Chapter Eleven

Liquidity and Working Capital

IN THIS CHAPTER, WE LOOK at working capital, one of the key drivers for liquidity needs, and how companies can appreciate, measure, and reduce the need for working capital and hence external dependence on liquidity sources.

Pressure on the Treasurer to find in-house solutions for funding increases as more and more cheaper sources of liquidity dry up. There is an increasing view that many of the reasons for cash flow inefficiencies are internal, but companies sometimes tend to look at outside sources first before looking internally. Many performance measures and metrics of business and procurement units have targets and incentives based on the top or bottom line, while focus on cash flow tends to be the baby of the Treasurer and chief financial officer (CFO).

This chapter focuses on these points, and how the modern company is managing to work on them to address larger issues and find concerted solutions.

WORKING CAPITAL IN THE OPERATING CYCLE

The Treasurer with support from the CFO works on reducing costs through process efficiency (centralisation, dematerialisation, consolidation, and in-house banking) while adding value through balance sheet efforts (supply chain finance and working on ratios) and process automation (straight-through processing to increase control and efficiency and reduce headcount).

The operating cycle (Figure 11.1) is the chain that starts with cash and moves on to procuring raw materials, manufacturing and storing the inventory, selling the finished product, and finally recognising cash from the customer to whom the end-product has been sold. The funding of the entire process or operations on a day-to-day basis, in a nutshell, is the working capital of the firm.

FIGURE 11.1 Operating Cycle

From a balance sheet point of view, working capital is used for the short term (see Figure 11.2).

FIGURE 11.2 Working Capital in the Context of Balance Sheet and Return on Invested Capital

Working capital, which is one of the main components of capital utilised by the firm, determines the denominator of the return on invested capital, a key ratio for shareholders and debtors to assess the firm’s performance. Other aspects driven by operations, such as profitability, determine the numerator.

Focusing back on the balance sheet, the cash flow (and hence cash) and short-term debt components work toward funding short-term resources, primarily working capital for the purposes of running day-to-day operations.

CASH CONVERSION CYCLE

Figure 11.3 depicts the supply chain with its two critical cycles, the procurement-to-payment cycle and the order-to-cash cycle.

FIGURE 11.3 Supply Chain with Two Critical Cycles

Part II discussed these cycles in terms of their float or delays and discussed the transactions (i.e., collections or payments) aspect of these cycles and delays. This chapter focuses on the balance sheet impact of the tenor of these cycles and how improving them affects the bottom line.

The cash conversion cycle (see Figure 11.4) is rough measure (in number of days) of how long a company must finance its cash outflows for operations before it receives cash inflows from sales. The cycle can be measured by the formula:

CCC = DSO − DPO + DIO

where:

CCC = cash conversion cycle, in days

DSO = days sales outstanding

DPO = days payable outstanding

DIO = days inventory outstanding

FIGURE 11.4 Cash Conversion Cycle

This means that the number of days it takes to convert cash is approximately equal to the number of days of receivable and inventory that needs to be funded, less the number of payable days (i.e., in effect, the supplier funding the firm).

The higher the CCC, possibly higher will be the cost of capital and lower the financial performance of the firm, owing to:

• Higher cost of funding owing to longer borrowing periods
• Possible supply disruption because of delays in funding purchases from suppliers
• Lower sales because of impaired ability to provide good credit periods or discounts
• Potential penalties because of late payments

The lower the CCC, the more efficient are the firm’s financial operations, since the number of days of operations to be funded, and hence the working capital requirement, is lower.

Table 11.1 compares the CCC of two different companies based in Germany.

TABLE 11.1 CCC Comparison (in Days)

The cash conversion cycle of Company Z is 55 days; it has 75 days of sales and 15 days of inventory outstanding as assets, while it has to pay 35 days’ worth of payables. Hence, it needs to fund around 55 days of its operations and can quantify the amount of working capital that it required.

Company Y has a high inventory level but relatively lower receivables, which means that its customers generally pay earlier. It also makes its payments later (DPO at 60 days) on an average, and its CCC is zero days, which means that the company is just about neutral on its working capital requirements.

