Strategies for High-Yield Working Capital in Today's Economic Environment

“Bank lending tightening for large and mid-market firms; small business under substantial borrowing pressure.”

Quotes like this one from the Federal Reserve are by no means unusual these days. The harsh reality of today's economic environment is bringing the importance of managing working capital to the forefront for buyers and suppliers alike. On one hand, purchasing organizations (buyers) are challenged to lower their net working capital by extending their Days Payable Outstanding (DPO), and to obtain the best possible return on their cash in an environment with historically low short-term interest rates.

On the other hand, suppliers are struggling to find sources of operational cash flow, with all of this creating significant liquidity risk in the supply chain. Working together, these factors of elevated risk, lower returns and locked-up working capital are creating a perfect storm of economic pressures.

So, how does a buying organization balance the need to reduce net working capital and raise the return on cash while reducing the supply chain risk created by the tight credit markets? What follows are some simple and practical ways industry-leading companies in energy, entertainment, and consumer goods were able to unlock the value confined in payables to optimize working capital while reducing the risk in their supply chains.

With the impact of the current credit crisis, more and more organizations are emphasizing the importance of a holistic working capital management strategy that minimizes the risk in their supply chain, while still reducing net working capital and maximizing their return on cash — a challenging proposition indeed.

The challenge is two-fold. On one hand, many buying organizations during tight economic times “protect” their own operations by delaying payment to hold on to cash as long as possible. Such an approach defeats its purpose when buyers do not account for the full impact delayed payments have on their suppliers and, ultimately, to their own bottom line. The benefit of this approach to buyers is particularly reduced with the short-term return on cash at near-historic lows.

On the other hand, suppliers of all sizes are under pressure to ensure that liquidity levels and cash flow are sufficient to support their operations, particularly as credit tightens and alternative sources of liquidity dry up or become more expensive. In fact, it is this issue of the credit crunch in general, and how it is affecting businesses large and small in particular, that is putting additional pressure on and adding significant liquidity risk to supply chains in many industries.

World-class companies in diverse industries such as pharmaceuticals, energy, financial services, telecommunications, transportation, etc. have been able to remove supply chain liquidity risk while raising their return on cash and reducing their net working capital using steps including:

1. Discount Management — Gives the ability to use cash to finance supplier early payment — preserving the suppliers' health — while at the same time generating excellent short-term returns for the company.

2. Third Party Financing — Introduces a third party to fund accelerated payment to suppliers at very low rates — again removing supply chain risk — thus enabling the extension of Days Payable Outstanding (DPO) and lowering net working capital needs.

A Gartner study predicts that, by the end of 2009, at least 30% of the Fortune Global 2000 would adopt dynamic early-payment discounting as a standard practice in their accounts payable departments.

Consequently, buyers would not only capture early-payment discounts where available, they would also proactively negotiate discounts with suppliers.

Many suppliers are currently unable to access adequate liquidity and those who can are often forced to resort to high-cost financing options. As an alternative, in exchange for accelerated payment, many suppliers are willing to offer discounts that equate to significantly better return on cash than other short-term liquidity management investment options. For example, buyers can offer to pay a supplier 20 days early in exchange for a 1% discount off the invoice, which represents a quite significant 18.25% APR return to the buyer. The supplier then gets access to the full amount of the invoice less the discount, which reduces their DSO and is not debt on the balance sheet. It is a win for both sides of the transaction.

But, what if there are no such pre-negotiated credit terms?

Buyers and suppliers can negotiate discounts dynamically depending on their cash flow position. In essence buyers and suppliers collaborate with each other and negotiate mutually beneficial payment timing. There are three ways in which Discount Management enables buyers to maximize the benefits of accelerated payment discounts:

1. Monetize missed discounts

2. Optimize discount terms

3. Capitalize on dynamic discounts

While most companies have negotiated early-payment terms (e.g. 2%/10, net 30 — 2% in 10 days, net in 30 days) with some portion of their suppliers, many find that they are unable to take advantage of those early-pay discounts because of the latency inherent in an accounts payable process still drowning in paper. In fact, in a recent survey by Paystream Advisors, almost half of the respondents stated that they know they are missing existing discount opportunities due to latency in the approval process. Half that group reports they are losing at least 30% of their pre-negotiated early-payment discount value.

Therefore, the first step to effective discount management is removing the inefficiencies and latencies in the invoice approval process in order to monetize missed discounts.

One step is to receive 100% of invoices electronically and then automate the routing, workflow and approval of those invoices. The net result is an average invoice approval time reduction from 30 or 45 days to four to six days (as little as one day in the case of PO invoices), which enables much greater capture of existing, prenegotiated discounts.

One large energy company removed the approval latency from its invoicing process and reduced its approval cycle down to an average of five days. As a result, they were able to take advantage of $15 million in pre-negotiated early-payment discounts that had previously been lost (on overall spend of $15+ billion).

