Best Practice in Working Capital Management

Podcast Transcript

Jacqueline Powell: It’s fair to say, the Covid-19 challenge has amply illustrated why it is imperative for organizations – of all sizes – to abandon paper-based and manual procedures. And to make sure they can safely and remotely access mission-critical systems without being physically present in the office. One of the few benefits of this has been the acceleration of digital transformation and cloud computing adoption.

Hello, I’m Jacqueline Powell, and you are listening to the Payments Podcast. In today’s episode, we are joined by Marcus Hughes, Head of Strategic Business Development to talk with us about how AP and AR automation can influence working capital management and make businesses more efficient.

Marcus Hughes: Hi Jacqui, it’s pleasure to be here.

Jacqueline Powell: So, jumping right into the first question, Marcus, what are the hindrances businesses face when it comes to AP and AR automation, and how do you think working capital management can solve this?

Marcus Hughes: The key pain points are the predominant use of manual, paper-based procedures in Accounts Receivable and Accounts Payable, this results in a lack of visibility and control.

The AP department, which is a mission-critical business unit, faces the challenge of receiving and approving inbound invoices in various formats, ranging from paper invoices to PDFs and other electronic formats. These invoices must be compliant with VAT rules, otherwise businesses cannot claim back tax. Processing large numbers of bulk payment files quickly and efficiently is another challenge faced by most AP departments and these payment files must also be validated to guard against fraudulent transactions.

When it comes to delivering invoices to customers, the AR department must do this quickly, efficiently, and ideally, in an electronic manner. To maximize the likelihood that invoices will be paid on time, the AR team must make sure that all pertinent information is readily available to their clients so that they can easily examine and approve these invoices. It is becoming more and more crucial that AR departments provide their clients with a variety of payment methods. I’d emphasize the importance of offering clients flexible payment choices on merchant websites, given the explosive growth in online sales in recent years. Nowadays that should of course include Open Banking payments, as well as cards.

Jacqueline Powell: Okay, thank you, and could you quickly define for us working capital management and how it can help improve these AP and AR processes?

Marcus Hughes: Yes, certainly the amount of day-to-day operational liquidity which is needed by a firm to run smoothly this is known as working capital. Therefore, one of the most important duties of CFOs and their finance team is working capital management. So, cash, receivables, payables, and inventories make up the four primary elements of working capital.

Managing that working capital is about ensuring that a business can fulfill all its financial commitments as they fall due while also enhancing the financial performance of the company by controlling its cash, receivables, payables, and inventories in an efficient manner. As a result, borrowing costs are reduced, and the financial return on any extra plus funds is increased.

The effectiveness of an organization's working capital management is often assessed using four key performance indicators, all of which must be carefully balanced, it’s quite a delicate balancing act. First, reduce Days Sales Outstanding (or DSO) by speeding up incoming cash inflows from sales. In addition, a company will postpone or delay, within reason, the cash outflows needed to settle supplier invoices; this is known as increasing Days Payables Outstanding (that is, DPO). So, DSO and DPO are important indicators of a company's working capital management. In order to optimize working capital, a CFO would often lengthen supplier payment terms wherever possible and speed up incoming cash flow on their receivables. Days Inventory Outstanding (DIO), which gauges how long stock is held until it is sold, is a crucial third KPI.

Finally, the Cash Conversion Cycle which is an important measure of efficiency, showing how much capital a business has tied up in its day-to-day operations. Hence, the Cash Convergence Cycle is the timing difference between paying suppliers and getting paid for sales invoices. There’s a simple formula for this important metric is:

Cash Conversion Cycle = DSO + DIO - DPO

The longer the Cash Convergence Cycle, the longer a business needs funding to bridge this timing gap. Reducing the Cash Convergence Cycle improves liquidity and profitability. Working capital techniques like Supply Chain Finance have been developed to optimize working capital and reduce the Cash Convergence Cycle.

Jacqueline Powell: So, If managed properly, it sounds like working capital optimization can really help put finance teams in a better place. Marcus, in your whitepaper on this topic, you talk about the use of technology and process automation to improve working capital and financial performance in AP. Can you dive into this for us?

Marcus Hughes: There are several layers of this process where technology can be adopted. To name a few, we have invoice data capture, invoice validation and invoice approval workflow.

A significant proportion of invoices are now being received as PDFs in North America and Europe and other regions across the world. Most PDFs are "application generated," or created straight from a business programme, such a billing application that creates PDF invoices. The most crucial feature of these computer-generated PDFs, known as Text PDFs, is that the original invoice data is included inside the PDF itself. This data layer can be extracted using AP automation technology and directly mapped from the PDF into an e-invoice format. Text Layer Extraction is the term used for this. An ERP or AP automation system will then receive this data for matching and approval.