Procurement-to-Payment Cycle

The procurement-to-payment cycle is simply the period from the issuing of the purchase order (formalisation of the procurement) until the time the money is actually paid out to the supplier. Figure 11.5 shows procurement-to-payment the cycle in context of the processes on the procurement side.

FIGURE 11.5 Procurement-to-Payment Cycle in the Context of Procurement Process

During the procurement-to-payment cycle, the purchase order is delivered, the shipment is made, the invoice is issued, the payment is executed, and instrument or instructions are sent out. The moment the debit appears on the accounts of the firm, the accounts payable on the balance sheet is liquidated, and the procurement-to-payment cycle comes to an end for that purchase.

Days Payable Outstanding (DPO)

For an aggregate set of payments at any point of time, the DPO denotes the number of days of purchases that have been recognised but are yet to be paid. The later the payment, the longer the company has to use the money, and hence the lesser is the need to look elsewhere for working capital sources. This time period is also called payment conversion period.

The payment date or number of days of the credit period is one of the critical terms negotiated between the seller or supplier and the buyer or customer. The DPO effectively becomes a measure of the efficiency of the payments mechanism and supplier management process for the group.

where:

AP = accounts payable

COGS = cost of goods sold

As can be seen, DPO numerically measures the AP in terms of the cost of supplies procured (COGS) and converts it to a percentage of the year or number of days.

The higher the DPO is, the longer the period allowed to make the payment and hence the greater the use of cash. Some companies take an improving DPO project to be license to delay payments to suppliers. This is not a good practice. The AP for a company is the accounts receivable (AR) for its supplier. If the payment needs to be delayed, the terms have to be agreed on up front at the time of negotiation.

What exactly does the improving DPO project contain? Figure 11.6 describes some of the simple processes in detail.

FIGURE 11.6 Generating Value in the Procurement-to-Payment Cycle

Centralisation of processes into a shared service centre and the increased automation that it will require generally do a lot to increase efficiency on the processing and operations side. Uniformity of vendor and expense policies and aligning with global expense policy may reduce the chances of disparity, especially for a geographically distributed procurement function. Finally, keeping one or two payment dates per month generally increases efficiency on the payments process.

Related benefits of improvements in the transactions side include lower processing and vendor costs, higher degree of control, lower opportunities for error, and easier and quicker reconciliation.

Potential hurdles for these improvements are general firm-wide resistance to centralisation and expense policy changes; these can be overcome to some extent by prudent senior management and linking employee goals to the firm’s performance.

On the balance sheet and liquidity side of the procurement-to-payment cycle, the supplier’s choosing optimal terms, providing liquidity to weak suppliers, and aligning goals of the procurement team are the three key methods. These are explained further in the case study later in the chapter.

The main wins for these methods are to increase the DPO and hence liquidity for the firm. Indirect benefits include better terms from the vendor and reduced chances of failure or outage anywhere in the supply chain.

Certain hurdles can block balance sheet improvements, not the least of which is suppliers’ willingness to admit to poor management and financial stress and to allow the larger company access to its own financials for purposes of assistance. Given the liquidity environment at that point of time, banks also may not be able to provide funding for weak suppliers, owing to prioritisation of their funds available for lending.

Calculation of DPO

Table 11.2 shows the DPO calculation for the same two European firms discussed earlier.

TABLE 11.2 Computation of DPO

Order-to-Cash Cycle

The order-to-cash cycle (described in the earlier section in the context of float) is the period from the sale being made until the time the cash flows into the account (see Figure 11.7).

FIGURE 11.7 Order-to-Cash Cycle in the Procurement Process

The cycle involves the booking of the sale in the company’s books (creating the AR), issuing the invoice receiving or collecting the instrument or instructions on the due date, and finally receiving the credit into the account on a clear basis. The moment the credit appears on the firm’s account, the AR on the balance sheet is liquidated, and the order-to-cash cycle comes to an end for that sale.

Days Sales Outstanding (DSO)

For an aggregate set of receivables at any point of time, the DSO denotes the number of days of sales that have been made but for which the payment has not been received. The earlier the payment, the more use the money has to the company, and hence the lower its need to look elsewhere for working capital sources. This is also called the receivables conversion period.

