MARKET REVIEWS
Optimising working capital: THE LATEST SOLUTIONS for sustained financial performance by Nicholas Havoutis, JPMorgan Treasury Services
How would you like to achieve profitability comparable to the days of double-digit, top-line revenue growth? The economy may have tipped the scale away from aggressive revenue streams, yet companies must still grow their bottom line. And some of them are managing to do just that.
According to Stephen M. Payne at REL Consultancy Group,
optimisation is a vital component of corporate strategy.
one Fortune 500 company generated over US$300m more
Charles Swindoll, a theologian, once said that life is 10%
in cash from its operations than the year before. That
what happens to us and 90% how we react. In corporate
1
represented a 21.4% increase in capital availability. The
life, the 10% is economic reality. Working capital
key to this achievement was effective working capital
optimisation can make the difference.
management. A successful business functions like an olive tree. Olive trees are remarkable for their survival skills. Deeply rooted
ECONOMIC REALITY CHECK
in Greek history, their branches crowned the heads of the first Olympic champions. Their longevity is a case study in
As the 21st century started on a sour economic note,
adaptability — they require little water and are easily
working capital efficiency became a vital tool for sustained
uprooted and replanted. Like the olive tree, a business must
performance. With less business activity, companies have
weather the elements of any economic climate. Companies
less access to liquidity from traditional external sources.
must adjust to macro business factors — economic activity,
They also endure intensified pressure from stock market
interest rates, stock market valuations, and regulatory
valuations as a performance measurement. Unable to rely
changes — over which they have little control. Working
solely on top-line revenue growth, companies are focusing
capital performance is fundamental to a company’s ability
on increasing their efficiency. Faced with historically low
to adapt in a challenging economy, because it is both
interest rates and negligible investment yields, treasurers are
independent of macroeconomic factors and firmly within an
adapting their behaviour. They seek to pay down or
organisation’s control. Reducing working capital fuels
refinance expensive debt, identify new cost-effective
success by enhancing economic value added (EVA),
financing sources, and secure higher yields through
regardless of environmental changes. Thus working capital
alternative investment strategies. Furthermore, treasury 33
Working capital management
Some companies prefer to take advantage of the lowLife is 10% what happens and 90% how we react.
interest rate environment to refinance debt. Again,
In corporate life, the 10% is economic reality. Working
select banks are positioned to nimbly respond with
capital optimisation is what makes the difference.
creative alternatives for expanding financing sources. For example, JPMorgan is developing an advanced solution to match shared interests of investors and
continues to extract excess liquidity internally.
borrowers on its own books. The solution leverages
Treasury has become a strategic partner in initiatives to
JPMorgan’s vast book of business and its role as
reduce working capital, such as minimising excess
financial intermediary. An automated program matches
inventory, reducing accounts receivable, and gainfully
a comprehensive set of investment criteria for investors
employing idle cash. Other initiatives include
against the specifications of borrowers seeking to
enhancing the availability and timeliness of
reduce the cost of their current obligations. JPMorgan
information for making the best-informed decisions.
serves as a broker to match investors to borrowers,
Best-of-breed companies are demanding an integrated
effectively offsetting the assets and liabilities on its
set of cash management products. They recognise that
own balance sheet. Depository clients enjoy a wider
to optimise working capital, they must address
array of investment options with higher yielding
inefficiencies across the full spectrum of business and
investment alternatives. Borrowers on JPMorgan’s
financial processes (i.e. order-to-cash, forecast-to-
books can establish direct relationships with potential
fulfilment and purchase-to-pay).
new investors.
SHIFTS IN BUYING BEHAVIOUR SPUR NEW SOLUTIONS
INFORMATION: A PREREQUISITE OF IMPROVED PERFORMANCE
As treasurers rise to the challenges at hand, they seek evolved financial solutions. In response, a few
Information remains a critical aspect of working capital
financial institutions are developing advanced tools
optimisation. First, the treasurer must understand the
that satisfy the new working capital requirements. For
nature and duration of the company’s obligations, as
example, some treasurers are choosing to pay down
well as the positions held by currency and by geography.
debt rather than place cash in low-yielding investment
Then educated decisions can be made for applying
vehicles. As a result, they require zero-balance
liquidity. In a global liquidity structure, information is
concentration structures that automatically apply excess
essential to allocating economic benefit back to
balances to reducing outstanding obligations. A
participating entities. Treasurers, therefore, continue to
handful of banks like JPMorgan are beginning to
place emphasis on improving the reliability and real-time
automate the process for linking a client’s excess
availability of actionable information.
balances to obligations due under the client’s credit
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Here too there are new developments, especially in the
programme. Such solutions give clients flexibility in
area of multi-banking. While banks have long used
specifying the portion of net liquidity to be assigned to
SWIFT as an international standard for consolidating
debt versus investment. Clients have the flexibility to
information across a client’s banking providers, few
designate the percentage of funds to be invested
banks have the same robust capabilities domestically. A
overnight versus longer term.
domestic industry has developed in which external
Working capital management
providers work with banks to consolidate multi-bank
and denominator of Return on Assets (ROA), a key
balance information and concentrate the associated cash
financial-performance indicator.
balances. Such services complement the robust, portal-
Treasurers can enhance EVA by understanding how much
based solutions that financial firms like JPMorgan offer
cash they hold versus how much is optimal, and then by
for consolidating cash flows and applying concentration
employing the appropriate tools to minimise cash on the
structures like pooling and sweeping.
