The treasury function of the firm might well be best explained in the context of its issue of identification, cash flow. Treasury operations have traditionally focused on two dimensions of business: (1) the settlement of cash flows associated with sales; and (2) the funding of the firm’s general operations. This is in essence a balance sheet focus. A more comprehensive treasury organization has, however, evolved in the past decade in which the focus of management activity has followed the economic factors which drive firm value, corporate wide cash flow. This modern treasury organization focuses on a different financial statement, the statement of cash flows, and is now in the process of adapting to the complex environment and cash flows of the global business. This post describes traditional and multinational treasury management in details. Enjoy this post!
Treasuries have historically focused their organizational form and manpower needs on the labor-intensive process of collections. As illustrated on below graphic, the organization devoted significant resources to the conversion of collections into cash, a constant substitution of one liquid current asset into pure cash. This functional role was passive and reacted to the cash flows which were created by the business; treasury’s role was quite clearly that of an overhead body for funding and settlement. There was no expectation of value-added activity from the treasury organization.
In addition to the basic cash management settlement function, treasury was charged with the funding of the firm. This meant that treasury would plan for and gain access to the funds necessary for the continued growth of the firm. Treasuries therefore worked closely with banking institutions and other credit-granting organizations which would create and maintain adequate access to affordable funding. Capital structure goals were basically the maintenance of a maturity match, the balancing of maturity of the useful life of assets with the funding of the individual obligations. An aggressive treasury organization was one which managed the maturity of the debt portfolio for interest expense—accepting repricing and refunding risks along the way—in the hopes of any competitive advantages which might accrue to the firm through lower capital costs.
Efficient treasury operations consider every element that affects the operating unit’s ability to collect, disburse, and manage the cash resources available to it. This includes the whole cash cycle, from sales to the payment of trade obligations. The following steps must be taken to minimize interest and administration costs:
1. Conserve cash resources.
2. Ensure adequate liquidity at the lowest overall cost for payments.
3. Invest surplus funds for highest return.
4. Protect operating returns from fluctuations in the foreign exchange market.
All within the constraints of maintaining good customer, bank, and supplier relations.
Implementation of treasury is a three-step process: (1) planning; (2) processing and control; and (3) investment and financing. Let’s discuss in more details. Read on…
Cash planning is short- and long-term forecasting encompassing everything that may affect cash flow. It requires timely collection of a great deal of information about inflows expected from recurring and nonrecurring sources, and about obligations that have to be met in the immediate and more distant future. The aim is to match inflows and outflows, thus reducing dependence on borrowed funds to meet maturing obligations. This is particularly important for organizations that are sensitive to daily cash flow and the cost and frequency of borrowing.
Good cash organization is based directly on the time value of money and recognizes that a dollar received and put to use today is worth more than a dollar tomorrow. In practice it means maximum acceleration of inflows, stringent regulation of outflows, and constant diversion of spare cash into profitable investment—not periodically but routinely, every day, and occasionally overnight. Good cash organization makes it normal to meet obligations with funds that were earning interest up to the last moment before disbursement. It also means having funds ready to gain every available advantage by prompt payment.
An integral component of the planning process is a thorough understanding of the firm’s cash flow conversion cycle. The three components of the cycle, days payments outstanding (DPO), days of inventory outstanding (DIO), and the days sales outstanding (DSO), are all indicators of how cash flows move through the business process from cash to sales back to cash.
The cash management process involves the forecasting, timing, and management of receipts and disbursements. With the receipts or cash inflow established, sales and accounts receivable are forecasted. In the disbursement process, analysis is pursued to pinpoint the timing and value of cash outflows. The inflows and outflows are matched as accurately as possible before surpluses of either are used by the financing or investment functions. The firm’s information and control system is integral to this process; timely information is critical for accurate planning of cash flows. The role of information technology in treasury, either domestic or international, is likely the single largest area of concern to treasury organizations today.
(2) Processing and Control
Planning and organization depend heavily on timely, accurate, and detailed information. The first step in matching receipts and disbursements is a detailed and itemized knowledge of transactions. The next stage is to ensure that things happen as they should. That is control. The type of control required depends on whether the treasury function is centralized or decentralized. The degree of centralization is dependent on the size and complexity of the corporate structure as well as the degree of computerization of the financial data. Whether to centralize or decentralize is generally based on considerations such as: (1) industry characteristics, type of business and cash flow; (2) corporation size, type of sale, diversification of business, products, operating locations; (3) complexity of the firm’s organizational structure; and (4) the corporate financial policy.
(3) Investment and Financing
To approach an ideal cash management system, it is necessary to devise and maintain a corporate investment policy that is the best compromise between yield and liquidity. In order to position funds properly, a cash manager must:
- know the amounts of incoming cash from recurring and nonrecurring sources;
- match cash requirements to sources of funds;
- arrange to acquire funds if necessary; and
- formulate short-term investment programs for surplus funds.
