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Wisdom Technology

The role of the treasury function within an organization is changing. The department is expected to play a wider role in strategic decision-making, adding value to the corporation. Treasury managers are expected to not only manage corporation cash, but also contribute to shareholder value. New technology brings new tools for treasurers to the table.

Historically, treasury has been mainly responsible for ensuring the liquidity of the organization while limiting risk. This is still part of treasury’s key objectives. However, adding value to the corporation wherever possible has moved to the forefront. Technology has helped treasury personnel do their jobs better – more effectively, more efficiently, and with less chance for error. As a result, technology implementation has been increased in corporate treasury departments in recent years.

Information technology was originally introduced into the treasury function to provide for automated exchange of treasury-related data between financial institutions and their corporate customers. It became even more prevalent in treasury with the introduction of treasury workstation technology in the early 1980s. Treasury workstations have provided information centralization for treasury and allowed many practitioners to replace multiple treasury systems with a central cockpit capable of maintaining treasury data, reporting pertinent information, and facilitating key daily treasury tasks.

Another player in the treasury technology arena is the ERP system. These systems are not treasury-specific, but are concerned with collecting, sharing, and managing data across an organization to automate business processes.

Finally, there is software that employs nonlinear optimization technology to decrease costs and increase returns associated with short-term cash management. Introduced only recently, this technology shows strong promise in increasing the efficiency of the daily cash management process. It provides decision support, freeing the treasury practitioner from tedious hand calculations so that he or she can focus on more strategic tasks.

With all of these technologies, treasury management is approaching the concept of straight-through processing – being able to poll information, consolidate it for reporting purposes, make optimal decisions based on it, and execute the resulting transactions, all automatically. While many treasuries still employ multiple systems and paper-based processes, the desire for simpler, faster, more cost-effective solutions is moving the field toward the use of innovative information technology products including optimization technology.

Why is Optimization Technology Needed in Cash Management?

Corporate short-term cash management is a difficult task. In a few hours each morning, cash managers must review overnight transactions, assess the corporate cash position, and make determinations on whether to invest or borrow, with whom and for what terms. Under pressure to get things done before rates change and offerings disappear, many less-than-perfect or “suboptimal” decisions can occur, costing a corporation many thousands of dollars. The daily corporate cash management process typically involves the following steps:

• Review prior day’s balance and transaction details on core bank accounts.
• Prepare the cash position based on today’s opening available balance and forecasted current day transactions.
• Collect and review interest rates on available instruments.
• Set today’s borrowing or investing strategy.
• Verify that today’s transactions will not cause portfolios to violate investment policies or debt covenants.
• Initiate financings or investments.
• Monitor today’s cash position.
• Prepare the next day’s cash position.

Currently, the majority of these steps are done by hand meaning that the cash manager pores over printouts and uses spreadsheets to do calculations before making decisions. While this process forms the basis of standard cash management, it is simply not sufficient to cover the range of investing and borrowing options available on any given day. It is important that every dollar of a corporation’s short-term portfolio is where it needs to be to maximize return or minimize cost, every day of every month.

Why is this such a difficult problem? One reason is that in order to minimize cost or maximize return for the corporation, the cash manager needs to look beyond today’s transactions over a longer-term planning horizon. In some cases, it actually benefits the corporation to take a suboptimal position for a given day in order to set up strategies that will provide the most benefit in the future. So, in order to perform a thorough analysis and find the most optimal strategies, a treasury practitioner would have to analyze all of the possible combinations and permutations of investment and borrowing transactions that could be initiated over a 30- to 60-day horizon. Further, this analysis would need to be done each and every day. This analysis includes making decisions about how many transactions to make each day and what the asset allocation, maturity date, and issuer should be for each one (Figure 1).

To accomplish this analysis in a few hours within a dynamically changing and uncertain environment is simply not humanly possible. Since cash flow forecasts, interest rates, and interest rate projections constantly change, any static borrowing or investing strategies are necessarily brittle and will produce suboptimal results in particular environments. The treasury practitioner needs the computational power of optimization technology.

Although the current practices have been sufficient for creating daily liquidity for corporations for years, without the power of optimization technology tools in treasury, many opportunities are missed and costs are incurred. In particular these financial inefficiencies result from:

• Over-borrowing or incurring the cost to break unnecessary borrowings
• Underinvesting
• Choosing suboptimal tenors for investments and borrowings
• Choosing suboptimal asset allocations or borrowing alternatives due to standard practice or complicated all-in rate calculations
• Violating debt covenants or investment policies
• Being surprised by unforecasted cash flows without the appropriate liquidity buffers or ability to pay down debt
• Exhausting normal borrowing options and being forced to resort to high-cost alternatives or overdraft positions
• Inadequate planning to use options that require forewarning
• Incurring unnecessary or unwanted interest rate exposure

Many of the situations listed above not only create suboptimal financial outcomes for the corporation but also create unwanted and unnecessary risk. Software that can calculate hundreds of scenarios every morning and suggest the optimal strategy not only increases return or decreases cost, but also provides those benefits while decreasing risk and helping to ensure liquidity.

What is Treasury Optimization Technology and How Does it Work?

When applied in corporate treasury, optimization software automates the short-term cash management process. It serves as a decision-support tool for the cash manager, allowing him or her to evaluate hundreds of possible financing scenarios in a matter of minutes.