The process then moves on to matching and verifying invoices, which involves automatically comparing data from invoices to Purchase Orders (POs) and Goods Received Notes (GRNs), in accordance with pre-established criteria. These POs and GRNs can also be received in paper or electronic format, much like invoices. However, all invoices, purchase orders, and GRNs should have been converted into uniformly structured electronic data at this point.

Since this procedure compares and records precisely what the items or services have been bought, received, and billed, it is crucial for lowering the risk of fraud. In order to detect any potentially fraudulent transactions, this activity will highlight any invoices that do not relate to products or services that have been ordered or recorded as received. To double-check these transactions, an additional approval procedure for payment authorization can be set up. These procedures may be automated, freeing up AP workers to focus on handling exceptions.

The next step is to develop a flexible approval procedure with as many approval levels as needed for invoices which don’t have a matching purchase order. These configurable positions can reflect the transactional value of the invoice or certain chosen suppliers which demand extra attention in this way an AP automation system can be accessed by authorized individuals with the required privileges to examine, approve, and manage exceptions of those invoices.

Jacqueline Powell: Thanks. I’d imagine that would definitely help teams to become more efficient and avoid unnecessary errors or delays. I noticed you mentioned the possibility of fraud if the invoicing procedure is not compared and recorded precisely. Is there more than one way to significantly lower the risk of fraud?

Marcus Hughes: Every firm should be extremely concerned about cybercrime and fraud because more and more businesses and banks are becoming targets of cyberattacks. In fact, in the latest Strategic Treasurer B2B Payments Survey, 30% of companies admitted fraud had been perpetrated where criminal(s) impersonated an existing vendor to update bank account details, which was not detected before payment was sent. This is evidence that scammers are becoming more skilled in how they produce fraudulent invoices and redirect payments. Data verification of invoices can greatly reduce the risk of invoice fraud.

There are several processes that can be easily automated to help with reducing risk, such as checking suppliers lists against fraud databases, as this ensures suppliers are legitimate. Validation of supplier details is important too, so you should always check whether the supplier details on an invoice match your own ERP supplier records. PO and GRN matching will identify whether the goods or services ordered and received reconcile with what is on the invoice.

A beneficial strategy that is increasingly being used in addition to all these practical precautions is the deployment of a cloud-based system to track user behaviour, as well as transactions. This aids in the detection of unexpected activities. A company's layered cyber defence should include this plan as a key component. An effective monitoring system recognizes typical transaction patterns and typical user activity via the use of advanced analytics and intelligent profiling of user behaviour and payments. This information is then applied as the foundation for real-time detection of anomalous and potentially fraudulent transactions.

Jacqueline Powell: Ok, so having covered the basics of working capital optimization, some best practices to engage technology in this process, and ways to mitigate fraud, perhaps you can brief us on the continuing problem of late payments of supplier invoices?

I saw in the Strategic Treasurer survey you mentioned, I saw that 58% of companies said receiving payment within agreed-upon payment terms was the top challenge for their AR teams.

What are the steps the government has put in place to reduce this and how does this affect the cash flow between buyers and suppliers?

Marcus Hughes: A significant issue that is frequently discussed in the media and that many businesses have complained about is the late payment of invoices. Your statistics validate against our Bottomline’s annual Business Payments Barometer too, where we discovered that 84% of financial decision-makers revealed they occasionally pay suppliers late. This is really high and illustrates the severity of the issue.

Unfortunately, commercial invoices, particularly those from small businesses, are frequently paid late in many other nations besides simply the UK. However, organizations may use a variety of technology and best practices to reduce the frequency and impact of these overdue payments.

For years, governments and industry groups have been working to help Small and Medium-sized Businesses to get paid sooner, but they have had only patchy success. In recent years, not just in the UK but also throughout Europe, there have been several significant government measures to prevent late payments.

Back in 2013 in the UK, the Late Payment of Commercial Debts Regulations were introduced to implement an EU Directive. These rules allow businesses to charge customers interest for late payments. Theoretically, this sounds great. However, in practice, it is unlikely that a small firm is going to jeopardize a significant client relationship by applying late payment penalties on their invoices. In the US, most states also have laws offering recourse and protection for suppliers regarding the overdue payment of invoices, but again their effectiveness is only patchy.

A recent example of "good intentions" to go beyond the Late Payment laws is the UK's Prompt Payment Code. This optional initiative encourages companies to intentionally settle payments closer to 30 days than the 60 days permitted by the payment regulations for private sector businesses. As there was little evidence of improvement, the government added another legal requirement in 2017, imposing on larger corporates a Duty to Report. This means that every 6 months companies are required to publish their actual supplier payment performance compared with their standard payment terms. Numerous UK organizations are affected by these Duty to Report regulations and actually examining your own customers' and suppliers' performance reports, which are made available to the public on a helpful government website, can be very instructive.

Jacqueline Powell: Marcus, if so much is being done to reduce late payments, can you explain why you think businesses persist in paying suppliers late, I mean despite recognizing the cash flow pain they are inflicting on their supply chain, especially on smaller businesses.