The basic objective is to put all cash, over all time periods, long and short, to the best active use. It is easy to lose sight of this overall objective because there are so many factors in a complete treasury management program, and it is easy to become preoccupied with one or two.
Once a consolidated cash position is achieved, timely decision must be made about surplus funds and/or obligations to be met. Concerning surplus receipts, the main criteria are the type of investments (e.g., treasury bills, foreign exchange), date of maturity (24 hours to 6 months), and yield. With regard to disbursement requirements, the Treasurer must decide whether funds are to be generated from the corporate cash flow or externally sourced. The exact nature of the financial vehicle, period of time, and interest rates must be determined. These investment and financing decisions must be viewed in terms of financial risk, flexibility, and opportunity cost. Financial risk measures the ability of the firm to meet future debt service obligations. Flexibility is the company’s ability to alter a course of action in order to meet future unspecified financial requirements in an undefined financial market. In today’s quick changing economic conditions, opportunity cost is an uncompromising yardstick, that is, the maximum profit that could have been obtained had cash been applied to some other use.
Although adequate for the time, the disassociation between the two functions—the lack of a theoretical or managerial linkage between asset management and funding strategy, and the lack of a general financial strategy focus for the firm—have proven inadequate for the modern multinational.
Whereas the traditional treasury activities focused solely on the conversion of collections into cash, the modern view of treasury is a much more proactive management of the entire business process, the management of the cash flows which create firm value. This is an assertive managerial approach akin to a view of the firm as a statement of cash flows. An indirect statement of cash flows divides the cash flows of the firm into three distinct areas: operating cash flows, investing cash flows, and financing cash flows.
This singular document captures the essence of the modern cash management cum treasury management activities:
- “Operating cash flows” are those arising from the true business line. In an indirect statement of cash flows, this is net income from operations plus depreciation less net additions to net working capital (current asset changes less current liability changes). The principal source of cash for investing in long-lived assets is from operations. The fundamental requirement for creating corporate value is by making good investment in long-lived assets. When firms do not generate enough cash internally—through their operations, they either cut investment more drastically than their competitors do or they are forced to turn to external markets for the requisite funding (financing cash flows). The effective management of the company’s operating cash flows is called working capital management.
- “Investing cash flows” arise from the capital investment analysis and acquisition needs of the firm. Firms evaluating new capital asset acquisitions (capital budgeting), mergers, or other independent business unit valuations (much of which historically was out-sourced to the investment banking sector) are conducted within this functional treasury area.
- “Financing cash flows” are those arising from the funding of the firm. Funding decisions such as debt issuance, form, maturity structure, restructuring, and dividend policies would all fall within the analytical and management capabilities of this treasury function.
The statement of cash flow highlights the modern view of the treasurer as a working capital manager. The modern view of treasury extends beyond funding to the full gamut of working capital management, including collections and concentration accounts, debt restructuring, financial risk management, to integrating data systems into the production processes of the firm. Working capital is the money invested by the business in those things—products, services—which are to be sold, and includes money spent on the purchase of materials, the processing of goods, and the overhead incurred for the period that the goods are being processed. In fact, business itself represents the investment of cash. The business therefore recycles cash, turning it into goods, labor, and overhead, so that it can cycle back into cash. The more time it takes to complete the cash-revenue cycle, and the more working capital that is invested during this period, the greater the financing costs and the lower the profits of the firm. Working capital management is therefore the management and funding of a physical/financial process. Mechanically, working capital management is the conversion of:
Although traditionally described as the cash conversion cycle, modern treasury management requires that the activities described here in the cycle of cash to sales to cash be simultaneously managed with the short-term funding cycle on the right hand side of the balance sheet. This integration of asset and liability management in the context of maximizing value-enhanced sales of the business line is the emerging challenge to treasury as a strategic business partner.
This emerging strategic role is a departure from traditional resource commitment in the treasury organization. The traditional functions of treasury have expanded to three with the addition of strategic value; the three treasury activities today are administrative, transaction, and strategic. The administrative activity of treasury, the record keeping and financial statement contribution, has been greatly reduced in recent years by the reengineering of business and financial processes, the redefinition of what data and financial records are essentially needed for record keeping of the past and for record/plankeeping for the future, and the introduction of technology which eliminates much of the work. Transactions activity, the time, manpower, and other resources devoted to the processing and completion of managerial treasury activities on an ongoing basis, is also seeing substantial reduction as a result of the integration of technology into the financial process. It is the third treasury activity, the strategic function, which is as yet the most undeveloped, yet most promising in providing additional value to the firm.
