Cash & Liquidity Management

Cycle repairs

Published: Nov 2015
Close up of classic guitar tuning mechanism

The cash conversion cycle measures the speed that cash tied up in the buying, production and sales process can be converted back into cash again. This is perhaps one of the most important business metrics and its optimisation makes sound business sense. Treasury Today considers methods of improvement.

As working capital metrics go, the cash conversion cycle (CCC) must surely rate as one of the fundamentals. Most businesses preside over a complex web of suppliers and customers, and cash permeates that entire structure. The purpose of CCC is to measure the amount of time, in days, a company’s cash is tied up in the purchasing, production and sales processes before it is converted back into bookable cash through the collection of receivables. It can be expressed as equalling DIO + DSO – DPO (where DIO is Days Inventory Outstanding, DSO is Days Sales Outstanding, and DPO is Days Payable Outstanding).

Ultimately, the longer the CCC, the longer it takes to generate cash so even with a full order book, if this figure extends too far, it can mean insolvency. Conversely, when a company collects outstanding payments quickly, correctly forecasts inventory needs and pays its bills slowly, it shortens the CCC. Most companies understand the importance of cash and more are engaging with the issue. In the REL Europe Working Capital Survey 2015, analysis of the accounts of almost 1,000 of the largest companies in Europe found that the CCC had improved in 2014 by 5.5% (the equivalent of 2.1 days).

Fixing the cycle

A good starting point for companies wishing to optimise their CCC is to understand the gaps in each of the working capital components in the equation referred to above. By benchmarking these components it will be possible for a business to see where it stands in relation to its direct competitors. Of course, benchmarking should only ever be seen as an input to a broader discussion on cash, not an end in itself. For Greg Person, Global Vice President of Presales, Kyriba, optimisation requires a “holistic” view of processes and systems. Functions such as treasury, the controller’s office, accounts receivable, accounts payable, those on the operations side (such as manufacturing) and even banking partners, all have a role to play when discussing working capital management and free cash performance.

However, it is a big ask to rally the many and varied functions for such an initiative, so is it worth it? Increasingly, the cash conversion cycle is a metric that the CEO and Board will be interested in. The ability to maintain a liquid business plays a major role in the capacity to fund capital expenditure projects, M&A activity, share repurchase programmes, dividend payments and a host of other significant capital allocation decisions that senior executives are tasked with, says Person. “Improving free cash flow and delivering an enhanced liquidity position is certainly going to help support those objectives.”

But company cash is increasingly of interest to external stakeholders too, he notes. The significance of a metric such as CCC is not lost on the markets, for example. Corporates, particularly those that are sensitive to cash flow (such as retailers), are often to be found giving guidance around their operating cash flow performance in earnings calls with analysts and the investor community. And well they might: if the capacity of the company to fulfil its capital allocation decisions is predicated on having the free cash flow and operating cash flow, then the ability to reduce its CCC is vital.

Cooperation required

With multiple internal stakeholders involved, shortening the time that cash is tied up in operations is a major initiative. For Person, the first point to acknowledge is that the focus should fall on cash when business is good. Wait for a downturn and it may be too late.

To help embed the idea that ‘Cash is King’ into company culture – and to steer an initiative in the right direction and encourage support and cooperation between functions – there needs to be buy-in and sponsorship from the top. It is a ‘C-suite’ role (possibly that of the CFO) to make sure there is clear ownership of duties and that all actions are aligned with the overall objectives of the business.

From a finance perspective, the areas of focus will most likely be DPO and DSO, simply because there will be less immediate influence over DIO (although the project sponsor should tackle any resistance). In terms of DSO, aside from simply renegotiating payment terms (which can be fraught with problems, as we shall see), effective means of shortening CCC include schemes such as factoring and trade receivables securitisation programmes. These schemes typically involve close partnership with a bank or other FI to make the receivables available for early payment. “It’s not free but it is a way of accelerating cash collection and ultimately reducing the cash conversion cycle,” notes Person. Complementing these relatively common schemes (at least in the SME sector) are a range of best practice AR workflow tools (from the likes of Gresham Computing, Fundtech and Bottomline), that facilitate the streamlining of cash allocation.

