For all the criticism that rating models and credit rating agencies have had through the years, they are still the most pragmatic and realistic approach for assessing default risk for your counterparties. Of course, the quality of the assessment depends to a large extent on the quality of the model used to determine the credit rating, capturing both the quantitative and qualitative factors determining counterparty credit risk. A sound credit rating model strikes a balance between these two aspects. Relying too much on quantitative outcomes ignores valuable ‘unstructured’ information, whereas an expert judgement based approach ignores the value of empirical data, and their explanatory power.

In this white paper we will outline some best practice approaches to assessing default risk of a company through a credit rating. We will explore the ratios that are crucial factors in the model and provide guidance for the expert judgement aspects of the model.

Zanders has applied these best practices while designing several Credit Rating models for many years. These models are already being used at over 400 companies and have been tested both in practice and against empirical data. Do you want to know more about our Credit Rating models, click here.

Credit ratings and their applications

Credit ratings are widely used throughout the financial industry, for a variety of applications. This includes the corporate finance, risk and treasury domains and beyond. While it is hardly ever a sole factor driving management decisions, the availability of a point estimation to describe something as complex as counterparty credit risk has proven a very useful piece of information for making informed decisions, without the need for a full due diligence into the books of the counterparty.

Some of the specific use cases are:

• Internal assessment of the creditworthiness of counterparties
• Transparency of the creditworthiness of counterparties
• Monitoring trends in the quality of credit portfolios
• Monitoring concentration risk
• Performance measurement
• Determination of risk-adjusted credit approval levels and frequency of credit reviews
• Formulation of credit policies, risk appetite, collateral policies, etc.
• Loan pricing based on Risk Adjusted Return on Capital (RAROC) and Economic Profit (EP)
• Arm’s length pricing of intercompany transactions, in line with OECD guidelines
• Regulatory Capital (RC) and Economic Capital (EC) calculations
• Expected Credit Loss (ECL) IFRS 9 calculations
• Active Credit Portfolio Management on both portfolio and (individual) counterparty level

Credit rating philosophy

A fundamental starting point when applying credit ratings, is the credit rating philosophy that is followed. In general, two distinct approaches are recognized:

• Through-the-Cycle (TtC) rating systems measure default risk of a counterparty by taking permanent factors, like a full economic cycle, into account based on a worst-case scenario. TtC ratings change only if there is a fundamental change in the counterparty’s situation and outlook. The models employed for the public ratings published by e.g. S&P, Fitch and Moody’s are generally more TtC focused. They tend to assign more weight to qualitative features and incorporate longer trends in the financial ratios, both of which increase stability over time.
• Point-in-Time (PiT) rating systems measure default risk of a counterparty taking current, temporary factors into account. PiT ratings tend to adjust quickly to changes in the (financial) conditions of a counterparty and/or its economic environment. PiT models are more suited for shorter term risk assessments, like Expected Credit Losses. They are more focused on financial ratios, thereby capturing the more dynamic variables. Furthermore, they incorporate a shorter trend which adjusts faster over time. Most models incorporate a blend between the two approaches, acknowledging that both short term and long term effects may impact creditworthiness.

Rating methodology

Modeling credit ratings is very complex, due to the wide variety of events and exposures that companies are exposed to. Operational risk, liquidity risk, poor management, a perishing business model, an external negative event, failing governments and technological innovation can all have very significant influence on the creditworthiness of companies in the short and long run. Most credit rating models therefore distinguish a range of different factors that are modelled separately and then combined into a single credit rating. The exact factors will differ per rating model. The overview below presents the factors included the Corporate Rating Model, which is used in some of the cloud-based solutions of the Zanders applications.

The remainder of this article will detail the different factors, explaining the rationale behind including them.

Quantitative factors

Quantitative risk factors are crucial to credit rating models, as they are ‘objective’ and therefore generate a large degree of comparability between different companies. Their objective nature also makes them easier to incorporate in a model on a large scale. While financials alone do not tell the whole story about a company, accounting standards have developed over time to provide a more and more comparable view of the financial state of a company, making them a more and more thrustworthy source for determining creditworthiness. To better enable comparisons of companies with different sizes, financials are often represented as ratios.

