Turning Assets and Liabilities into Liquidity

Today, the increased pressure on corporates’ supply chains comes from two interconnected factors:

  1. Several industry sectors have experienced a change in the geographical distribution of their sales, moving towards an increased balance in favour of emerging markets, with the Asia-Pacific countries driving this demand. The order-to-cash (O2C) cycles for sales to emerging markets has led to a longer cash conversion cycle, as a result of greater transportation distances and changed payment terms and trade finance instruments.
  2. For many companies, the legacy production and procurement infrastructure was originally built mainly for sales to Europe and North America. This means that although sales cycles have increased, payment times for servicing factories located in Europe and/or North America have remained the same.

The combination of these factors places multiple pressures on corporates’ working capital and liquidity position.

In addition, without full visibility of what is on their books and a strategy for how to release trapped cash, many corporates are still struggling to make the best possible use of their assets and liabilities.

Cash Flow Forecasting

Looking at working capital management, the release of tied-up working capital is the primary focus for nearly one-third (32%) of respondents to gtnews Financial Supply Chain Survey 2010, in association with SEB. However, forecasting and planning capabilities continue to be a major obstacle, with 48% of organisations surveyed citing these as the main challenge to their working capital strategy – and a full 70% believed it was the main challenge in the overall management of their company’s liquidity

A company’s ability to release liquidity starts and ends with planning based on its forecasting capabilities. Without accurate cash flow forecasting, it is almost impossible to manage working capital efficiently and this becomes even more challenging as the company structures change. A lack of data is the key culprit, making identifying and freeing trapped cash difficult.

This issue is analogous to a physical supply chain with a just-in-time production/manufacturing process where it is important to have sufficient knowledge about the availability of raw materials you have ordered. A company needs to keep track of its inventory and match it to its order book and the financial supply chain (FSC) shouldn’t be treated any differently.

Treasurers’ lack of information regarding their cash position stems from:

  • FSC not being integrated with the rest of the business, leading to an information vacuum.
  • Lack of attention to the supply chain – just 6% of corporates surveyed in the Financial Supply Chain Survey 2010 cited counterparty risk as a key risk concern.
  • A combination of the first two issues, resulting in the lack of a liquidity conversion ratio (LCR) strategy.

The lack of a clear overall process for monitoring every part of the FSC is caused in part by a lack of alignment between company departments. One reason for this could, ironically, be the presence of a supply chain manager, which may make treasury staff believe they can divest responsibility for the FSC to a specific person. In fact, all departments should remain mindful of creating efficiencies in the FSC.

Although manufacturing firms commonly have a strong focus on sales and service models for their physical supply chain, establishing best practice standards for the FSC is a challenge, not least because of the unique nature of each company’s FSC. Benchmarking, even for corporates in the same industry segment with the same customers, is limited to the measurement of days sales outstanding (DSO) and days inventory outstanding (DIO). There are some indicators that can be used, however. For example, the amount of cash on the balance sheet over a relevant cycle is a good indicator of a cash flow forecasting weakness within the company. This demonstrates a higher degree of uncertainty in the amount of cash coming in and going out of the company. However, more information is needed for a thorough analysis. This could be achieved by incorporating trade finance data into cash flow forecasts, for example.

In addition to ensuring that every corporate department takes responsibility for the FSC, payment terms agreed with suppliers and the type of instrument used should be closely linked to the company’s asset and liability management (ALM) strategy. For this strategy to be effective, the treasurer needs both to be aware of what is in the ledger and ascertain that the liquidity ratio is maintained in practice. For example, if the target is to have an 60% liquidity conversion ratio (LCR), 60% of the accounts payable (A/P), inventory and accounts receivable (A/R) ledger should be liquid at all times. This strategy needs to include setting relevant policies regarding the type of instruments used, maximum payment terms and what valid information should be attached to the transaction.

Striking the Right Balance

As mentioned above, the information treasurers rely on to manage working capital is scattered between the logistics, marketing, production and account departments. But these departments’ key performance indicators (KPIs) will clearly differ from those of the supply chain manager. If logistics fail to ship goods in time, that will have negative consequences for the company. But if payments are delayed by two days it is perceived as being of low impact, as long as the company has cash in its accounts.

