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JPMorgan Xign

Advances in payment processing can enable companies to unlock working capital.

Decades ago, credit card networks transformed B-to-C commerce through electronic settlement of transactions. Today consumers and the companies they buy from would have a difficult time imagining life without “plastic.” Another dramatic change is occurring currently with the emergence of business settlement networks.

A business settlement network dramatically lowers the costs of processing and paying an invoice, but more strategically, it enables companies to unlock working capital through early payment discount programs and more proactive management of payables and receivables. By tapping the “hidden profits” in accounts payable to increase returns on short-term cash, the business settlement network is giving corporate finance operations a serious makeover.

The Next Wave of Business Settlement

Financial settlement for B-to-B commerce involves the back-office operations associated with delivering a purchase order to a supplier and processing and paying the invoice. With traditional paper-based processing, the financial settlement cycle can stretch from weeks to months and involve a large number of invoices with errors (see Figure 1). These problem invoices further complicate invoice processing and can double or triple settlement-related costs. More importantly, they limit the earnings opportunities from early payment discounts.

Numerous approaches have been employed over the years to streamline portions of the settlement cycle. They include enterprise resource planning (ERP) systems, electronic data Interchange, imaging systems, evaluated receipt settlement and, most recently, electronic invoicing.

While each of these solutions addresses a specific aspect of B-to-B settlement, challenges persist in enabling organizations to quickly realize the operational and working capital benefits of electronic settlement.

End-to-End Visibility
The lack of end-to-end visibility for buyers and suppliers is a major limitation of legacy approaches to electronic settlement. In a paper-based world, suppliers have no way to track payment status in real time.

Organizational Alignment
The lack of focus on process excellence has thwarted efforts to transform financial settlement operations. Success requires organizational alignment across different departments, including accounts payable, purchasing and treasury; but too often these departments are not in alignment.

Constrained IT Resources
In many organizations IT is overburdened with multiple projects, including upgrades to financial and ERP systems or installation of purchasing systems, such as e-procurement, sourcing and contract management, which are viewed more strategically.

Supplier Participation
Supplier participation in electronic settlement initiatives is essential but often challenging to secure. Many suppliers were negatively impacted by an earlier generation of e-procurement systems that were designed with buyer benefits in mind and forced suppliers to lower their prices. Developing a strategy that articulates the substantial benefits of electronic settlement across the supply chain is a prerequisite for success.

Impetus for Change
Finally, electronic settlement has been largely viewed as a tactical solution that streamlines a business process to lower operational costs. Largely overlooked in the analysis, however, has been the significant positive impact on working capital from a business settlement network.

Emergence of the Business Settlement Network

The business settlement network (see Figure 3) overcomes these issues, linking users via the Internet to automate “order to pay” operations for buyers and “invoice to cash” operations for suppliers. A business settlement network facilitates the exchange of settlement-related documents, such as purchase orders and invoices; provides electronic payment to suppliers along with remittance information; and facilitates early payment discounts to reduce days sales outstanding (DSO) for suppliers while lowering buyers’ costs.

Key characteristics of a business settlement network include:

• Universal access to suppliers of every size and level of technical sophistication is ensured, since the only connection requirement is an Internet-enabled PC with Web browser;
• A built-in shared supplier network directory enables every participating supplier to conduct electronic transactions with all current and future buyers;
• Pre-built adapters integrate the business settlement network with the ERP or financial system of record for file exchanges;
• Bank integration supports the file format of the buyer’s bank for handling electronic funds transfer;
• Early payment discount programs provide suppliers with greater liquidity and buyers with cost savings; and
• On-demand architecture speeds time to deployment and reduces IT dependency.

Operational Impact: A Win-Win

By linking the payables function on the buyer’s side with receivables operations on the supplier’s side, a business settlement network delivers compelling value to both trading partners. For buyers, automating manual, paper-based processes reduces costs and compresses the cycle time. In addition, buyers have the opportunity to monetize discounts for early payment that were previously out of reach due to inefficient payables processing.

Unlike an earlier generation of business networks built for electronic procurement, a business settlement network offers suppliers many incentives to participate. Simply providing real-time invoice and payment status – a basic electronic settlement network feature – is a huge benefit.

In addition to business process improvements, companies on both sides of the transaction can improve corporate accountability and compliance through functionality such as electronic notification and detailed reporting. These features enable trading partners to follow the payment trail through the financial supply chain – from the time an order is placed until the payment clears. Furthermore, because it can be deployed rapidly with minimal IT resource requirements, a business settlement network lowers total cost of ownership (TCO). Sprint Corporation, for example, reported that it was able to reduce its TCO by 40 percent with this financial settlement approach (CFO Insights, “Delivering High Performance,” Sutcliff, Donnellan; John Wiley & Sons, 2006).