As the REL survey, referred to previously, suggests, many big organisations do not seem to focus on getting the cash in quite as efficiently as they could or should. For these firms, it may be possible to drive the strategic value of their shared services operation on the AR side. But benefits can easily be wiped out by poor results. Some 44% of respondents to SunGard’s ‘Credit and Collections Global Benchmarking Study 2015’ stated just how complex dispute approval processes can be, particularly where multiple departments are involved. This, said the report, makes it very difficult to set up different resolution workflows for every type of dispute, so they are often handled manually as a result.

C.J. Wimley, COO for Receivables in SunGard’s Corporate Liquidity Business, wrote that “while disputes inevitably require human intervention and therefore need to be managed in a different way to routine collections, it is very easy to lose visibility, control and monitoring of these invoices if they are managed outside of the normal systems environment”. Instead, he believes that it is typically better to accept that disputes need to be handled “in a collaborative way”, adding that technology may be used to support this aim. If successful, stakeholders will have visibility over the status, responsibility for follow-up steps will be clear, and any insensitive or inappropriate intervention is avoided. “This ensures that disputes are handled quickly, improving customer relationships but also minimising the impact on DSO.”

Wimley also suggested that it may also be possible to carve out disputed parts of an invoice and pursue payment for the rest in the usual way, rather than holding up the entire invoice. However, the SunGard study demonstrated that 43% of companies choose to hold up the entire invoice. “This can have a material impact not only on DSO but also on the predictability of cash flow for working capital and cash flow forecasting purposes,” he noted.

A cycle made for two?

On the DPO side, one of the most common options is that of supply chain finance (SCF) where the buyer, often working in partnership with its bank, pays its supplier on shorter terms in exchange for a discount on those invoices. SCF is something of a catch-all phrase that includes schemes such as dynamic discounting and supplier finance. For the buyer, this extends DPO, shortening the CCC and, by providing the supplier with funding, lends a degree of continuity to its supply chain. SCF can come across as nothing more than a pretext used by large corporate buyers to coerce SMEs into accepting longer and longer payment terms and charging them a fee for the privilege. In fact, because the bank settling the invoice uses the buyer’s credit rating to determine the cost, it can be a ‘win-win’ offering as long as the supplier needs early settlement: it effectively provides them with finance at rates they could never achieve on their own. Convincing them that this really is the case is often the first hurdle in the on-boarding process.

SCF has been around in one form or another for a very long time but speaking at a session during the 2015 Annual ACT Conference, the issue of its sustainability was broached by James Kelly, Head of Treasury at Rentokil Initial. He asked, somewhat provocatively: “If we all just paid on 30-days wouldn’t the world be a lot simpler?” Although this elicited many nods of agreement, he admitted that whilst this would indeed be beneficial, the constant working capital tension between buyers and suppliers is unlikely ever to ease as no one was likely to break ranks first.

Of course, this tension is precisely why SCF exists. The ACT’s Peter Matza, playing Devil’s Advocate, asked why, if it is so good, so few are using it (a straw poll of the session revealed only around 2% had adopted it so far). Cranfield School of Management lecturer, Simon Templar was on hand to argue that although SCF has emerged as a practical solution, “it has not yet crystallised”. To be truly sustainable, Templar believes it must see large corporate buyers assuming the role of “stewardship” in the whole supply chain. He argued that few would tie suppliers into punitive and ultimately unsustainable contracts not least because sourcing and on-boarding good new suppliers costs time and money. In fact, Templar sees sustainable SCF as a truly collaborative effort. He applies the term ‘horizon scanning’ to the view a buyer should be taking right across its supply chain, from tier one down, seeking to understand the cash-cycle times of all suppliers in a more steward-like way.

Responsibility and reputation

Indeed, as an alternative means of extending DPO (and as part of an effort to optimise CCC), SCF seems like a more responsible corporate approach than the easier alternative of simply paying late. The latter is a common practice which has earned much damning coverage in mainstream media in recent years. “Late payment is not sustainable and certainly puts a strain on business relationships,” comments Person. He adds, that it can also have an internal impact, especially where the AP department is forced to handle the backlash from suppliers and constantly fight fires. The negativity does not end here.

