Cash Management

The Argument for Financial-Chain Management

Advances in information logistics have driven huge advances in supply-chain management. It's time to apply those advances to the finance chain as w...
Bernard De Groeve and Kevin MellynDecember 1, 2000

The Internet is one step in a long transformation, which dates back to the telegraph, and which we call the “information logistics” revolution. It is all about exchanging information electronically instead of on paper or in person. The result is a long-term decline in the cost and complexity of interactions between economic actors. The progression from telegraph, to telephone, to Internet is largely one of bandwidth and the convergence of networks.

Logistics, of course, is the art and science of moving things from one place to another. Until the last century, the great constraint on economic interaction was the time and cost involved in physical logistics. Under sail, five weeks was a good passage from New York to Liverpool. Land transportation was far worse.

The revolution in “physical logistics” represented by the railroad, motor vehicles, and aviation has changed all that. But optimizing physical logistics was impossible beyond a certain point before better information logistics were applied to the problem. Electronic data interchange (EDI) and now the Internet have allowed far more efficient information exchange between suppliers, manufacturers, distributors, and customers. This improvement in information logistics has translated directly into better physical logistics.

Re-engineering the Financial Supply Chain

Turning to working capital and the cash cycle, we can observe how the reduction of information float in physical logistics has taken friction and working capital out of the value chain. Unfortunately, it is also clear that corporations have made far more progress attacking the physical component of working capital than they have in attacking its purely financial component. The proxy for physical working capital is typically inventory to sales; the proxy for financial working capital is receivables to sales.

Looking at the corporate cash cycle from purchase to pay in very simple terms, physical working capital was a larger item in the U.S. corporate balance sheet in 1980 than was financial working capital. Between then and the end of last year, the inventory turnover period was reduced from 73 days to 48 days, a net saving of 25 days, while receivables turnover moved down only from 68 days to 57 days. Not only has physical inventory gone from being a larger component of working capital in the economy to a smaller component over the last 20 years, but it is also declining at over twice the rate, 34 percent as opposed to 16 percent.

Business has done a very good job of creating clarity between trading partners in the physical supply chain. Using EDI and more recently the Internet, firms have leveraged the information-logistics revolution — the ability to exchange and process ever-increasing volumes of information between economic actors at ever decreasing cost — to achieve just-in-time procurement manufacturing and distribution. Increasingly, they are building linkages between their own internal information management environments, typically ERP systems, and those of their suppliers and customers. Many initiatives are underway to move large categories or procurement, especially MRO, onto digital exchanges. Exchanges for engineered goods and highly specified materials like steel and chemicals are well advanced.

Why the Holdup in Finance?

Where business has done a less effective job is in leveraging the information-logistics revolution to attack financial working capital tied up in the purchase-to-pay cycle. This is true even though the task of linking the physical value chain involves integrating very complex information flows within and between thousands of firms, while integrating financial accounting information is relatively simple.

Why? The key factor is not the limitations of technology per se. More than enough information exchange and processing capability is in place to make radical improvements achievable. The real problem is a misalignment of power and focus, which makes the buyer side in business-to-business transactions — the side that has driven efficiencies in physical working capital — far less motivated to adopt the same mechanisms to attack financial working capital.

Put starkly, buyers hold the upper hand in almost any commercial relationship. Absent a monopoly, buyers have choices, sellers have competitors. Buyers have every motive to create rich information transparency — that is, clarity — between their own operations and those of their suppliers. To date, however, they have had no such motivation to create clarity at the level of accounts receivable/accounts payable interaction with their suppliers.

The reason is simple: Financial working capital is traditionally a zero-sum game. The seller has to finance his buyer about 90 percent of the time. There is more working capital finance in corporate balance sheets than in the banking system for the simple reason that from a buyer’s perspective, it is free.

Of course, it is not free. The seller’s cost of financing receivables is an element of his cost of goods sold to the buyer. But that is not a cost that is visible in the buyer’s accounting. His books look better to the degree his payables are larger and slower than his receivables. In fact, if aggressive enough, a firm can run on negative working capital, effectively financed by its suppliers and customers.