Achieving alignment and breaking down silos between departments is therefore just as important as having the relevant KPIs and workflow systems in place. This might seem obvious, but it is not often practiced in treasury departments.

However, it is also important to remember that an over-reliance on the liquidity policy can inhibit operational flexibility as well as customer service. Customers’ varying needs and unique supply chains demand an individual approach – and the more individual the approach, the greater the data collection efficiency required.

To use a hypothetical example, a Nordic company producing air compressors might sell one air compressor to a company in Vietnam. It simultaneously also sells an identical air compressor to a large corporate in Norway. The product is identical but the FSC looks completely different for these two transactions. The compressor sent to Norway is transported by truck with International Commercial Terms (Incoterm) free on board (FOB). Payment terms are 30 days on invoice. For the Vietnamese company, the product has to be shipped, which takes 18 to 22 days with Incoterms (cost, insurance, freight) CIF. Payment is by a letter of credit (LC) because of the higher level of counterparty risk, requiring advance payment of 15% on shipment. The company has to present an advance payment guarantee to obtain the advance payment.

Variation thus creates operational inefficiency, locked in working capital and operational risk. It will also affect the liquidity ratio. But to handle these two clients and contracts and supply chains in exactly the same way would be a disaster, not least because the customers would not accept the same payment terms. Striking the right balance between operational efficiency and customer service is therefore vital. The higher the level of customer service a company offers, the greater the variability in the FSC.

Risk in the Ledger

Stress testing the ledger is crucial – as well as book value, individual assets should be valued on their LCR. Getting bank backing on risky elements within the FSC is difficult. For example, if a company is sitting on a 420-day receivable, no bank will want to buy or discount it. A bank should value that receivable differently from an LC guaranteed by a global bank or insurance company, which can be turned into liquidity at any given time. Also, the value of the receivable will change over time, which increases the possibility of being turned into liquidity by financial re-engineering with a remaining tenor on 45 days. However, many corporates do not stress test often enough to get a clear picture of the LCR value of their assets and liabilities. Unlike banks, which constantly mark-to-market their asset portfolio, many corporates check their book value once a year (at annual reporting time). It is beneficial to do this stress test twice a year to see how much cash is trapped, similar to that performed on the physical inventory.

These principles also apply to selected instruments to work with. An invoice will be much harder than an LC or bill of exchange to sell. The LCR between the former and either of the latter – where the bank acts as guarantor – is considerable.

Working with Supply Chain Finance

In terms of using supply chain finance to free up liquidity from the company’s A/R ledger, overestimation of counterparty risk can lead to inefficiencies. SEB sees a lot of inefficiency among its Nordic retail customers that have suppliers in China. The retailers pay Chinese suppliers 15% at shipment and the remaining 85% when they receive the goods. The cash conversion ratio for them to receive the goods, send it to the stores and have it sold is often 90 days or longer. This means that the total cash conversion cycle from the payment date until they receive the money in the retail store from the buyer is 180 days or more. Instead of the buyer using their overdraft to pay the supplier, an import LC will guarantee the supplier their money and the buyer does not need to pay until they receive the goods, or even until they are paid by the consumer.

Suppliers will often accept a later payment in exchange for reduced counterparty risk, which they can use with their bank or financial institution. Adjusting the payment date depending on the company’s cash position is thus a key way of freeing up liquidity. Responses to the gtnews Financial Supply Chain Survey 2010 support this, with 58% indicating that the best opportunity to enhance performance within their organisation’s FSC was in the negotiation of commercial and payment terms.


The increased pressure on corporates’ supply chains that has occurred due to the evolving structural change in corporate business models needs to be addressed in both the physical and the financial value chain. To be able to tackle the increased risk and usage of working capital in the financial value chain, corporates need to know the why, the how and the what in relation to their cash flow.

Information is therefore a key factor – and one that many corporates do not currently have. However, a closer alignment of departments, coupled with a stronger awareness of the LCR attached to their assets could offer them greater control. This, in turn, will allow companies to make more informed decisions regarding their working capital.

To read more from SEB, please visit their gtnews microsite.


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