Optimal Working Capital: Turning Aspiration into Reality

The concept of optimal working capital efficiency is relative, not absolute. Factors specific to a corporation, such as the industry in which it operates, will determine the precise degree of efficiency that is practically possible. For example, achieving a day sales outstanding (DSO) figure of 35 might be seen as excellent in one industry, but indifferent or even poor in others.

The concept is also not about hitting a static target. As new technologies emerge, regulations change and banks introduce new products/solutions – the boundaries of the individually optimal also change, as do the techniques corporations use to push against those boundaries.

Focus: Collections and Reconciliation

One example of this change has been the shift in focus within many corporations in Asia to collections and reconciliation as the key components of efficient working capital via reduced DSO. While much has already been done to improve the efficiency of the physical supply chain, the associated financial supply chain has not always kept pace.

From conversations with our clients, it is apparent that this situation is now changing; more effort is now being made to accelerate the order-to-cash (O2C) cycle to reduce DSO. The key here is no longer just about getting the cash in from sales but applying it accurately and quickly to specific customer invoices. Financial statements that show large balances of unallocated cash do not impress – nor do disgruntled customers being chased for invoices they have long since paid, or being prevented from making further purchases because their account has been erroneously placed on stop.

A further element in this shift in emphasis is information. Chief financial officers (CFOs) and treasurers need accurate and complete information from their internal systems if they are to manage corporate liquidity effectively. The quality and timeliness of this information is hugely dependent upon the effectiveness of the corporation’s collections and reconciliation.

The treasury that is armed with clean real-time cash information is ideally placed to apply the same ‘just-in-time’ techniques used in manufacturing to liquidity management. This in turn feeds back into working capital efficiency; business units in deficit can be funded with inexpensive internal liquidity to reduce their cost of working capital, while those in surplus can be rewarded with better investment returns.

DSO Reduction

Reducing DSO can be achieved with a range of strategies that are often overlapping and complementary. For example, if customers can be persuaded to pay electronically this expedites the receipt and correct application of cleared funds. This in turn allows customers’ credit lines to be managed more efficiently because the actual balance on their accounts can be tracked in a more timely manner, which allows the faster release of new shipments and a compressed order to cash cycle.

Another (often overlooked) area is broader training of sales personnel. While virtually all corporations put resources into training sales people in selling, very few train sales teams on the working capital implications of their role. If sales people are only incentivised by sales commissions, they will be oblivious of the potential impact of offering extended credit terms to customers in order to close a deal. A sales team that is ‘working capital aware’ and/or has working capital as one of their key performance indicators can substantially improve the working capital position.

Improving DSO and Receivables Operations

A global bank should have a variety of tools at its disposal that can be used to assist corporates in improving many of the operations that underpin DSO reduction and more efficient working capital management. One obvious example is in helping corporate clients to craft and implement a strategy for convincing customers to switch to electronic collection channels such as direct debit.

For those situations where customers prefer to continue paying the corporation by cheque, the bank should be able to provide outsourced cheque processing that can capture data from paper and convert this to a stream of electronic information. This can then be fed directly to the corporation’s enterprise resource planning (ERP) system via a direct host-to-host link, which from the corporation’s perspective means that fully automated processing of even paper payments is possible.

Many banks support enhanced payer identification by assigning unique reference numbers to each customer, thus enabling more efficient payment reconciliation. Furthermore, if a bank has extensive market presence, a more direct route to identification may be possible. If a bank has both the corporation and its customer(s) as client(s) then it can directly complete the information loop and provide uniquely enriched data.

DPO Opportunities

The situation regarding days payable outstanding (DPO) in Asia is as demanding as for DSO. Particularly where corporations have followed a decentralised model for their Asian operations, a non-standardised approach to payment terms tends to develop. Where multiple business units are dealing with the same supplier, this leads to significant working capital inefficiencies as some units will be paying sooner than necessary and accurate cash flow forecasting also becomes harder.

The corollary to this is that costs are also being replicated in this type of situation. This is further exacerbated by the tendency for many companies in Asia to use cheque payments, which have a far higher total item cost than automated clearing house (ACH) payments. Again, this is an area where the right bank can add considerable value, by assisting with a migration to electronic payments or (if paper instruments are absolutely essential) by cheque outsourcing.

Switching to electronic payments also presents opportunities in areas such as workflow and settlement discounts. Instead of the compressed (and disruptive) workload of a monthly cheque run, the payment workload can be distributed more evenly across the month. A number of JP Morgan clients are already taking advantage of this to do weekly or fortnightly electronic payment runs, which also allows payments to be more closely aligned to supplier terms. It also provides the necessary operational flexibility to negotiate and take advantage of early settlement discounts.

Stretching DPO

Extending DPO has obvious benefits for the working capital position, but this is a process that requires care. While large corporations may have the brand and commercial leverage to impose extended settlement terms on suppliers, in some cases this can create significant operational risks. If a relatively small number of suppliers are delivering a critical component they may be forced out of business by extended payment terms or may simply decide that they cannot afford the working capital burden of continuing to supply.

In certain industries (such as auto manufacturing) where joint ventures (JV) for certain components are commonplace, extending DPO can be self-defeating. Lengthening payment terms to a supplier in which your corporation is a JV partner is somewhat illogical.

In the aftermath of the financial crisis, the relative paucity of external sources of working capital has also made the ‘direct’ approach to extending DPO less viable, as suppliers may be unable to source the necessary capital to support this. As a result, a growing number of larger corporations operating in Asia are switching their attention to other less direct methods of extending DPO – such as supply chain finance (SCF). This delivers a win/win situation by leveraging the credit differential between a creditworthy ‘anchor’ buyer and its suppliers; the corporation extends its DPO, while suppliers have ready access to economically priced working capital.

Improving DPO Operations

As with DSO, DPO operations are an area where a suitable banking partner can offer valuable assistance. In addition to providing tailored supply chain financing solutions, this assistance can extend across the entire payments processing spectrum. For example, the bank may be able to engage directly with a corporation’s suppliers to assist them in migrating to electronic invoicing (e-invoicing), thus saving on the cost of manually processing paper invoices. Ultimately the bank should be able to build on this by also offering host-to-host consolidated payment processing, thereby completely automating the payment process from end-to-end.

As part of that payment automation, a bank should also be able to provide professional consulting regarding the (re)engineering of the entire payment process. While this will obviously cover areas such as automation of exception handling, it can also be extended to larger scale infrastructure matters such as the design of (and migration to) shared service centre workflows.

Completing the Picture

The common factors that traverse optimal working capital management are visibility, efficiency and control. A bank that can effectively leverage its knowledge, processes, products and services will ultimately be able to deliver on all these key factors.

However, many corporations tend to forget that working capital efficiency is about more than just pushing up DPO and pushing down DSO. Only when liquidity and working capital management are symbiotically integrated can the maximum benefits be achieved. For example, better performance of liquidity management tasks (such as forecasting feed) back into more efficient deployment of working capital.

By the same token, the improved information quality resulting from fast/accurate reconciliation makes more accurate forecasting possible. The end results of bringing together improved accounts receivable (A/R), accounts payable (A/P) and liquidity are tangible: numerous companies have already found that this more joined up approach delivers enhanced and readily accessible cash flows.

Conclusion

Achieving this virtuous cycle obviously necessitates internal change, but also requires consolidation and streamlining of banking providers. Multiple banking relationships beget multiple (often surplus) accounts. Apart from unnecessary maintenance charges, these also create fragmentation/duplication of interfaces, data and processes. This then impacts reconciliation and the ability to achieve a true picture of total available liquidity, with the result being poor forecasting and impaired working capital.

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