While reducing invoice approval time first enables a company to harvest the “low-hanging fruit” of previously missed discount opportunities, it also opens the door to optimize their existing discount terms and capture new ones as well.

With traditional two-part terms such as 2% 10/net 30, an early payment is worth a 2% discount if paid by day 10, but worth nothing if paid on day 11 or later, up to day 30. Similarly, an invoice approved prior to day 10 is limited to a 2% discount, even if it is paid on day three. While such early-payment terms may have been the best option in the days of paper processing, these terms are insufficient to the opportunity presented by electronic invoicing.

Automating the process enables buyers to offer their suppliers accelerated payment at any point on the invoice timeline and can include automatically pro-rating the discount, allowing the buyers to capture the full value that otherwise would be lost.

Discount management enables buyers to capture Standing Early Payment opportunities on a greater proportion of their spend through automated notifications and supplier self-service.

One large computer manufacturer introduced pro-rated standing early-payment discount terms to its supply chain and increased the number of suppliers accepting standing payment terms by over five times, penetrating greater than 30% of their spend.

Finally, while it is ideal to establish early-payment terms with as many suppliers as possible, there are many who do not need accelerated cash flow on an ongoing basis and are not willing to agree to standing early-payment discounts. Depending on the nature of the suppliers' particular businesses, they may have an increased desire for cash at various points in their business cycles. With these suppliers, automated Dynamic Discounting adds value by enabling buyers and suppliers to make opportunistic decisions on payment timing depending on the cash situation.

Dynamic discounting allows buyers to establish offers of discounted early payment to suppliers that are automatically presented whenever an invoice from a particular supplier or group of suppliers is approved. At that point, the supplier has the self-service ability to accelerate their payment whenever they need it simply by clicking a button to accept the discount offer. Essentially, dynamic discounting enables buyers to capture previously missed opportunities to finance suppliers in a supplier-self-service, automated model.

An entertainment industry company utilizes automated dynamic discounting to offer early payment to 100% of their suppliers not on prenegotiated early-payment terms. Rather than relying on suppliers to call them and request early payments, or trying to reach out manually themselves, they employed a “set it and forget it” strategy to automate the process and reap the return with little effort on their part. They have averaged 10% APR return on discounts captured in this supplier self-service model.

The bottom line on discount management is that by removing latency from the invoice approval process in order to capture missed discounts can inject liquidity into the supply chain and earn returns on short-term cash far exceeding alternative liquidity investments.

Following is an illustration that demonstrates that for $1 billion in spend, buyers can earn $4.5 million in discounts — assuming an average discount of 1.25% (~15% APR on avg. 30 days early pay) on 30% of spend.

While Discount Management gives buyers the ability to fund their suppliers' short-term cash flow needs in exchange for an above-average return on cash, many organizations choose to focus instead on lowering their Net Working Capital needs by maximizing their Days Payable Outstanding (DPO). And that is where third party financing fits into the cash management picture. Introducing a third party can inject cash into the supply chain, leveraging buyers' credit strength to offer suppliers financing at rates typically far below their alternatives.

With Supply Chain Financing, the supplier is still paid early, while the buyer pays the invoice at its full net term — thus taking out costs from the supply chain through cheaper financing, removing liquidity risk through accelerated cash flow, and reducing Net Working capital through maximizing DPO.

In practice, a nationwide auto parts retailer with high Days Inventory Outstanding and low Days Payable Outstanding needed to reduce its Net Working Capital. To accomplish this, the retailer employed Third Party Financing as a tool to enable it to extend its DPO without adversely affecting its suppliers. Because of the very low financing rates the third party was able to offer, the impact to suppliers was net neutral in most cases (longer terms offset by cheaper financing = net neutral cost to suppliers). As a result, over a period of six years, this company increased its DPO by 91 days (11% year over year), freeing up $873 million in working capital.

By leveraging the buyer's credit rating and low cost of capital, supply chain financing is able to provide early payment to suppliers at an extremely low rate, often less than half what suppliers can get through other credit sources (e.g. factoring, asset-based lending, and the like). As a result, buyers can extract some of those savings from suppliers through longer payment terms, thus extending DPO and freeing up working capital. For every $1 billion in payables, extending terms by just 15 days frees up $41 million in working capital.

For example, 35% of $1 billion overall spend targeted for a DPO extension of 15 days frees up over $14 million in working capital. At an annualized rate of 10%, that cash is worth over $1.4 million in bottom-line savings.

While the dark clouds of the current economic climate may signify many challenges for buyers and suppliers alike, there is a silver lining. Buyers have a unique opportunity to remove supply chain risk and yield significant returns by leveraging cash flows and discount terms and, when appropriate, injecting third party financing to extend DPO.

Drew Hofler. is Senior Manager, Financial Solutions for Ariba. Ariba Inc is a leading provider of on-demand spend management solutions designed to help users source, contract, procure, pay, manage, and analyze their spend and supplier relationships. www.ariba.com