Thunderbird—The American Graduate School of International Management
CONTENTS
5.1 Introduction 1
5.2 Treasury Management 2
(a) Traditional Treasury 2 (b) Treasury Implementation 3
(i) Planning 3
(ii) Processing and Control 4 (iii) Investment and Financing 4
(c) Modern Treasury 5
(d) Treasury Organization 7
(e) Treasury Drivers 9
5.3 International Treasury Management 10
(a) Stage 1 10
(b) Stage 2 11
(c) Stage 3 11
5.4 International Cash Management 12 (a) International Cash
Management Goals 12
(b) Mechanics of International
Cash Management 12
(c) Techniques for Effective
Deployment of Funds 14
(d) Barriers to Effective Inter-
national Cash Management 15 5.5 Foreign Exchange Management 15 (a) Risk Management Guidelines 16 (b) Front-Office/Back-Office
Division 17
(c) Position Monitoring and
Performance Measurement 17 5.6 Summary: The Emerging Value-
Added Role of Treasury 18 SOURCES AND SUGGESTED
REFERENCES 18
5.1 INTRODUCTION. The financial management of the nonfinancial firm is tradi- tionally divided between treasury activities and controller activities. Simplistically, this is a distinction between cash flow(treasury) and financial reporting(controller).
Controller activities such as end-of-month closings, internal reporting and forecast- ing, and external financial reporting have become increasingly automated. Continu- ing advances in the field of information technology, combined with the increasing focus by management on the future rather than the historical details of the account- ing past, have led to a larger role for treasury within financial management.
*Additional research assistance was provided by Timothy Magnusson.
As firms have expanded the global scope of their operations, and as global finan- cial markets have increased their pace and volatility, the complexity of international treasury has expanded exponentially. Globalization, combined with the expanding scope of business reengineering, including the financial functions of the firm, have placed new demands on treasury to add value to the business. Many working in the field of treasury management today might argue that it is an area of significantly un- derdeveloped potential; the treasury function in many firms today is often under- staffed and underinvested. To use the business parlance of the day, the treasury which is not keeping pace with the best practices of the day may be leaving a lot of money on the table.
This chapter provides a detailed overview of the principle purpose and practices ofinternational treasury management. Although it is increasingly difficult to differ- entiate international from domestic treasury, understanding the unique responsibili- ties and challenges presented by multinational operations for treasury management is our primary goal. After explaining the basic dimensions of treasury in practice, we focus on the two areas of most general application: multinational cash management and multinational currency management. Throughout this chapter we suggest main- taining a classical financial focus: Cash flow is king.
5.2 TREASURY MANAGEMENT. The treasury function of the firm might well be best explained in the context of its issue of identification, cash flow. Treasury opera- tions have traditionally focused on two dimensions of business, the settlement of cash flows associated with sales, and 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.
(a) Traditional Treasury. Treasuries have historically focused their organizational form and manpower needs on the labor-intensive process of collections. As illus- trated in Exhibit 5.1, 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 cre- ated 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 organi- zations which would create and maintain adequate access to affordable funding. Cap- ital structure goals were basically the maintenance of a maturity match, the balanc- ing of maturity of the useful life of assets with the funding of the individual obligations. An aggressive treasury organizationwas one which managed the matu- rity 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.
(b) Treasury Implementation. Implementation of treasury is a three-step process:
(1) planning; (2) processing and control; and (3) investment and financing.
(i) Planning. 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 recog- nizes that a dollar received and put to use today is worth more than a dollar tomor- row. In practice it means maximum acceleration of inflows, stringent regulation of outflows, and constant diversion of spare cash into profitable investment—not peri- odically 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 Exhibit 5.1. The Traditional Treasury Function of Cash Management Settlement.
outstanding (DPO), days of inventory outstanding (DIO), and the days sales out- standing (DSO), are all indicators of how cash flows move through the business process from cash to sales back to cash.1
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 financ- ing 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.
(ii) Processing and Control. Planning and organization depend heavily on timely, ac- curate, and detailed information. The first step in matching receipts and disburse- ments is a detailed and itemized knowledge of transactions. The next stage is to en- sure 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 characteris- tics, 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.
(iii) 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 com- promise between yield and liquidity. In order to position funds properly, a cash man- ager must: (1) know the amounts of incoming cash from recurring and nonrecurring sources; (2) match cash requirements to sources of funds; (3) arrange to acquire funds if necessary; and (4) 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 preoc- cupied 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 require- ments, the Treasurer must decide whether funds are to be generated from the corpo- rate cash flow or externally sourced. The exact nature of the financial vehicle, period of time, and interest rates must be determined.
