Escaping the Trap: Freeing Cash

Trapped cash is one of the most common and biggest problems faced by companies with overseas operations. Trapped cash is idle cash, that when left unmanaged creates a huge drag on corporate profitability and efficiency, so treasurers need to make releasing it a top priority. Along with tackling the more conventional issue of cash trapped due to regulatory constraints, companies will also benefit by seizing opportunities to reduce cash trapped by corporate inefficiencies.

                                                                                                                                                                     

Cash Trapped by Inefficiency

Companies are continually procuring, buying and selling goods and services. The shorter the time between the company paying for the raw material and getting paid from their buyer, or asset conversion cycle, the faster the company can use its cash. Conversely, when a company is not paid promptly its money is locked due to inefficiencies in the cash conversion cycle.

Take as an example a garment company selling clothes that receive payments by cheque. When a cheque is drawn in a different city in India, it can take from two days to a whole week to clear. Even when each individual cheque is small, the overall amount is cumulative for a company that still receives thousands of payments through this traditional form.

As they consider how to receive cash faster, efficient companies examine three components of the cash conversion cycle. The first is days payable outstanding (DPO), which is the number of days that elapse from when the company receives its raw materials until it pays for them. The second is days inventory outstanding (DIO), which is the number of days that it takes inventory to be converted into a sale. The third is days sales outstanding (DSO), which is the number of days between goods being sold and cash being received in the company’s account. The cash conversion cycle is represented by the equation DIO + DSO – DPO. For example, a company may buy raw materials and pay the supplier 60 days later. It then takes 90 days to convert the materials into goods for sale and may then take a further 75 days until the company gets paid and receives cash in its account. The resulting cash conversion cycle is 105 days. If the company can shorten the cash conversion cycle it is out of funds for a shorter period of time and the amount of cash trapped in unproductive net working capital is reduced.

In some industries, top companies can get paid before they pay their supplier and move into negative working capital. During the 2008 global financial crisis, Asian companies had learned lessons from the region’s own crisis 11 years before. They knew they needed to manage their working capital and improve asset conversion by reducing inventory from up to three months down to a far more efficient level of six or even three weeks. The majority of companies have a longer cycle and a higher cost for their working capital. 

There are several reasons for cash getting trapped by inefficiency. One is the domestic infrastructure and practices such as the clearing system in a particular country. Some companies operate in many cities across China, for example, and moving cash between them can be slow. A second is visibility over cash, since a company that cannot quickly see the funds it collects has difficulty reducing its receivables. Cash can even be trapped within the supply chain ecosystem inside a company, as cash takes time to move between different divisions or subsidiaries or affiliates for intra-company payments. Reducing inventory can free cash trapped there.

Finding the Right Partner

Finding the right partner can help to reduce the problem of trapped cash in several ways. One is before cash has come into the company, which can happen when cheques received from customers have yet to clear. In some cases, the company can replace cheques with direct debits (DDs) to withdraw money from customers’ accounts and receive funds with a high degree of predictability. Another is for the company’s bank to provide funding. In a market such as India, cheque clearing takes longer. Say, for example, the seller is in Mumbai and the buyer is in Kerala, then it may take almost a week for a cheque to clear. But a bank with the right network and/or correspondent partnerships can step in to provide cheque purchasing, and credit the beneficiary before the cheque gets cleared.

In cases where payment is slow, another alternative is for the company to sell the receivables and use receivables financing from its bank to get money upfront. DSO becomes zero, which is extremely efficient.

A company with substantial inventory could monetise it by placing the inventory with the bank, pledging it, and receiving cash immediately. It will then take stock from the inventory when needed and use the proceeds of sales from the inventory to repay the bank financing.

Another option is using vendor prepay financing to pay the supplier and extend the company’s DPO, which also overcomes the supplier’s difficulty if the company simply pays later. This is particularly important when companies are dealing with strategic suppliers and need to ensure they remain viable and get paid in a timely manner. Companies can work with their bank to determine which options would optimise internal trapped cash.

Overcoming Regulatory Constraints

In some cases, cash is trapped in certain markets and the company cannot move the cash to where it is needed due to regulatory constraints. A regional treasurer may have surplus cash in China from the company’s normal operations, yet a related entity in the Association of Southeast Asian Nations (ASEAN) still has to borrow from a bank because it is unable to access inter-group funding from the cash-rich Chinese entity. 

In China specifically, regulations are changing and regulators are starting to allow companies to move renminbi (RMB) out of China for a certain period. The People’s Bank of China (PBOC) is promoting offshore RMB, and has started a pilot scheme for cross-border lending. A company can seek approval to move RMB to an offshore entity in Hong Kong. Once the RMB leaves China, it is treated as RMB traded offshore or CNH, which from the regulatory perspective enables the company to use the cash more freely and efficiently. One solution is multi-currency notional pooling, whereby a company can combine its CNH with US dollars and other lesser regulated currencies. The company then has flexibility in how it uses various currency positions and can utilise the net cash pool in their currency of choice.

In the ASEAN region, India, Taiwan and other markets, the regulations around cash vary. There may be regulations on foreign exchange (FX), fund repatriation or whether intra-company lending is allowed. Some markets require permission before moving funds cross-border, others allow up to a certain cap per annum and still others require post-transaction reporting. Companies can benefit from working with their bank to avoid trapped cash and to optimise the cash they have amid the non-homogenised regulatory regimes in Asia.

Some companies work to reduce future trapped cash by establishing re-invoicing centres so they can restructure their supply chain and optimise intra-company cash flows for the underlying trade between entities. This option allows companies to overcome the issue of trapped cash as there is a genuine underlying commercial transaction between the related entities. However, the re-invoicing centre must be structured carefully so that it is compliant with local regulations, including tax requirements that the pricing of goods and terms of trade are arms-length transactions. A company could not pay US$9 for goods that cost US$10 to produce, for example, and it could not offer five-year payment terms rather than standard 60-day payment. Re-invoicing centres are highly scrutinised as the tax authorities are keeping an eagle eye on ensuring proper transfer pricing treatment for intra-company trade.

As an alternative to re-invoicing centres, more companies are now looking at using a principal commissionaire structure. The entity, often located in Hong Kong or Singapore, takes on the ownership and risk of the supply chain. It then owns the raw materials, commissions the manufacturing and consigns goods for distribution. The sales office becomes a sales agent and gets paid commissions for the services rendered. The commissionaire structure is preferred because it can reduce trapped cash in a tax-compliant and justifiable way. In practice, only the most sophisticated companies use this structure.

If a company already has trapped liquidity, neither the re-invoicing centre nor the commissionaire structure can reduce this. It may need to wait for deregulation in order to move the cash out of the country. Fortunately more countries, such as Malaysia, are gradually allowing a freer flow of funds, as they recognise the importance of ensuring a helpful regulatory environment that promotes the financial flows necessary to sustain economic growth. Until the deregulation process is finally completed however, corporates can benefit by working with their bank to look at alternatives to use the trapped cash more efficiently.

There are a range of benefits to freeing trapped cash, but as shown the difficulties and complexities of doing so are equally numerous. It is essential for companies to look for a bank partner that combines deep local knowledge with a strong global network in order to really optimise their cash. Escaping the trap will require some investment, be it time, effort, or resources, but ultimately the results are highly rewarding.

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