The payment date or number of days in the credit period is one of the critical terms negotiated between the customer or buyer and the company salesperson. The DSO is not usually an accurate stand-alone measure of the efficiency of the group’s collections mechanism and client management process. (It can be used along with overall sales, improvement in collection times after due date, and reduction in external float.) The primary use of the DSO number is to weigh the negotiation and process improvements (if any) on the customer side; in addition, it is a critical component used in measuring the CCC and hence the company’s working capital requirements.

As can be seen, the DSO numerically measures the AR in terms of the sales made by the company and hence converts it as a percentage of the year or number of days. The lower the DSO is, the shorter the collections period and hence the greater the use of the cash. How can DSO be brought down?

The improving DSO project can be done through some of the simple process explored in Figure 11.8.

FIGURE 11.8 Generating Value in the Order-to-Cash Cycle

Centralisation of collection management, working on reducing float, and automation of information and interfacing with bank collections systems bring increased efficiency and controls on the processing and operations side. Goal congruence and getting partner unit (especially sales and planning) buy-in on the criticality of forecasting generates sufficient synergies in management of cash and liquidity.

Related benefits include lower processing and collection costs, higher control, lower opportunities for error, and finally easier and quicker reconciliation.

On the balance sheet and liquidity side of the order-to-cash cycle, quoting optimal terms to the customer, providing access to liquidity to financially weaker customers, better credit risk management, watching for early warning signals, and aligning goals of the sales team with that of the firm’s overall financials constitute some of the key areas for change.

The main wins for these methods are to lower the DSO and hence improve liquidity for the firm. Indirect benefits include better financial condition for customers, and hence greater customer satisfaction and lower opportunities for disruption of sales.

Calculation of DSO

Table 11.3 shows the DSO calculation for the same two European firms discussed earlier.

TABLE 11.3 COMPUTATION OF DSO

Financial Benefits of Working Capital Requirement Improvement

We now look at how we can assess the improvements on the cost of capital to the firm when there is an improvement in the cash conversion cycle. Figure 11.9 depicts the three cycles. The aim is to increase the DPO through more efficient terms and payments while reducing the DSO through better terms and efficient collections float reduction techniques.

FIGURE 11.9 Impact on Financials

Let us say that the process improvement has moved the DSO down by 10 days and the DPO up by 10 days, which means that the company is collecting cash sooner by 10 days and delaying its payments by 10 days more.

In effect, the average receivables have been brought down to EUR 2.791 billion and the average payables have moved up to EUR 964 million. Table 11.4 summarises this move.

TABLE 11.4 Computation of CCC for Company Z

Assuming that the credit sales, inventory, and COGS have not changed, the CCC has been brought down to 35 days from 55 days, resulting in working capital reduction from EUR 2,793 billion to EUR 2,149 billion or a reduced borrowing of EUR 644 million.

Assuming a borrowing cost of 5% per annum for a two-month period, the reduction in interest costs would amount to a whopping EUR 5.4 million.

Impact of CCC on Financials

How does the tracking and management of the CCC impact decisions made by the company on its negotiations on terms with suppliers or customers? What is the benefit of coordinating with Treasury on these issues?

Generally, the procurement and sales teams of most companies are equipped to handle discussions on pricing and credit periods. Incentives, performance parameters, and evaluation tend to be in terms of the price—the lower the price of procurement, the higher the price of the sale.

In cases where liquidity is tight or interest rates are high, the value or discount provided by the credit period of the supplier or the early payment for the customer could be worth more for the company in actual cash terms (interest cost).

Let us consider an example on the procurement side. The supplier offers these terms: 1–10 net 60 (i.e., 1% discount if paid within 10 days); if the company pays within 60 days, there is no discount.

What should the buyer do?

Buyers will not be faulted for going with alternative 1—after all, the lower the cost, the better their performance will appear to be. Yet, from the company’s perspective, the best decision will be the one that provides lower cash flow on an overall basis and perhaps more liquidity.

To answer the question, we need more information on the availability of credit and its price. Let us assume that working capital lines are available to the firm at 10% per annum for the borrowing period. To compare alternatives 1 and 2, we can assume that the company has enough liquidity to pay 100 on the 60th day. Hence, to pay earlier, the cost of borrowing 99, the amount to be paid on the earlier payment date (i.e., after 10 days), has to be considered. If the net cost is less than 100, alternative 1 is better.