1An example of how important simple planning of cash flow needs can be is that of the United States Postal Service. Through cash forecasting, the U.S. postal service was able to reduce average cash on hand from $7 billion to between $1 and $2 billion in 1995. This, in conjunction with significant changes such as allowing customers to use credit cards and electronic transfers, has resulted in a significant downsiz- ing in the postal balance sheet, and a 1995 profit of $1.8 billion.
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 un- defined financial market. In today’s quick changing economic conditions, opportu- nity 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.
(c) Modern Treasury. 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 di- vides the cash flows of the firm into three distinct areas: operating cash flows,in- vesting cash flows, and financing cash flows. This singular document captures the essence of the modern cash management cum treasury management activities.
• Operating cash flowsare 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 lia- bility 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 inter- nally—through their operations, they either cut investment more drastically than their competitors do or they are forced to turn to external markets for the requi- site 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 budg- eting), 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 flowsare those arising from the funding of the firm. Funding de- cisions such as debt issuance, form, maturity structure, restructuring, and divi- dend 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 work- ing capital manager. The modern view of treasury extends beyond funding to the full gamut of working capital management, including collections and concentration ac- counts, 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 rep- resents the investment of cash.2The 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.3
Working capital management is therefore the management and funding of a phys- ical/financial process. Mechanically, working capital management is the conversion of:
Contract Manufacture Booking/AR Settlement
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Cash Materials Work-in-progress Final goods Shipping Cash 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 ad- ministrative, transaction, and strategic. The administrative activityof treasury, the record keeping and financial statement contribution, has been greatly reduced in re- cent 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 ac- tivities on an ongoing basis, is also seeing substantial reduction as a result of the in- tegration 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 pro- viding additional value to the firm.
As illustrated in Exhibit 5.2, administration was the consuming activity in treas- ury in the recent past. Currently, the introduction of technology for the documenta- tion of treasury activities has resulted in a significant reduction in administrative ac- tivity burdens, but transaction activity has not been as successfully computerized. A contributing factor to the current dominance of transaction activity has been the ex- pansion of risk management activities of all kinds—foreign exchange, interest, and commodity prices—which in times past was not widespread. The challenge for the
2The concept that a business is basically the investment of cash is highlighted by the Ethnic Chinese expression for investment which roughly translates the concept of “investment” as “cash which is asleep;” the problem is always the reconversion of an investment back into cash (waking it up).
3One example of this in practice is American Standard, a U.S.-based multinational which has estab- lished a goal of zero net working capital in order to minimize the size of its balance sheet and reduce cap- ital needs to the bare minimum.
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 tradi- tional 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.
(d) Treasury Organization. Although people manage, not organizational structures (or charts), the generic organizational structure used by multinational firms to organ- ize their financial management activities is a good place to start in understanding the multitude of activities required of management. The “typical” organizational chart of a multinational firm’s treasury department—if there is such a thing as typical—might appear as that in Exhibit 5.3, illustrating 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 decision- making 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 func- tions of the firm as they are understood across all functional areas (tax management), and the international financial activities of the firm (international treasury). Obvi- ously there are as many organizational charts and combinations of vice presidents, di- rectors, 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.
Exhibit 5.3 also illustrates a fairly typical mix of function and geography in the in- Exhibit 5.2. The Changing Resource Use of Treasury Activities: The Evolution of Adminis- trative, Transaction, and Strategic Activity in Treasury Management.
ternational treasury. Larger multinational firms will often possess such a large num- ber of foreign subsidiaries and affiliates that they are frequently managed both on the regional level (in this case Western Europe and Latin America) as well as by the basic functions (cash management, foreign exchange, and foreign exchange risk manage- ment). 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 ac- tivity.4However, there is frequently a duplication in responsibility and activity, both between the regional treasury offices and global cash and foreign exchange manage- ment, as well as between international treasury and the other first level treasury man- agement 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 regard- ing 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 de- voted to countertrade and other nonmonetary exchange business lines.
• Firms involved in large scale capital intensive projects financed with heavy par- ticipations of debt, may create entire treasury staff expertise in project finance.
Exhibit 5.3. Modern Treasury Organization.
4For North American-based multinational firms, it is not uncommon to have intensive subsidiary op- erations in Western Europe and Latin or South America. Regional treasuries representing these activities are therefore common and heavily utilized due to commonality of time zones and market activity. The Far East or Asian Pacific, however, is uneven in industrial and financial market developments, causing many of these same multinationals to manage these individual affiliates on a selective basis, although rarely from the parent office direct.