industry is going and, two, where the clients would like you to go,” he adds.

Currently, the client-centric approach is leading integrated developments in working capital products. Kundha says: “Corporates are realising that there is a lot of value in terms of looking at it in an end-to-end manner, not only in terms of cost savings and efficiency but also in terms of liquidity management, as well as from the perspective of risk management.”

Indeed, the current liquidity environment is emphasising not only the importance of optimising working capital, but the additional benefits, including strengthening of supply chains, which can be achieved. Value chains are becoming more integrated from a financing perspective, says Vivek Ramachandran, Global Head of Product and Proposition for HSBC. “Large companies are looking at working capital optimisation as a means to secure their supply chains and to mitigate risk so it is not just releasing capital, or the financing of the cash flow, it is more to mitigate risk on the balance sheet or to inject capital into the supply chain”.

A liquidity failure?

For Andrew Burns, Director of C2FO, an online working capital marketplace, it is important to understand why the current economic situation has led to an increased interest in large buyers looking to support suppliers through supply chain finance. “It’s a bit of a paradoxical situation because on the one hand there is too much liquidity and on the other hand, too little,” he notes. Central bank initiatives are, he says, putting more liquidity into the system but this is going towards the bigger buyers because the banks are doing their jobs through Basel III and pushing cash towards the less risky companies. “Which are, of course, the larger ones.” This he believes is failing the SMEs and the longer tail of the supply chain.

Whilst smaller suppliers wait for receivables, they might go to the banks to get a bridge loan. “They are finding it very difficult because there is a smaller pool of loans – and that pool of loans is at a higher cost for them.” The situation is particularly problematic in Asia with average payment terms of 120 days. “In the shadow banking market, it costs suppliers 30% to bridge those loans. In Europe, it’s around 60 days and can cost between 5-15% for those loans,” says Burns.

Ramachandran has seen a rising number of local corporates in India, China and Indonesia looking at supply chain programmes. His colleague, Stuart Tait, Head of Global Trade and Receivables Finance, HSBC adds: “In Asia, as the number of large conglomerate rises, there is more opportunity for them to arbitrage price.”

It is perhaps unsurprising that C2FO’s recent Supplier Finance Survey found that 96% of treasurers believe the role of supplier finance is growing. “Everybody recognises that there is a systemic failure of liquidity in the marketplace,” states Burns.

How treasurers can help suppliers (and themselves)

Of course, banks have offered SCF in the form of reverse factoring for a long time. They allow suppliers to be paid early by “essentially taking ownership of accounts payables and paying it earlier, taking the credit risk of the buyer to reduce the risk”, explains Burns. But this doesn’t reach into the longer tail because of the time and cost involved in on-boarding suppliers, not least due to KYC and anti-money laundering checks required by banks.

Ninety percent of SCF programme activity typically comes from about 20% of a corporate’s suppliers, says Tait. “If a corporate has this 20% on-boarded, the reasons for going through the bottom end of suppliers – such as your paper supplier – are limited.” Therefore, the bank has positioned itself to view the supply chain slightly differently and “supports all the segments, from some of the world’s largest companies right down to sole proprietorships in China or Japan”. This includes supplier pre-shipment financing, for example, and benefits larger buyers who want a stable and financially sound supply chain.

An alternative for treasurers may be found in the rising number of fintechs entering the SCF landscape. A McKinsey report, titled ‘Supply-chain finance: The emergence of a new competitive landscape’, noted that some have been offering innovative business models (C2FO; Taulia), others have improved the digital interfaces and tools on offer (PrimeSCI) and some have simplified implementation and on-boarding (Orbian).

Considering 67% of treasurers in C2FO’s survey believe their supply chain is currently suffering cash and liquidity challenges, solutions such as C2FO’s own marketplace, for example, offers voluntary models with potentially higher returns, Burns says, than the “narrowing options corporates have to invest”.

Finding the right fit

One problem, however, is the tendency to rely on legacy working capital metrics. If you relied on these in isolation, Burns says, you’d actually avoid dynamic discounting – despite the advantages discussed. “Metrics in working capital need to catch up with modern day,” he adds. “Because what early payment would do is slightly decrease your DPO and increase your CCC in terms of extending it – which doesn’t look good.” But quite clearly there is profitability in accelerating payments. Burns’ advice: “You can generate discounts, strengthen the supply chain and increase profitability but must make sure that it is offset as a separate metric.”

He believes there is an opportunity to be had that treasurers are waking up to. “But working capital optimisation needs to be done in a way that’s collaborative with the rest of the organisation, understanding how they can work together in order to modify the metrics and open up the opportunity to generate income and turn treasury into more of a profit centre.”

For BofAML’s Batliwalla, the potential is obvious. “Most corporates don’t treat metrics as the sole source of truth and look at the impacts of any SCF programme on working capital metrics, as per their individual situations.” This affords corporates with different priorities to select solutions, from fintechs or banks, which optimise working capital in a way that suits. There are exciting times ahead in terms of collaborative product development, he argues. But it remains vital for treasurers to make a consistent effort in working capital management – even in times when it feels there is less immediate need to do so.

Case study

Astro Malaysia Holdings Berhad

Since 1996, Measat Broadcast Network Systems Sdn Bhd (MBNS), a wholly-owned subsidiary of AMH, has been providing satellite solutions to customers across Asia Pacific. It now has a reach that covers over 150 countries across Asia, Africa, Europe, the Middle East and Australia.

The challenge

MBNS offers satellite pay television services to consumers in Malaysia and the revenue is realised over the life of the equipment. Consumers will typically be bound by a contract for pay television with monthly fees via a commercial package lasting two or more years.

MBNS signed major contracts with its vendors to procure a full range of the latest set-top box technology and content licenses. These contracts were relatively significant amounting to around $100m payable over short tenors. Charles Chen, Vice President, Treasury & Strategic Contracts explains: “This effectively created a fundamental mismatch between the purchases from these major vendors and the repayment source from our consumers.”

The key objectives for treasury included matching the financing with the life of the equipment, improving liquidity and avoiding the need to use its own funding to make the procurement payments, and meeting their KPI objectives to extend payment terms to its vendors and achieve the treatment as desired. This would result in the company’s payables aligning with its subscriber/consumer agreement packages.

The solution

Deutsche Bank provided a first-of-its-kind solution to MBNS. It effectively allows the company to expand its payment terms on significant procurement contracts to compliment the revenue stream from subscribers and receivables, usually under commercial packages lasting two or more years.

Deutsche Bank provided a three-year account receivable purchase (ARP) solution, backed by promissory notes with recourse to MBNS, for the procurement of set-top boxes and satellite dishes for the reception of cable pay television (ASTRO) services in Malaysia.

The sales and purchase agreement between MBNS and its vendors clearly outlines the option of the promissory note as one of the instruments of payment between buyer and seller with a maturity date of up to three years from the purchase date.

Deutsche Bank’s implementation of this structure is an ‘off balance sheet’ solution, with recourse on the client, backed by a legally binding promissory note and factoring agreement. The solution created liquidity for MBNS while avoiding leverage. This improved the firm’s overall financial picture and indirectly helped MBNS to keep its financial ratios in-line with expectations while providing extended payable tenor of up to 36 months.

Key benefits included:

  • Risk mitigated.

  • Revenue enhancement.

  • Cost savings.

  • Interest cost efficiencies.

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