The total cash outflow for the firm is 99 + 1.375 = 100.375. Thus, it is better for the firm to take the 60-day credit period, which is worth paying the normal undiscounted price.

If the interest rate is 4% per annum, however, the situation could be different. In this case, the value of the discount is 99 × 50/360 × 4% = 0.55, and hence the total outflow is 99.55, which is less than the full price of 100 paid on the 60th day. In this case (and we assume liquidity is quite good since rates have dropped to 4% from 10%), it might be more effective to take the discount.

A similar approach on the sales side will also be useful—deciding the credit period and incentivising the customer to pay earlier in times of tight liquidity and higher interest rates.

FINANCIAL SUPPLY CHAIN AND ITS POTENTIAL PAIN POINTS

We conclude this chapter with a review of the financial supply chain and its various pain points, along with a case study of how a global company facing supply chain issues in 2008 put in place some measures to reduce such instances in the future. This discussion leads into supply chain financing in Chapter 14.

Pain Points in the Supply Chain

Figure 11.10 shows the supply chain with potential pain points marked with upward-pointing arrows.

FIGURE 11.10 Pain Points in the Supply Chain

The balance sheet is the focus, since any issues with the movement of cash in the financial supply chain will negatively impact the balance sheet. Decisions made by the procurement team (buyers), manufacturing, and sales have a direct impact on inventory, cash, receivables, and payables. Disruption along any part of the supply chain could result in an adverse impact and hence a liquidity issue for the company. Potential areas of pain in the supply chain include the dependence on external elements, such as the financial soundness of the supplier (and hence the longevity and reliability of supplies); operations and efficiency of the logistics (transportation, distribution, and warehousing) companies; and the customer’s ability to pay on time. Some of these risks may be reduced through diversification, but not all companies have the ability, scale, and bargaining power to lower their dependencies on external sources of pain.

Interestingly, suppliers could face similar problems (where the corporation is the supplier’s customer), as could the logistics companies or the end customers themselves. Each of these companies has its own supply chain, and the corporation is either the customer or supplier in those related supply chains.

Figure 11.11 delves a little deeper into the various external entities and the possible sources of their pain points.

FIGURE 11.11 Causes and Impact of External Pressure Points

Each external leg of the supply chain has its own set of potential areas of distress. These could disrupt the firm’s supply chain or directly result in nonrealisation of receivables.

For the supplier, a credit squeeze and poor management of finance, its own credit, receivables, and inventory could strap it for cash and liquidity. Potential compromises on quality might ensue, resulting in delayed or nondelivery of goods.

For logistics and transportation companies, the risks are a little different. In many cases, dependence on global fuel prices and relative inelasticity of pricing, coupled with variations in end customer demand, working capital management, and potential disasters (natural or man-made) directly impact their functioning.

For distribution firms, poor management and inability to address credit, inventory, and funding issues coupled with risk of natural disasters create an environment where insurance can compensate for only some immediate short-term financial value but not all, and not medium- or long-term situations. Late shipment or arrival of goods could cause issues in the supply chain, including an avalanche impact to customers’ value chains.

Finally, the customer’s inability to pay due to financial stress and liquidity issues at its end directly impacts the credit and receivables for the firm, delaying the availability of cash and putting added pressure on the Treasurer to sustain the operations while waiting for the funds to come in.

Over the last few years, especially after the 2008 crisis, there have been several success stories regarding managing receivables and improving the collections and cash concentration processes. Many firms have focused on the DSO aspect and have brought down their receivables and speeded up the collection process, seeing dramatic results on their working capital efficiency and hence cost of capital.

But disruptions to the supply chain through other legs have been a worry in the back of the minds of chief executive officers (CEOs) and chief financial officers (CFOs), and few firms have put thought, effort, and resources in that direction. I hope we do not need another crisis to teach us that lesson.

With simple and intuitive tools and focused efforts, firms can tap into internal available resources to help understand, develop, and reinforce the financial strength of all elements in the supply chain whose credit and financial position is weaker than their own. Doing so will enable the chain and its financial flows to work smoothly and lower the chance of disruption.