The promotion of voluntary industry initiatives such as the UK’s Prompt Payment Code, whilst offering a solution of sorts, serve to highlight the prevalence of late payment. As does more forceful legislation such as the EU’s Late Payments Directive which intends to put a stop to protracted payment times, limiting terms to 60 days (or 30 days for public sector firms). These initiatives are well-intentioned but could be better: a voluntary code is just that, and the EU Directive does not prevent large corporate buyers from strong-arming small suppliers into accepting new unfavourable terms. The call in the UK for a mandate to publish the late payment practices of public companies tackles the subject from a different angle. Should it happen, it will seek to impact corporate reputation by naming and shaming the worst offenders. A growing reputation for late payment could negatively affect investor behaviour and may even see more muscular suppliers enforcing certain types of guarantees to protect themselves, suggests Person. However, he continues, it need not be like this at all when seeking to optimise DPO and CCC “because there are more prudent and responsible ways of achieving this objective”.

Pay by the book

One company that “lives within” the EU Payments Directive is global pharmaceutical player, AstraZeneca. “Quality and surety of the supply chain is absolutely paramount,” stated the firm’s VP Finance – Cash Generation, Steve Williamson at the ACT event. One of AstraZeneca’s key focuses is its strictly adhered-to ‘pay-to-terms’ metric. It always pays its suppliers on time, never late nor early. There is an exception process for immediate payments, but these must be approved either by the CFO or CEO. Generally the reason for such urgency is to rectify an error, explains Williamson. But rather than sanction such a need, he believes the best way is to correct the underlying issue that led to it so that it does not happen again. Effectively, this means there are very few exceptions: “The moment you have an exception you are sub-optimal”.

As part of his ‘cash philosophy’, Williamson understands the importance of it being seen as a matter for the whole business, not just finance. To this end he firmly believes in “communicating, educating and repeating” the message until it permeates the culture of the company. However, he adds, AstraZeneca is “not solely about the cash”, basing all of its plans and decisions “around meeting the needs of customers and suppliers”, the goal being to build long-term relationships. “We can generate as much cash as we like, but in a year’s time we might not have a business. We try to reflect what the commercial reality is,” he states. Cash optimisation for Williamson is thus all about “good internal housekeeping” and developing an understanding of how cash is seen and handled by other companies and industries.

Nothing for free

The intelligent deployment of technology is fundamental to the effectiveness of CCC improvement programmes. On the DSO side, for example, being able to electronically post and exchange receivables is a necessary component of reaching the market. And from an ERP/TMS perspective, the ability to automatically reconcile, apply cash and manage disputes more effectively will facilitate a shorter cycle. But regardless of how good a vendor or bank’s cash solution may seem, Person warns of the need for cost/benefit analysis.

The intelligent deployment of technology is fundamental to the effectiveness of CCC improvement programmes.

Even low or non-tech solutions can have a cost. For the company, both factoring and securitisation have a P&L impact because the full amount of the invoice is not collected. Although payment arrives quicker, which can support the company’s liquidity position, if the time-value of that cash does not meet or exceed the objectives of the business then there needs to be a rethink, warns Person.

Historically, only the larger companies have been able to exploit working capital initiatives such as SCF. But new technologies such as those facilitating the exchange of receivables in the public domain where the banks are not involved (such as C2FO and Taulia) enable even smaller firms to make incremental improvements to their overall cash flow and operational cash position. There is great potential for all businesses in gaining a consolidated view across a broad spectrum of commercial functions – including AP, AR, treasury, production, purchasing, the supply chain and even their banks – and the means to do so are readily available.

By acting on information drawn from this viewpoint to shorten the cash conversion cycle it could, for example, facilitate more aggressive paying down of debt or perhaps improve the company’s investment position. If sufficient gains are made – and the REL 2015 survey suggests that working capital realisations are there for the taking – then these could also allow the funding of important capital allocations, such as stock buyback or M&A activity, without taking on additional debt. Whilst there is likely to be a cost attached to effective CCC optimisation, cash will always be an enabler so the arguments for getting the cash cycle to work more effectively remain compelling.

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