Contact details:

david.blair@acarate.com

Website:www.acarate.com

Optimising collections

Collections are intrinsically harder than payments. When you pay, you know what you are paying and you control when you pay. (If not, you won’t keep your job for very long!) For most of us, it is much harder to know when customers will pay and what exactly they are paying.

This is why there are a lot of reconciliation services from software vendors and banks. The situation is complicated by variations in national clearing systems and business practices. Although sometimes painful to set up, things like boletos in Brazil and payment references in Finland can greatly speed collection reconciliation. In other countries, short or non-existent reference fields in payments hamper reconciliation.

Best practice in auto-reconciliation of commercial collections is in the high 90% range. For treasury flows, it is easy to get close to 100% auto-reconciliation, because treasury transactions are usually low volume and high value and strictly value dated. Many treasury centres combine standard settlement instructions (SSIs) with formal net settlement arrangements, and further reduce cost and risk with CLS (Continuous Linked Settlement).

For timing, many studies have shown that the majority of payment delays come from invoice errors. The logical way to reduce these is to embrace straight through processing (STP) in order to cash (O2C) as well with e-invoicing, and encourage customers to do likewise. E-invoices do not get lost, do not get miscoded by manual operators, and therefore get paid promptly.

Inter-company

Inter-company flows are necessary, but offer zero value added. So it is incumbent on treasurers to settle and reconcile them quickly, safely, and cheaply. The tools of choice for this are netting and in house bank (IHB).

Netting (multilateral inter-company netting) nets off the flows between subsidiaries, across currencies and across multiple subsidiaries, so that each subsidiary has only one net flow in its home currency per month. This saves float, foreign exchange spreads, and payment fees. An IHB nets off inter-company balances – simply put, all inter-company flows are booked to an IHB multi-currency account, and the resulting home currency balance can be settled or funded monthly or on some other frequency. The end result from a flow perspective is similar to netting, and an IHB also has balance implications.

The choice of netting vs an IHB is beyond the scope of this article. The key point from a flow perspective is that both eliminate inter-company flows through the banking system and the associated costs and risks. Furthermore, both techniques practically eliminate inter-company reconciliation issues, which also reduces costs and risks still further.

Balances

Balances present a different series of problems including visibility, availability, credit and other risks.

Visibility is knowing how much cash you have and where it is. Availability is having access to use your cash when needed. The risks are what might reduce the value of your cash.

The context is critical here. Balances cannot be optimised without clarity about the desired balance sheet structure, and especially things like leverage and cash levels. From a cost perspective, zero is the ideal cash level, but for most people the resulting liquidity risk would be uncomfortable. From a risk perspective, we would all like to have $150 billion in cash, but the cost – currently zero interest income minus weighted average cost of capital (WACC) – is prohibitive for most. You cannot define optimal cash management without clarity on this.

In these days of exceptional corporate cash – some $5 trillion between US and EU multinationals – it appears that corporates are holding cash to mitigate fear uncertainty and doubt about the macro economic outlook and market liquidity. Since there is no financial formula to justify such high cash balances, the solution has been to segment cash into operating cash (with a policy formula and high availability) and strategic cash (with no strict formula and potentially longer tenor).

Cash visibility is a cornerstone of effective balance management. If you do not know how much cash you have and where it is, you cannot manage it.

Visibility

Cash visibility is a cornerstone of effective balance management. If you do not know how much cash you have and where it is, you cannot manage it.

Visibility is normally defined as ‘What percentage of my cash do I see next morning?’ Best practice on this metric is close to 100%. The denominator for this calculation should reconcile with cash reported in the financial statements. Some organisations look at percentage of accounts, but the amount of cash is ultimately more important, and small, difficult to report accounts may be a distraction.

Visibility is normally achieved through some kind of e-banking. If you have more than one bank, you will want multi-bank connectivity. This can be achieved through SWIFT, third-party services, or a bank offering multi-bank connectivity. The goal is to collect closing balances overnight, so that all interested parties can see the transactions (for reconciliation) and balances (for management) in the morning. Sometimes, the data is gathered internally by asking subsidiaries to input their own banks, but this takes time, is error prone, and is normally done weekly. At the opposite extreme, some corporates request real-time reporting, or multiple intraday updates, especially to be able to reconcile and process commercial collections as fast as possible.

Visibility in the best cases is complemented by forecasting. Just to avoid confusion, cash visibility and cash forecasting are different if related things. Cash visibility forms the starting point for cash positioning or short-term cash forecasting, but visibility is historic (last night) whereas forecasting is about the future.

Availability

When you have visibility over your cash, the next step is to have control over it. Availability can be limited by issues like rights and connectivity to tax and regulation.

If the cash balance is in a joint venture, treasury may not have the right to deploy the money as it wishes. In extreme cases, recalcitrant subsidiaries may refuse to report balances. “Cash belongs to treasury” is an excellent motto I heard from one corporate.

With the right to the cash clarified, you need to establish connectivity and access rights to the bank so that you can move the money when needed. In the majority of countries, e-banking and SWIFT connectivity are available. Good practice in this respect is to make SWIFT capability a pre-condition for any cash management bank.