The next case study presents a different approach to supplier management. Solutions using a similar approach can be built for other partners in the supply chain.

CASE STUDY: AN INNOVATIVE APPROACH TO SUPPLIER MANAGEMENT

This case explores an alternative method to managing supplier-related issues. We explore how the Treasurer can add value to traditional methods of approaching suppliers for products and how Treasury expertise can benefit the relationships with suppliers and translate into financial improvement for the company.

Traditional Approach to Supplier Interface

Historically, procurement teams have been the main points of contact, discussing and negotiating supply terms after understanding the supplier’s product/material, operations, and supply chain (see Figure 11.12).

FIGURE 11.12 Traditional Approach to Supplier Interface

The buyer or procurement officer is the key point of interface, keeping the scope of discussions with the supplier on the quality of the product, terms, and condition of the sale and delivery. The payments and AP management teams provide the necessary payments on due date. The finance and Treasury teams at the supplier’s end maintain an independent existence, interfacing with their own bankers and service providers.

The coming of age of the Treasurer and the recognition of the Treasury team’s skill sets and influence has helped to improve on these methods.

In Part I, we discussed the role of the Treasurer and some of the various hats that he or she wears. Two of these hats (see Figure 11.13) stand out with respect to the situation with suppliers: one is as trusted advisor and internal consultant and expert on credit, and the other is as trainer.

FIGURE 11.13 Treasurer’s Place in the Context of Supplier Interface

Now we explore how these Treasurer skills can be put to use in reengineering the interaction and relationship with suppliers (see Figure 11.14).

FIGURE 11.14 Improved Interface with Supplier

The difference from the traditional approach is the involvement of Treasury. The Treasurer, by his or her job description, is the person in the group who understands credit and its various aspects the best, being responsible for the credit rating and creditworthiness of the group, and is the main point of contact with the largest providers of liquidity to the corporate sector: the banks. Hence, the Treasurer can add value by providing on-the-ground support to the procurement team and the supplier in these ways:

• Assess the supplier’s financials and advise on how the supplier can improve its financials
• Provide the firm and the buyers with an early-warning mechanism on potential supplier failure
• Interface with banks to provide solutions in supplier financing
• Help buyers choose the right payment terms in line with the firm’s cash flow requirements and needs

The resultant liquidity, advice, and confidence add to the supplier’s own liquidity position and hence profitability. In most cases these improvements result in increased partnership from the supplier’s end backed by improved terms that improve profitability consistently in the medium term.

This activity is not a bottom-up one but has to be enforced top down.

A couple of bottlenecks could arise at this stage:

• For a company with a varied supplier base, this task would be suboptimal for every supplier. Hence, the bottom-rated materially important supplier (i.e., whose failure could cause an impediment to the supply chain) could be the first to target, as it is both the low-hanging fruit and the supplier that would have a maximum impact on de-risking. The company can follow up with other suppliers later.
• The supplier’s sales team, used to dealing with company buyers and having discussions focused on product, pricing, and delivery, may not be appreciative or welcoming of what they might deem to be interference on the part of the customer. Two activities can help to change that attitude:

1. Train the buyers to understand the core concepts of liquidity and credit, and speak the language that the customer would understand in terms.

2. Appeal to suppliers’ requirements enough to convince management at the supplier’s end to be involved and also get the finance management engaged in the process.

Once the firm’s finance management has enough confidence in the solution-centric approach, the Treasurer as expert can be brought in. The treasurer’s core skills and knowledge can be what brings suppliers into the mainstream and empowers them with increased liquidity and reduced chances of failure (see Figure 11.15).

FIGURE 11.15 Treasurer’s Skill and Network Set

These Treasury team skills and networks will serve them in good stead as they work with suppliers for:

• Understanding of credit
• Appreciation of balance sheet and management
• Access to banks
• Knowledge of financing solutions
• Tools to determine financial impact of purchasing decisions and evaluating the best credit terms
• Market presence and awareness

European Firm

A European firm with a presence across all continents and a large customer base was facing serious issues and disruptions on the supply side, which were only getting worse (see Figure 11.16).