balance sheet. The challenge is to determine the right amount of cash. Unpredictable cash flows, like those related to invoice-based commercial activity, weaken even the best
CASH IS KING: APPLYING THE LATEST TOOLS FOR
cash forecast. The more uncertainty a company faces in its
CASH EFFICIENCY
cash flow, the bigger the cash cushion it requires, and the less efficient its use of cash. Therefore, measuring cash-flow
Companies must be as concerned with minimising cash
uncertainty provides a basis for pinpointing the cash needed
on the balance sheet as they are with reducing accounts
to satisfy working capital requirements.
receivable and minimising excess inventory. In today’s
JPMorgan has been promoting methodologies for
low interest rate environment, it is impossible for idle
analysing cash-flow volatility. The techniques aim to
cash to earn more than the cost of raising it. Therefore,
quantify volatility, then estimate a company’s precise
unused cash has a negative impact on the balance sheet.
cash-cushion requirement. This can prevent companies
Additionally, cash on the balance sheet increases a
from issuing surplus debt or under-utilising cash. At the
firm’s asset base. The combination of low interest rates
same time, cash can be employed for more profitable
and increased assets negatively impacts the numerator
purposes. A simple cash-flow volatility analysis, accompanied by an assessment of a company’s tolerance
Optimising working capital
Exhibit 1
for overdrafts or other consequences, produces a formula for defining cash requirements. For example, JPMorgan’s
Optimising working capital improves the bottom line: - Reduces capital employed - Increases operating income - Reduces interest expense
Cash earnings %
only US$16m of an average US$25m cash held in its operations was profitably employed, with US$9m remaining as an unnecessary cushion.2
Stock price
Capital employed
analysis of one client’s European affiliates showed that
THE SQUEEZE PLAY: BUSINESS PROCESS
Return on capital
REENGINEERING FOR ENHANCED EFFICIENCY Earnings
Total capital
Beyond defining a precise cash cushion, treasurers are zeroing in on the business processes behind commercial-related cash flows. For example, web-
Operating i ncome Interest Income/ expense
Working capital
Fixed capital
based cash management solutions like Electronic Invoice Presentment & Payment (EIPP) reduce accounts receivable to improve efficiency. EIPP enables suppliers
Diagram source: REL Consulting
to dynamically present their electronic invoices through a secure, branded Web site in multiple languages and
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MARKET REVIEWS
Cashing in on efficiency
shifts its lower borrowing cost to finance the working
JPMorgan’s analysis of one client’s European affiliates
capital requirements of its buyers. The arrangement
showed that only US$16m of an average US$25m
also strengthens the relationship between buyer and
cash held in its operations was profitably employed,
seller.3 Companies desire a single source of information
with US$9m remaining as an unnecessary cushion.
on receivables that consolidates details across collection streams, both open account and commercial trade activity. Banks that deliver a complete receivables
multiple currencies. Likewise, payers can review, route
information will greatly aid treasury in optimising
and amend the invoice, as well as initiate payments
working capital.
online. They can also input the payment date, which provides better information to sellers for predicting cash flow. The interactive dispute management capability
ROOTED IN REALITY, FOCUSED ON SUSTAINABLE
can dramatically improve Days Sales Outstanding (DSO).
SUCCESS
By moving the process for initiating and resolving disputes online, sellers can address issues before
Just as the olive tree has continued to thrive by
payments become delinquent. This also serves to
adjusting to its surroundings, businesses must achieve
strengthen client relationships. Further, EIPP’s timely
growth despite the climate of economic and regulatory
information flow accelerates receivables matching,
changes. A strong programme for optimising working
dispute resolution and reconciliation to reduce DSO.
capital roots a company in those activities that add
EIPP is one way to enhance supply chain
economic value and enhance financial performance.
management. Financial institutions that offer an
This is the definition of adaptability in action: the
integrated set of cash management and commercial
ability to adjust in structure or habit to improve one’s
trade financing tools help their clients achieve optimal
condition or relationship to the environment.
results. For example, companies looking to satisfy the working capital needs of their buyers are applying evolved payables financing solutions. In some markets,
Notes:
where credit has tightened, buyers are pushing for term
1. “The Keys to Unlocking Hidden Cash”, by Stephen M. Payne, A Treasurer’s Guide to US Cash
payments on open account rather than by letter of
Management 2002.
credit. Forward-thinking banks are supporting sellers
2. “Rethinking Cash Management” by Mark Beard, published by JPMorgan, July 2002.
with more strategic, portfolio-based buyer-financing
3. “The Commoditisation of Commodities: A Business Model in Transition” by Asif Raza, to be
solutions to address this challenge.
published by JPMorgan in 2003.
Continuing with the example, let’s say a highly rated company (the seller) has a credit policy restricting payment terms to a maximum of 30 days. However, the company’s long-time buyers need 90 days working
Nicholas Havoutis is Senior Vice President and Global Head of Liquidity and Investments at
capital financing. Based on a solid payment history the
JPMorgan Treasury Services in New York.
seller can extend terms from 30 to 90 days by allowing
For further information, please
its bank to discount the drafts or purchase the receivables on behalf of the buyer. Thus the seller
telephone +1 (212) 552 5365 or e-mail:
[email protected] 37