Any cross-border flow has tax consequences. When you move money from subsidiary to treasury, you need to know the tax implications, and whether they are acceptable or not. For example, many US corporates have the right and the connectivity to their cash abroad, but the cash remains trapped there by Subpart-F, costing 30% to repatriate. Hence the mountains of cash in their financial statements, coupled with apparently contradictory domestic bond issues to pay share buybacks. Regulation can also trap cash. Many emerging markets require documentation plus professional certification, plus government sign-off, before money can leave the country. In extreme cases, the central bank may not have enough hard currency to fund the payment.

For all these reasons, it is critical to segment visible cash into cash that is available and cash that is not. Preferably, you will have some understanding of how to make the unavailable cash become available, and how long that might take. For clarity, available cash + trapped cash = total cash. It is good practice to measure and track available cash as a percentage of total cash, but benchmarking against other corporates is difficult since trapped cash issues are highly contextual.

Risk

If you are lucky enough to have cash, you do not want to lose it and you want it available when needed. Short-term cash is normally invested to ensure security, liquidity, and yield – aka SLY. Note that yield is the last priority. The main risks to cash include counterparty credit risk, sovereign risk, FX risk and interest rate risk.

Counterparty credit risk is the main risk treasurers think of when dealing with cash. The most common metric used is agency ratings from Standard & Poor’s (S&P), Moody’s and Fitch, despite their role in the global financial crisis. Best practice augments agency ratings with implied ratings, credit default swap rates, equity data, balance sheet analysis, and other metrics. When measuring counterparty credit risk, it is important to remember that risk comes not only from cash and deposits but also from letters of credit (LCs), derivatives, etc.

Sovereign risk is the risk alluded to above that either a country changes its regulations so that you cannot get cash out anymore (for example by imposing exchange controls) or the central bank does not have hard currency to pay out.

Foreign exchange (FX) risk is – broadly speaking – the risk of loss from depreciation of a currency in which cash is held. FX risk management is beyond the scope of this article, but clearly cash (and cash investments) must be considered in your FX risk management. It is also important to ensure clarity about the base currency for risk measurement and the relative importance of cash flow and accounting risk.

Interest rate (IR) risk is the risk of loss from changes in interest rates along the yield curve. IR risk management is beyond the scope of this article, but it is critical to have clarity on the benchmark duration of cash (and its different segments if applicable). Since most corporate balance sheets are not easily converted into duration, the benchmark duration(s) will normally be set by policy rather than by formula.

Cash pooling

Cash pooling is a popular aid to balance management. The main tools used are notional pooling, sweeping, and an IHB. These tools can be combined in various ways. In a sense, the baseline would be manual inter-company loans from and to treasury; sweeping and an IHB essentially automate this but do not change the tax issues; notional pooling both automates the inter-company balance management and eliminates the tax issues arising with inter-company balances.

Notional pooling is an agreement whereby the bank offsets negative and positive balances to eliminate interest spread. No cash moves and the balances remain bank balances not inter-company balances, which takes away all the tax problems that come with intercompany lending. Best practice is multi-currency multi-entity notional pooling.

Notional pooling gets a lot of bad press because most banks struggle with the technical and regulatory challenges it poses for them. Whatever difficulties banks have with notional pooling, these do not diminish the considerable benefits for corporates. If your bank is trying to persuade you to do sweeping rather than notional pooling, I recommend you talk to a specialist – like Bank Mendes Gans.

Sweeping (also called ZBA) involves transferring balances to a designated master account. Interest spread is eliminated as with notional pooling. The big difference is that the balances move from being bank balances to inter-company balances. Inter-company balances attract a host of tax problems including withholding tax, debt to equity limits (‘thin cap’), transfer pricing, and so on. Essentially, sweeping is outsourcing to banks the transfers that treasurers could otherwise do manually (or with in-house (IHB) systems). An IHB structure, like sweeping, concentrates cash at the IHB, resulting in intercompany balances. It is the most common in house alternative to bank sweeping services. An IHB can be combined with notional pooling.

Sweeping in general can be used to automatically transfer cash from operating and non-core accounts into pool accounts and the IHB. Cash concentration (like cash pooling without debit balances) can complement pooling and an IHB to widen the reach of balance management.

Cash pooling brings many important benefits including increasing the real availability of cash, eliminating interest spread paid to banks, reducing investment risk, increasing investment yield and reducing FX risk (multi-currency notional pools only).

The target is to have all available cash in one place at end of day (even if it is then invested in different ways to avoid concentration risk). Trapped cash by definition cannot be brought into cash pools and IHBs, but onshore cash pooling is often possible.

Technology

It is not good practice to try to accomplish your cash management on paper, and terrible practice to do it with Excel. Excel is a wonderful tool for playing with numbers, and it is a disaster for ongoing critical operational processes – no access control, no audit trail, error prone manual work. Good practice is a properly implemented TMS with multi-bank connectivity, with security, access control, audit trail, and preferably delivered over the web or intranet.

TMS selection is also beyond the scope of this article, but it is worth mentioning that the kind of functionality described here need not be expensive or complicated to implement. SaaS vendors often provide SWIFT connectivity built in and offer competitive pricing per user per module. Some banks offer white labelled solutions or partner with TMS vendors to facilitate this functionality for their customers.

In conclusion

It is not possible to say precisely what best practice in cash management is because different corporations will have different needs. Nevertheless, I hope this article helps to clarify some of the desirable practices that can help lead towards best practice for your organisation, as well as some of the bad practices to be avoided.

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The views and opinions expressed in this article are those of the authors.