Financial Ratios

Financial ratios are being used for credit risk analyses throughout the financial industry and present the basic characteristics of companies. A number of these ratios represent (directly or indirectly) creditworthiness. Zanders’ Corporate Credit Rating model uses the most common of these financial ratios, which can be categorised in five pillars:

Pillar 1 - Operations

The Operations pillar consists of variables that consider the profitability and ability of a company to influence its profitability. Earnings power is a main determinant of the success or failure of a company. It measures the ability of a company to create economic value and the ability to give risk protection to its creditors. Recurrent profitability is a main line of defense against debtor-, market-, operational- and business risk losses. 

Turnover Growth

Turnover growth is defined as the annual percentage change in Turnover, expressed as a percentage. It indicates the growth rate of a company. Both very low and very high values tend to indicate low credit quality. For low turnover growth this is clear. High turnover growth can be an indication for a risky business strategy or a start-up company with a business model that has not been tested over time.

Gross Margin

Gross margin is defined as Gross profit divided by Turnover, expressed as a percentage. The gross margin indicates the profitability of a company. It measures how much a company earns, taking into consideration the costs that it incurs for producing its products and/or services. A higher Gross margin implies a lower default probability.

Operating Margin

Operating margin is defined as Earnings before Interest and Taxes (EBIT) divided by Turnover, expressed as a percentage. This ratio indicates the profitability of the company. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy Operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. A higher Operating margin implies a lower default probability.

Return on Sales

Return on sales is defined as P/L for period (Net income) divided by Turnover, expressed as a percentage. Return on sales = P/L for period (Net income) / Turnover x 100%. Return on sales indicates how much profit, net of all expenses, is being produced per pound of sales. Return on sales is also known as net profit margin. A higher Return on sales implies a lower default probability.

Return on Capital Employed

Return on capital employed (ROCE) is defined as Earnings before Interest and Taxes (EBIT) divided by Total assets minus Current liabilities, expressed as a percentage. This ratio indicates how successful management has been in generating profits (before Financing costs) with all of the cash resources provided to them which carry a cost, i.e. equity plus debt. It is a basic measure of the overall performance, combining margins and efficiency in asset utilization. A higher ROCE implies a lower default probability.

Pillar 2 - Liquidity

The Liquidity pillar assesses the ability of a company to become liquid in the short-term. Illiquidity is almost always a direct cause of a failure, while a strong liquidity helps a company to remain sufficiently funded in times of distress. The liquidity pillar consists of variables that consider the ability of a company to convert an asset into cash quickly and without any price discount to meet its obligations. 

Current Ratio

Current ratio is defined as Current assets, including Cash and Cash equivalents, divided by Current liabilities, expressed as a number. This ratio is a rough indication of a firm's ability to service its current obligations. Generally, the higher the Current ratio, the greater the cushion between current obligations and a firm's ability to pay them. A stronger ratio reflects a numerical superiority of Current assets over Current liabilities. However, the composition and quality of Current assets are a critical factor in the analysis of an individual firm's liquidity, which is why the current ratio assessment should be considered in conjunction with the overall liquidity assessment. A higher Current ratio implies a lower default probability. 

Quick Ratio

The Quick ratio (also known as the Acid test ratio) is defined as Current assets, including Cash and Cash equivalents, minus Stock divided by Current liabilities, expressed as a number. The ratio indicates the degree to which a company's Current liabilities are covered by the most liquid Current assets. It is a refinement of the Current ratio and is a more conservative measure of liquidity. Generally, any value of less than 1 to 1 implies a reciprocal dependency on inventory or other current assets to liquidate short-term debt. A higher Quick ratio implies a lower default probability.

Stock Days 

Stock days is defined as the average Stock during the year times the number of days in a year divided by the Cost of goods sold, expressed as a number. This ratio indicates the average length of time that units are in stock. A low ratio is a sign of good liquidity or superior merchandising. A high ratio can be a sign of poor liquidity, possible overstocking, obsolescence, or, in contrast to these negative interpretations, a planned stock build-up in the case of material shortages. A higher Stock days ratio implies a higher default probability.