New Paradigm for Optimizing Payables-Related Working Capital

For most treasury organizations, the prevailing working capital strategy has always been to “stretch” payables and earn interest off the float. While the extent to which payables are stretched varies widely by industry and vendor, this approach inevitably has two consequences: 1) it is one-sided, placing financial stress on suppliers, and 2) in today’s interest rate environment, it generates a low return.

The business settlement network enables a buying organization to shift from a “stretch payables” model to an “accelerate for discounts” approach, to drive measurable increases in net income and achieve lucrative cash returns. As part of a 2006 survey of business settlement network suppliers, 85 percent stated that they would always or occasionally accelerate payments for discounts. In discussions with more than 200 Fortune 2000 companies, however, JPMorgan Xign has found that, on average, only 5 percent of suppliers have discount terms. This “discount gap” represents an opportunity to optimize working capital.

By compressing the settlement cycle from weeks to days, the business settlement network makes early payment discounts the norm, not the exception. Not only can the buyer take full advantage of the discounts that are already in place, but the network provides the means to recruit a much larger percentage of suppliers into early payment discount programs.

With electronic settlement, both trading partners have the flexibility to manage working capital more effectively, based on the immediate needs of the business. Buyers can set and adjust benchmark targets to optimize cash earnings, cash return and days payable outstanding (DPO). They can choose to stretch or accelerate payables depending on cash goals and DPO targets. For instance, in a quarter where cash is not as readily available, the buyer has the option of taking fewer discounts in order to maximize cash on hand. In another quarter, when cash is more plentiful, the company can maximize its early payment discounts.

Suppliers have an incentive to offer discounts for prompt payment: the opportunity to accelerate collections and reduce their DSO. This can occur systematically or on an ad hoc basis. For example, to help fund a capital project or meet end-of-quarter financial goals, a supplier might want to accelerate payment for a large order by offering a more aggressive early payment discount. A business settlement network promotes these “dynamic” discounts and provides a mechanism for offering discounts outside the standard term period on a sliding scale.

Real-World Results

The financial incentives to buyers of early payment discounts are compelling. Consider a typical payables environment in which a $100 invoice, based on net 30 terms, is held for the full 30 days. Assuming an interest rate of 5 percent, the company realizes a 0.41 percent return for the 30 days of float. Compare this with an invoice for which the buyer and seller have negotiated a 2 percent discount for payment in fewer than 10 days, or terms of 2 percent 10 net 30. That 2 percent discount works out to an annualized return of 36 percent, or many times that of more conventional short-term investments. And this return on cash is risk-free.

One global retailer achieved dramatic results with electronic settlement by focusing on maximizing early payment discount opportunities across its supply chain. The company increased the number of suppliers offering discounts by a factor of 10. With this expanded program, the company is now earning discounts on 90 percent of spending processed through the business settlement network.

It is entirely possible to establish early payment discount programs that are DPO- and cash-neutral. A Fortune 500 energy company based in the Northeastern U.S. proactively drove early payment programs to suppliers, increasing the number of suppliers offering dis-counts by a factor of nine and discount savings by a factor of five. At its current run rate, this energy company is on track to deliver a 36 percent annual return on short-term cash from early payment discount programs, and contribute a seven-figure sum to earnings. Furthermore, by extending its net terms, the utility was able to self-fund the program and lengthen DPO by eight days.

A Fortune 1000 retailer took a different approach to early payment discounts and achieved favorable results. This retailer had been making immediate payments to a large number of suppliers without payment terms. With the business settlement network in place, the retailer instituted a net 60-day payment policy to encourage early payment discounts. In addition to reducing purchasing costs from these discounts, the retailer has expanded DPO by 24 days and freed up $24 million a year in short-term cash.

Across the board, buyers realize a significant annualized return on their participation in early payment discount programs, with 36 percent being typical for top-performing companies (see Figure 4). By driving as much as 90 percent of business settlement network spending into early payment discount programs with a high rate of return, companies can maximize their working capital to positively impact net earnings and company performance.

Strategic Value of Electronic Settlement

Business settlement networks have evolved to fulfill the promise of automating financial settlement processes for B-to-B commerce. They provide real- time transaction processing on a global basis, and, by accessing the network and its broad functionality through standard Internet technology, they allow companies to enjoy streamlined settlement with fewer errors. Because all transaction-related documents and data travel through the network, there is virtually no manual processing.

Not simply a tactical solution for lowering operational costs, electronic settlement has a significant positive impact on working capital. The savings from optimizing working capital – anywhere from five to 10 times the operational cost savings – can improve net income by up to 5 percent.