From a systemic perspective, the only winners in this game are the financial intermediaries who price and ration the working capital shortfall in the overall economy.

Total working capital management represents the extension of information logistics beyond the physical supply chain into the financial supply chain. It is the first difficult but vital step toward doing more business with less working capital.

Corporations Must Take the Initiative

The survey report “Electronic Payment Initiatives and the Internet,” published in August 2000 by the Association for Financial Professionals, gives three top reasons, from the perspective of corporations, why business-to-business commerce is slow in adopting electronic settlement of transactions. First, electronic payments systems are not integrated with the accounting systems which hold the relevant AR/AP information. Second, integrated payments and remittance information cannot be sent and received. Third, linkages between payment and financing and risk management providers are either cumbersome or nonexistent.

In other words, it is easy to manage current cash positions and make electronic payments through the current treasury management services of banks, which are very good at what they do. These services, however, are not very useful for total working capital and risk management across the full purchase-to-pay cycle.

So, what can be done? The technology is now becoming available to streamline AR/AP processes, link the flow of funds to the flow of transaction data, and — by creating greater visibility to future cash flows — give businesses access to a wide array of financing options.

Corporations must create the kind of financial information logistics connectivity with their trading partners and suppliers that they have been achieving in the physical supply chain. Banks can be and must be valuable partners, but their key strengths are as trust agents, liquidity providers, and settlement executors. They simply do not have a deep understanding of the purchase-to-pay cycle as their corporate customers live it.

Corporations themselves must take the initiative to do the following three things:

  • First, implement new Web-based solutions that link accounts payable/accounts receivable systems and payment systems, both within and between firms. The proven techniques for doing this already exists in the financial economy. Wholesale financial markets handle cash settlement using value-dated, pre-reconciled (that is, sum certain/date certain) payment instructions that have been confirmed between the parties after the trade but before the due date. This saves vast amounts of reconciliation and dispute resolution cost, as well as cash liquidity. The same degree of collaboration between buyers and sellers in the real economy is possible at a minuscule fraction of the investments made by the financial economy players by using the Internet.
  • Second, apply Internet technology to overlay a data-rich information flow on top of narrow bandwidth EFT flows. Corporate remittance detail is complex; so are invoice disputes and adjustments. The bandwidth, connectivity, and interactive nature of the Internet make it perfect for collaborative commerce. It is far less suitable for high-value payments. The bank EFT system is actually very efficient at what it does, which is moving debits and credits between bank accounts with minimal data. Payment and remittance data can be integrated through efficient information logistics without having to travel together through the same channels.
  • Third, leverage connectivity and data availability to improve trade terms, risk management, and financing. Today, sellers are almost always involuntarily bankers for their customers. They, in turn, need to finance their working capital largely on the strength of their current balance sheet and historical cash flow. If trading partners can achieve clarity and transparency about future cash settlements between themselves, they lower credit risk to bankers and other providers of working capital.

The goal toward which corporations should be heading is global working capital optimization. This represents a significant step beyond simply managing working capital more effectively. It really does mean, Do more business with less working capital.

Detailed Action Plans

The key concept is to break out of the zero-sum game between buyer and seller over who bears the burden of working capital by using information logistics to better leverage the financial markets, which are awash with liquidity and capital. But before this third side of the working-capital triangle can be brought into play, information logistics have to be introduced into the financial supply chain in a three-step progression.

These are really more detailed action programs building upon the total working-capital management imperatives outlined above.