Debtor Days

Debtor days is defined as the average Debtors during the year times the number of days in a year divided by Turnover. Debtor days indicates the average number of days that trade debtors are outstanding. Generally, the greater number of days outstanding, the greater the probability of delinquencies in trade debtors and the more cash resources are absorbed. If a company's debtors appear to be turning slower than the industry, further research is needed and the quality of the debtors should be examined closely. A higher Debtors days ratio implies a higher default probability.

Creditor Days

Creditor days is defined as the average Creditors during the year as a fraction of the Cost of goods sold times the number of days in a year. It indicates the average length of time the company's trade debt is outstanding. If a company's Creditors days appear to be turning more slowly than the industry, then the company may be experiencing cash shortages, disputing invoices with suppliers, enjoying extended terms, or deliberately expanding its trade credit. The ratio comparison of company to industry suggests the existence of these or other causes. A higher Creditors days ratio implies a higher default probability.

Pillar 3 - Capital Structure

The Capital pillar considers how a company is financed. Capital should be sufficient to cover expected and unexpected losses. Strong capital levels provide management with financial flexibility to take advantage of certain acquisition opportunities or allow discontinuation of business lines with associated write offs.  

Gearing

Gearing is defined as Total debt divided by Tangible net worth, expressed as a percentage. It indicates the company’s reliance on (often expensive) interest bearing debt. In smaller companies, it also highlights the owners' stake in the business relative to the banks. A higher Gearing ratio implies a higher default probability.

Solvency

Solvency is defined as Tangible net worth (Shareholder funds – Intangibles) divided by Total assets – Intangibles, expressed as a percentage. It indicates the financial leverage of a company, i.e. it measures how much a company is relying on creditors to fund assets. The lower the ratio, the greater the financial risk. The amount of risk considered acceptable for a company depends on the nature of the business and the skills of its management, the liquidity of the assets and speed of the asset conversion cycle, and the stability of revenues and cash flows. A higher Solvency ratio implies a lower default probability.

Pillar 4 - Debt Service

The debt service pillar considers the capability of a company to meet its financial obligations in the form of debt. It ties the debt obligation a company has to its earnings potential. 

Total Debt / EBITDA

The debt service pillar considers the capability of a company to meet its financial obligations. This ratio is defined as Total debt divided by Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). Total debt comprises Loans + Noncurrent liabilities. It indicates the total debt run-off period by showing the number of years it would take to repay all of the company's interest-bearing debt from operating profit adjusted for Depreciation and Amortization. However, EBITDA should not, of course, be considered as cash available to pay off debt. A higher Debt service ratio implies a higher default probability. 

Interest Coverage Ratio

Interest coverage ratio is defined as Earnings before interest and taxes (EBIT) divided by interest expenses (Gross and Capitalized). It indicates the firm's ability to meet interest payments from earnings. A high ratio indicates that the borrower should have little difficulty in meeting the interest obligations of loans. This ratio also serves as an indicator of a firm's ability to service current debt and its capacity for taking on additional debt. A higher Interest coverage ratio implies a lower default probability.

Pillar 5 - Size

In general, the larger a company is, the less vulnerable the company is, as there is, usually, more diversification in turnover. Turnover is considered the best indicator of size. In general, turnover is related to vulnerability. The higher the turnover, the less vulnerable a company (generally) is.

Ratio Scoring and Mapping

While these financial ratios provide some very useful information regarding the current state of a company, it is difficult to assess them on a stand-alone basis. They are only useful in a credit rating determination if we can compare them to the same ratios for a group of peers. Ratio scoring deals with the process of translating the financials to a score that gives an indication of the relative creditworthiness of a company against its peers.

The ratios are assessed against a peer group of companies. This provides more discriminatory power during the calibration process and hence a better estimation of the risk that a company will default. Research has shown that there are two factors that are most fundamental when determining a comparable peer group. These two factors are industry type and size. The financial ratios tend to behave ‘most alike’ within these segmentations. The industry type is a good way to separate, for example, companies with a lot of tangible assets on their balance sheet (e.g. retail) versus companies with very few tangible assets (e.g. service based industries). The size reflects that larger companies are generally more robust and less likely to default in the short to medium term, as compared to smaller, less mature companies.