Marcus Hughes: In every supply chain, domestic or international, there is a built-in cash flow tension between the buyer and supplier. This is because most people making financial decisions follow well-established working capital principles, which dictate that a company should carefully manage its outbound cash flow and put a priority on getting paid as quickly as feasible.

The primary measurement for this activity is the decrease in a company's DSO. In the AR department, reducing DSO significantly accelerates a company's inbound cash flow, which is essential of course to the financial health of any firm. This is a measure of how long it takes a company to receive payment for its invoices so turning to the AP department, it’s obvious that extending DPO benefits a company's outgoing cash flow and prevents the requirement for any extra borrowing that might be needed to pay a supplier. As a result, by delaying invoice payment, a firm saves money on overdraft fees and delays the withdrawal of cash from its bank accounts. This represents effective working capital management from the payer's point of view although not from a supplier’s perspective that why banks have developed a number of by chain finance and receivables finance techniques to resolve this tension between buyer and supplier cashflow needs.

Jacqueline Powell: Thanks, Marcus. That’s interesting. I’d now like to shift the discussion towards data insight. So, earlier we had talked about process automation lending a hand to improve the efficiency of working capital management, and you mentioned the wonders of data analytics and smart data to drive this efficiency. Can you talk more on this for us?

Marcus Hughes: Data has become increasingly important in recent years, to the point that we might almost claim that it is the new green energy for corporations. Intelligent data analytics can definitely boost performance in areas like payables, treasury, and receivables. Despite their great interdependence, these units have traditionally operated in isolation. However, with modern technology and improved data management techniques, these components may be genuinely integrated, enabling data to flow between various systems as well as the ERP, of course.

Treasurers and other financial decision-makers, whether in AP, AR, or central finance, are increasingly relying on data analytics and methods like machine learning and predictive analytics. In-house corporate systems including the ERP, the treasury management system (TMS), as well as AP, AR, and the Customer Relationship Management (CRM) system, include a plethora of data, which is extremely valuable.

But the greatest value comes from merging this in-house corporate data with external banking data and then utilizing dashboards to display a company’s key performance indicators to create a single view, which is a summary of all this data from which financial decision-makers can gain enormously analytical tools that allow them to measure and improve their KPIs, such as DSO, DPO, and the Cash Conversion Cycle of course. The overall financial success of an organization is greatly impacted by this activity

Increasing the accuracy of cash flow forecasting is, as we all know, an important goal for treasury teams. But far too many businesses (apparently around 30% in the UK and the US, according to this year’s Business Payments Barometer), they continue to rely excessively on spreadsheets for this difficult and crucial task. So, it’s of little surprise that more than half of companies in both regions also admitted their cash flow forecasts are seldom accurate.

Utilizing technologies like variance analytics, these cashflow forecasts must be continually compared to actual cash flow. Predictive analytics may be used to increase the precision of future forecasting by studying the variance of historic cash flow predictions. Some of the inbound and outward flows are admittedly quite predictable (like loan repayments on set maturity dates), whereas other elements, like when a client will pay an invoice, are more difficult to anticipate. An effective TMS enables treasury teams to set up automatic sweeps and cash concentration pools in combination with these cash flow forecasts that optimize the working flow of capital management.

With the help of this rich mix of data and analysis, a treasury and finance team can get deeper insights and make better decisions. Throughout the business cycle, advanced methods like artificial intelligence and predictive analytics can be used to analyze historical performance and increase the accuracy of forecasts.

Jacqueline Powell: That’s very insightful, and I imagine helpful for our listeners, thank you, Marcus. As we bring this episode to a close, is there anything you would like to share before we conclude today’s recording?

Marcus Hughes: Yes. As we've seen, working capital is a crucial indicator of how well a company is performing financially.

By enabling unparalleled real-time management and visibility of payables, treasury, and receivables through a single platform that is securely connected to multiple banks, the intelligent use of data can revolutionize how finance professionals operate. The consolidation, automation, and digitization of these activities enable better decision-making and improved financial performance.

Anyone who reads the whitepaper which I’ve written can benefit from a checklist of the main tips given throughout the document which can help in implementing effective working capital management and improved financial performance. Another important way to improve working capital which we’ve not had time to cover in this podcast is to use early payment programs, supply chain finance, and other forms of invoice finance to accelerate cash flow. These valuable financial tools help suppliers to get paid quickly, at the same time enabling buyers to preserve their cash and defer settling their invoices. This creates a win-win for buyers and suppliers. There’s plenty more information on these techniques in the white paper.

Jacqueline Powell: That’s a concise and great conclusion Marcus, thank you. And thank you for joining us today.

Marcus Hughes: You are welcome, Jacqui.

Jacqueline Powell: Well, that brings this episode to a close. But we'll be back soon with more educational insights on the changing payments landscape, but for today… that's all from the Payments Podcast.