FIGURE 11.16 Company’s Situation in 2008–2009

The company’s suppliers were becoming financially unsound, and a few failures had caused minor disruptions in the procurement chain. Potential defaults were looming large, but some were also coming as shocks to the buyers who were interacting with the suppliers on a daily basis. While the firm itself had had no concerns about its own liquidity, across different parts of the world, bank liquidity was being tightened and the smaller suppliers were feeling the impact, being squeezed by their customers for reduced prices and heavy discounts (and longer credit periods in some cases), adding to stress on their receivables and product quality. The procurement team’s emphasis on discounts was also causing suboptimal utilisation of the suppliers’ credit period.

After much discussion, brainstorming, and planning with numerous stakeholders across functions, it was decided to embark on a three-pronged approach to resolve this problem (see Figure 11.17).

FIGURE 11.17 Three-Pronged Approach

The three areas of action and their action items resulted in overall better performance for the firm through a smoother supply chain, translating into better terms, higher DPO, and low working capital.

The first area of improvement, supply chain improvements, involved identifying supplier financing solutions from banks and identifying optimal credit terms. The Treasurer became involved on advice of the CEO and the CFO, working with the key lower-rated suppliers with declared liquidity issues and connecting them with banks to help find risk-mitigated funding solutions.

The second, financial training through simulation, was conducted by Treasury and rolled out globally to every procurement officer around the world. It enabled the procurement team to appreciate the financial impact of its decisions. Experiencing real-life situations increased learning and provided a sense of partnership and ownership toward the financials of the group.

The final prong, aligning performance goals of the procurement team, would not have been possible without the direct support and appreciation of the criticality of cash flow by the CEO and the board. The goals of the procurement team were tied to financial benefit from its decisions, and this enabled more rationalised thinking on the decisions and negotiations of terms with suppliers. Benefits of this approach are highlighted in Figure 11.18.

FIGURE 11.18 Benefits of the Approach

While this led to a smoother supply chain over the short term after implementation (see Figure 11.19), largely owing to better liquidity and access to credit for weaker suppliers, the firm also gained more medium-term benefits of better financial performance. These included:

• Better terms and higher DPO resulting from cheaper financing for suppliers
• Procurement team evaluating the financial benefit of the credit period versus the value of discounts
• Increased liquidity for firm and reduced need for working capital, lowering overall cost of capital

FIGURE 11.19 Simulation-Based Training to Enhance Financial Knowledge for Non-Finance Function Partners

The training conducted (see Figure 11.19) was a simulation-based effort developed for the firm, focusing on:

• Appreciating the impact of business (procurement and sales) decisions on the financials of the firm and its credit ratings
• Evaluating credit ratings of stakeholders in the supply chain
• Looking for early warning signs of distress
• Making decisions of using credit period versus using discounts
• Understanding the impact of competitor best practices on the firm’s financials
• Fostering a sense of teamwork and working with Treasury to improve organisational performance

While the training and entire effort in this case was for the partners in the procurement team, the same training and partnership to achieve desired results can be used for other functions. We dwell on benefits of simulation-based training in the Toolkit section of this book (Part Five).

Key Learnings from the Company’s Experience

The company learned three key things from this experience that are worthy of sharing. These are:

1. Focus on credit.

• Understand credit of key partners in the supply chain.
• Identify the financially weakest suppliers.
• Identify the financially strongest customers whose credit can be harnessed.
• Put in place a process to evaluate financial impact of credit versus discounts.

2. Implement strong training modules.

• Train both procurement and sales.
• Help them understand the impact of their decisions on the firm.
• Partner with Treasury to make the best decisions.
• Use simulation, an increasingly strong and cost-effective method that provides real-life feel and hence deeper and immediate learning impact.

3. Align organisational goals.

• Set goals based on financial impact, and not necessarily on lower procurement price or higher sales price.

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SUMMARY

In this chapter, we looked at various aspects of the balance sheet linked with working capital and at the role of the cash conversion cycle. We explored how the financial supply chain can be diagnosed for pain points and saw how financial pain on the supplier side can be reduced. We now move to a more holistic look at the balance sheet and financials and at the ratios used to assess the health of the company and its liquidity and other risk aspects.