  • First, undertake pilots with key trading partners to implement interactive Web-based links between accounts payable and accounts receivable systems. Obviously, EDI-enabled partners can do this today, but the Web allows dynamic dispute resolution around the common view of the data. It allows partners to engage in a bid/offer process with an audit trail, so that settlement terms can be agreed, value dated, and even confirmed in advance of settlement. This is a departure from “normal” practice, but normal practice evolved in the absence of tools. Certainty of cash receipt, in terms of amount and timing, is worth a lot to sellers, and buyers who can offer it can extract reciprocal benefits.
  • Second, deploy the information from interactive AR/AP connections internally to manage working capital. Even with sophisticated cash management disbursement and collection services, there is a buffer of underinvested cash to be managed down. Clarity around settlement details, in effect pre-reconciliation and confirmation, can improve the forecasting of cash inflows and outflows beyond statistical models. This clarity can be offered selectively to negotiate better trade terms and prices with suppliers.
  • Third, work with financial intermediaries to better leverage the capital markets to obtain cheaper working capital and to remove receivables from the balance sheet. Clarity about future cash flows between trading partners impacts the credit risk profile of borrowers, especially borrowers with sales to strong, highly-rated companies. This can change price. Value dated, confirmed payment obligations can easily be turned into electronic bills of exchange or promissory notes by agreement between the counterparties. Such simple credit instruments are far cheaper and easier to finance in the markets than more-complex receivables-backed securitizations.

To drive home this capital markets point, the Internet allows us to “miniaturize” proven wholesale financial market confirmation and settlement technologies and make them available across the real economy.

The U.S. security markets turn over the equivalent of the entire GDP every week. Markets settle using about $1 in cash balances for every $250 value exchanged, most of that in free daylight credit. The real economy turns over the $9.2 trillion in GDP on about $1.6 trillion in net working capital, a leverage ratio of less than six. These are very different markets, but the scope for systemic improvement is nonetheless compelling.

There are only two levers for global working capital optimization:

  • First, speed it up. Optimize throughput using information logistics. For example, aggregate figures for the economy suggest an average DSO of about 57 days. Elimination of printing, mailing, and re-keying times should be able to knock DSOs down by 10 percent if invoice data was online. Process savings from dispute resolution, fewer processing errors, and pre-reconciliation are incremental benefits on top of the time value of money from speeding up the cycle.
  • Second, get it off your balance sheet. Firms are increasingly selective about the uses to which they put their balance sheets. They want to get out of the business of financing other peoples’ working capital.

However, the current receivables securitization technology was really built for funding mortgages and other long-term cash flow loans. It is too cumbersome and expensive for short-term capital loans. If corporations can use information logistics to create greater clarity around settlement and trading relationships, it will be up to buyers to grant that degree of certainty, and the ability to make it visible to finance providers, to their suppliers. This will be a valuable quid pro quo to negotiate better trade terms.

Moreover, by doing so, corporations will be giving the financial services provider a far finer, more granular, forward view of credit, default, and dilution risk. These are the raw materials for leveraging the creativity and appetite of the global capital markets to reduce risk and thereby the cost of financing working capital.

This program for optimizing global working capital is both ambitious and difficult, but the same could be said for the deployment of information logistics in the physical supply chain before the great gains of the last 20 years. Many of the necessary tools are coming into place, but no one supplier can provide the whole solution, and the benefits will be achieved only through unprecedented levels of information transparency and collaboration. This program can be made to work given the will and the focus of leading financial professionals. It is really up to you.

This article is adapted from Bernard De Groeve and Kevin Mellyn’s presentation to the annual conference of the Association for Financial Professionals in November 2000 in Philadelphia.

Questions for Your Management Team

First, a simple question of financial efficiency: Are we really making the best strategic use of our balance sheet? Specifically, do we really know how much working capital is tied up in our purchase-to-pay cycle, end to end? How much of this is financial working capital — AR/AP financing?

Second, do we really know the costs we are paying for the lack of clarity in the AP and AR relationships with our trading partners? Are the real costs of disputes, cash buffers, credit risk of buyers, and lost discounts fully understood? What scope for improvement are we foregoing in terms of trade terms and financing costs? Is this more or less than what we would have to invest in order to achieve settlement clarity?

Third, do we have the right technology strategy and initiatives in place to optimize our working capital? Do we have a common framework like global working capital optimization to integrate and leverage our information logistics efforts across key functional areas, including procurement, manufacturing, distribution, and — yes — treasury operations?