Using optimization technology, each day the cash manager would check his or her bank transaction reports for any overnight transactions and enter them into the software. The product would then perform the necessary calculations to provide the practitioner with a correct starting balance for the current day. Rates, both current and forward, would then be checked and changes in them, as well as any changes in treasury policy, would then be entered or uploaded into the system. Finally, any updates to the cashflow forecast would be entered.

Once these steps are complete, the cash manager could then execute an optimization, asking the system to recommend the best short-term borrowing or investment strategy for that day. The software would scan the entire short-term financing period and determine what transactions the manager should execute for the current day, calculating hundreds of funding and investing scenarios in minutes.

At the end of this processing time, the software would generate a comprehensive plan that included the best short-term investing or borrowing decisions based on that corporation’s specific financial situation. The manager would then review the plan and accept it, or go back and modify the parameters as needed, and rerun the optimization. Any executed transactions would be entered into the system. The next day, the process would be repeated.

If the optimization software includes simulation capabilities, the treasury manager would be able to make trial modifications to the strategy and to view the financial impact of those modifications. This would be useful when the manager is performing comparative analyses or making financial decisions for nonfinancial reasons. The software also provides sufficient flexibility to allow users to provide a partial strategy or a few transactions, allowing the technology to optimize the remainder of the strategy consistent with those the user has added.

Benefits of Optimization Technology

What is produced by the optimization technology each day is a multiday plan that is optimal given all of the information that is available on that given day. However, due to the uncertain nature of much treasury-related information (e.g., cash flow forecasts, interest rate projections, etc.), the plan needs to be modified whenever relevant information changes. Companies that are conducting multiple rounds of investment or debt per day would update the input information and run the optimization once for each financing. Companies that are conducting a single round of investment or debt per day would perform updates and run the optimization once per day. In either case, the technology is suggesting the optimal multiday plan given a specific set of input information – the best information available at that time.

What are the effects of this multiday planning? In controlled studies optimization software produced the following quantitative benefits:

• Less over-borrowing and underinvestment.
• More optimal asset allocation or exercise of appropriate debt facilities.
• More optimal maturities on both debt and investment transactions for projected cash flow, current interest rate environment, and any future projected interest rates.

Case Study: Tactical Implementation for a Bank Line Borrower

A Fortune 1000 diversified utility was interested in improving the efficiency of their short-term cash management process. The company was a net borrower with a short-term debt portfolio of approximately $500 million divided between two subsidiaries. The first subsidiary’s debt was on a revolving credit line with several participating banks. The other’s debt was from financing acquired through a variety of sources, including a debt sweep and an accounts receivables conduit.

Treasury management approved a test of optimization technology’s ability to cut their borrowing costs. A blind side-by-side treasury operations comparison was run. The cash manager continued with normal procedures for 30 days while identical daily treasury data was fed into optimization software, and the system ran calculations for covering the short-term debt. After 30 days, the optimization software showed an annualized, hard-dollar savings of $406,000.

The optimization software has the capability of being able to evaluate hundreds of cash management strategies in minutes. A typical cash manager manages for the short-term because that is all that he has time to consider. Generally, optimization technology can look out over a longer time horizon, so borrowing or investment decisions that are made for today aren’t necessarily the least expensive that day, but result in a less expensive solution over the entire optimization period, which is the overall goal.

The first subsidiary’s portfolio included a line with a varying fee based on the amount of debt outstanding. The optimization technology was able to calculate all of the effective rates of all the possible debt amounts on that line for the current day and for each day into the future. It then determined the optimal use of that line. The software was also able to manage the LIBOR-based credit facilities (which required “forewarning” or prenotification) to keep them maximally utilized while being careful not to over-utilize them and create an expensive borrowing against the same-day prime facility.

There were two important emergent behaviors in the technology’s management of the second portfolio. First, the company had a securitized line against its accounts receivable. This line had a very favorable borrowing rate but also had a limit to the number of contracts that could be issued against the line in any given month. The technology was able to maximize the usage of that line within the given usage constraints. Second, the technology managed the debt sweep line appropriately to allow for both unforecasted cash inflows as well as unforecasted cash outflows. Constraints were set so that the technology kept a certain amount of debt drawn down against the line with the associated debt sweep, so that unforecasted cash inflows could be swept against the debt. On the other hand, it also managed the maturity profile so that the company could pay off debt as the opportunity arose, since it was in a declining debt business cycle. A key observation is that the technology greatly facilitated the management of a variety of complex aspects of this portfolio.

The results that have been cited are not anomalous. In fact, similar results occur when net borrowers and net investors utilize the optimization technology to manage their short-term investment and borrowing.  For additional case studies, please see the longer version of this article at www.CFOproject.com.

Conclusion

Optimization technology introduces a new method of corporate cash management.

The technology augments the current cash management process by allowing treasury personnel to review many more working capital management scenarios than is possible manually. It is a powerful decision support tool that can provide guidance for decisions regarding short-term debt and investment as well as substantial assistance with testing and setting cash management policies and strategies.

Financial optimization technology products go beyond and complement treasury workstation technology in not only storing and organizing data, but also performing analysis on that data. The software makes informed recommendations based on a corporation’s cash position, cashflow forecast, treasury policy, and market rates. It also helps the treasury manager to perform strategic analysis by allowing “what-if” scenarios to be run to see how changes in any of these factors will affect borrowing cost or investment return. The primary benefit is a financial gain, either via decreased borrowing costs or increased investment return. Other benefits include increased forecast accuracy, ensured adherence to treasury policy, and improved decision quality through consistency.