Administration was the consuming activity in treasury in the recent past. Currently, the introduction of technology for the documentation of treasury activities has resulted in a significant reduction in administrative activity burdens, but transaction activity has not been as successfully computerized. A contributing factor to the current dominance of transaction activity has been the expansion of risk management activities of all kinds—foreign exchange, interest, and commodity prices—which in times past was not widespread. The challenge for the treasury of the future is to achieve the goal of increased resource utilization for the benefit of the business—strategic activity—while the total treasury burden continues to contract (the sum of the three activities). The shifting of resources from the traditional administrative and transaction roles to strategic activities will put treasury staff and functions into a business partnership with the other business units of the firm. This is the ideal, and is the goal of treasury managers worldwide.
Although people manage, not organizational structures (or charts), the generic organizational structure used by multinational firms to organize their financial management activities is a good place to start in understanding the multitude of activities required of management. “Typical” organizational chart of a multinational firm’s treasury department—if there is such a thing as typical—might appear as that the functional vice presidents and frequent staffing below the vice president level. The international treasury is actually more “typical” than the superstructure in which it falls.
In principle and in order, the activities focus on the financial strategy and decisionmaking of the firm (corporate finance), the management of the cash flows of the firm (cash management), the funding of the firm (capital markets), the tax planning functions of the firm as they are understood across all functional areas (tax management), and the international financial activities of the firm (international treasury). Obviously there are as many organizational charts and combinations of vice presidents, directors, managers, and assistants, as there are firms, but this minimum requirement list serves as representative of the underlying functional areas required of all treasury departments.
Larger multinational firms will often possess such a large number of foreign subsidiaries and affiliates that they are frequently managed both on the regional level (e.g.; Western Europe and Latin America, Far East, Etc.) as well as by the basic functions (cash management, foreign exchange, and foreign exchange risk management).
Regional treasuries are often needed as an intermediate step between the sparsely staffed foreign affiliate, its dependence on other regional affiliates, and the needs of the parent to coordinate and centrally manage financial and operational activity. However, there is frequently a duplication in responsibility and activity, both between the regional treasury offices and global cash and foreign exchange management, as well as between international treasury and the other first level treasury management activities such as cash management and capital markets.
As firms expand and evolve, the nature of the individual industry of the firm, or the corporate goals of the specific firm, may require that specific treasury functions evolve and expand more rapidly than others:
- U.S.-based multinationals with manufacturing operations in the U.S. territory of Puerto Rico, a special office or director of Section 936 tax management regarding the specific tax benefits under the U.S. internal revenue service code section 936 often are required.
- Firms with substantial cross-border trade or payments with firms domiciled in nonconvertible currency environments may require a full-time staff member devoted to countertrade and other nonmonetary exchange business lines.
- Firms involved in large scale capital intensive projects financed with heavy participations of debt, may create entire treasury staff expertise in project finance.
- Firms that are searching for value-added activities within the firm (spinoffs, restructuring) or from outside the firm (mergers and acquisitions) are developing in-house expertise in valuation and investment banking which was previously outsourced.
- Cash flow can be disrupted by movements in external factors such as exchange rates, commodity prices, and interest rates. Ensuring that these external prices do not adversely impact the firm’s ability to make value-enhancing investments is the domain of financial risk management.
All of these examples reflect the treasury services required of an increasingly strategic, proactive, value-added role for treasury.
A number of trends have emerged in the 1990s that are driving change in the treasury function. The reexamination of business processes, reengineering, the adoption of new technology and electronically linked business partnering, and the changing view of finance’s role in the global firm are now causing drastic changes in the way treasury looks and works.
Activities can be subdivided into three major classifications: administrative, transaction, and strategic.
- Administrative activities focus on the reporting dimensions.
- Transaction activities include working capital concerns (A/R, A/P, etc.), and have themselves fallen under considerable scrutiny in the past few years as firms have reengineered many of their financial functions.
- The strategic dimensions of treasury activities, for example, treasury operating as an internal consultant to line functions or business units, treasury acting as a focal point for intelligence gathering regarding the currency and interest rate positions and sensitivities of major competitors, are all relatively new additions to the role of treasury. They are, however, the primary future direction of treasury managerial resource use and attention.
Treasury may be treated as a cost center, a service center, or a profit center, though the latter is relatively rare and of considerable debate as to its appropriateness. Because most treasury departments are cost centers, they are typically small in manpower resources and large in capital/technology commitments. This point cannot be overstated; treasury organizations today are attempting to expand the scope and sophistication of their activities with higher-powered people, and higher-powered processes. For example, many of the transaction-based activities which have occupied manpower in the past such as the processing of accounts receivable and payable have now been automated. An efficient treasury function today requires sophisticated human and capital resources alike.
Technology is also having real functional and organizational impacts on treasury. The development of real-time systems has had a profound impact on the cash manager’s ability to execute the three-step implementation process outlined above:
- The most important real-time system innovation is that of electronic “data interchange (EDI)“, a cross-industry standard format for data transmission between customers, suppliers, and firms. EDI involves the conversion of paper documents such as purchase orders, invoices, checks, to electronic form. This electronic transmission expedites the processing of all stages of not only the settlement process, but more comprehensively the entire business process. In addition, EDI allows for more accurate and timely information on interfirm transactions, as well as for traditional financial and market data for balance reporting and cash management between the firm and its domestic and foreign banking business partners. Most importantly, EDI has allowed many firms to reduce funds invested in inventory, improve cash disbursement forecasting through more accurate and timely shipping notices, and allowed more disbursement forecasting through more accurate and timely shipping notices, and allowed more precise prenegotiated payment terms with suppliers and customers.
- The second real-time innovation is that of “electronic funds transfer (EFT)” systems. These systems, such as the automated clearing house (ACH) and the corporate trade payments (CTP) systems, allow a much more efficient use of capital resources. These systems, in conjunction with the Society for Worldwide Interbank Financial Telecommunications (SWIFT), allow efficient utilization of financial resources regardless of their physical or time-zone locale. The ability to routinely access and manipulate capital market information and balances—although still somewhat an ideal rather than a reality—can potentially allow the modern treasury to add value by allowing the business to support the same basic operating cash flows with fewer financial resources (financing cash flows).
The final force driving treasury change is globalization; the globalization of the organization, the business, and the financial markets themselves. Outside of the previously identified risks associated with international operations—currency risks—the financial management requirements of the multinational enterprise have essentially doubled the stakes of adequate treasury management.
International Treasury Management
Multinational firms develop their international treasuries as business demands. As the scope of the firm’s global operations expand, so do the specific functions and structures of international treasury. Again, although there are no rules as to the stages of global treasury development, a simple three-stage approach captures much of the variety of developments.
Stage 1. Representative of firms with active exporting and/or importing of goods, the early stages of dealing with international operations typically includes two primary areas:
- Foreign exchange management
- Basic international cash management
The establishment of only one or two foreign affiliates initiates the need to pursue improved cash management as the firm explores repatriation of profits and other cash flow-based decisions. International tax management is often added to the scope of work of the domestic tax management division of treasury, although issues of international taxation are complex and material to the firm’s financial results.
Stage 2. As multinational operations expand, international treasury continues to expand so that it is often duplicating all domestic treasury functional areas:
- Foreign exchange risk management, reporting and analysis of derivative positions
- Multinational cash management, netting, pooling, and bank relations
- International tax management and earnings repatriation
- International capital markets, subsidiary funding, capital structure
It is often at this stage, prior to the firm truly addressing the organizational and functional conflicts, in which many of the worst treasury management practices arise. The firm has outgrown the effectiveness of its managerial structure.
Stage 3. A large multinational firm now reflects both the scope of its global activities through functional areas (foreign exchange, cash management, etc.) but is also highly regionalized, requiring regional treasury specialists or managers in addition to a redefinition of the functional financial overlap and duplication problems arising under Stage #2.
Although foreign currency management, foreign exchange risk management, and international tax management are the most widely recognized unique features of international treasury, managing the cash flow process within the multinational firm is first priority. The fact that many of the cash flows are denominated in multiple currencies (the subject of the following section on currency management) complicates the process significantly. But the complexity of issues in international treasury defies simple categorization.
Note the variety of functional areas which are working in combination in the following sample of an international treasury problem:
In countries such as Italy and Switzerland withholding tax rules will strongly influence the choice of technique. A Dutch company, for example, was confronted with recurring deficit situations of its subsidiaries in Italy. A zero balancing structure would result in intercompany loans from the treasury (located in the Netherlands) to the Italian subsidiaries. The average lending amount over a year would be US$2,000,000 on which 10% debit interest would be charged. On the US$200,000 interest payment, 10% withholding tax (according to the treaty between Italy and the Netherlands) would be deducted. This US$20,000 would result in an actual cost for the treasury because the loan would be financed by a credit facility in the Netherlands, which would lead to the unavailability of settlement opportunities within the Dutch corporate income tax system. Faced with this scenario the company decided to re-evaluate their original zero balancing structure. [“International Liquidity Management: Efficiency Through Creativity“, by Marcel Van Eijk, Treasury Management International, Special Report, 1995].
It is readily apparent that all the financial functions—cash management, foreign exchange management, centralized versus decentralized management and control (the whole, the region, the individual affiliate), disbursements, tax—influence the management process.
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