Since ratios tend to behave differently over different industries and sizes, the ratio value score has to be calibrated for each peer group segment.

When scoring a ratio, both the latest value and the long-term trend should be taken into account. The trend reflects whether a company’s financials are improving or deteriorating over time, which may be an indication of their long-term perspective. Hence, trends are also taken into account as a separate factor in the scoring function.

To arrive to a total score, a set of weights needs to be determined, which indicates the relative importance of the different components. This total score is then mapped to a ordinal rating scale, which usually runs from AAA (excellent creditworthiness) to D (defaulted) to indicate the creditworthiness. Note that at this stage, the rating only incorporates the quantitative factors. It will serve as a starting point to include the qualitative factors and the overrides.

"A sound credit rating model strikes a balance between quantitative and qualitative aspects. Relying too much on quantitative outcomes ignores valuable ‘unstructured’ information, whereas an expert judgement based approach ignores the value of empirical data, and their explanatory power."

Qualitative Factors

Qualitative factors are crucial to include in the model. They capture the ‘softer’ criteria underlying creditworthiness. They relate, among others, to the track record, management capabilities, accounting standards and access to capital of a company. These can be hard to capture in concrete criteria, and they will differ between different credit rating models.

Note that due to their qualitative nature, these factors will rely more on expert opinion and industry insights. Furthermore, some of these factors will affect larger companies more than smaller companies and vice versa. In larger companies, management structures are far more complex, track records will tend to be more extensive and access to capital is a more prominent consideration.

All factors are generally assigned an ordinal scoring scale and relative weights, to arrive at a total score for the qualitative part of the assessment.

A categorisation can be made between business analysis and behavioural analysis.

Business Analysis

Business analysis deals with all aspects of a company that relate to the way they operate in the markets. Some of the factors that can be included in a credit rating model are the following:

Years in Same Business

Companies that have operated in the same line of business for a prolonged period of time have increased credibility of staying around for the foreseeable future. Their business model is sound enough to generate stable financials.

Customer Risk

Customer risk is an assessment to what extent a company is dependent on one or a small group of customers for their turnover. A large customer taking its business to a competitor can have a significant impact on such a company.

Accounting Risk

The companies internal accounting standards are generally a good indicator of the quality of management and internal controls. Recent or frequent incidents, delayed annual reports and a lack of detail are clear red flags.

Track record with Corporate

This is mostly relevant for counterparties with whom a standing relationship exists. The track record of previous years is useful first hand experience to take into account when assessing the creditworthiness.

Continuity of Management

A company that has been under the same management for an extended period of time tends to reflect a stable company, with few internal struggles. Furthermore, this reflects a positive assessment of management by the shareholders.

Operating Activities Area

Companies operating on a global scale are generally more diversified and therefore less affected by most political and regulatory risks. This reflects well in their credit rating. Additionally, companies that serve a large market have a solid base that provides some security against adverse events.

Access to Capital

Access to capital is a crucial element of the qualitative assessment. Companies with a good access to the capital markets can raise debt and equity as needed. An actively traded stock, a public rating and frequent and recent debt issuances are all signals that a company has access to capital.

Behavioral Analysis

Behavioural analysis aims to incorporate prior behaviour of a company in the credit rating. A separation can be made between external and internal indicators

External indicators

External indicators are all information that can be acquired from external parties, relating to the behaviour of a company where it comes to honouring obligations. This could be a credit rapport from a credit rating agency, payment details from a bank, public news items, etcetera.

Internal Indicators

Internal indicators concern all prior interactions you have had with a company. This includes payment delay, litigation, breaches of financial covenants etcetera.

Override Framework

Many models allow for an override of the credit rating resulting from the prior analysis. This is a more discretionary step, which should be properly substantiated and documented. Overrides generally only allow for adjusting the credit rating with one notch upward, while downward adjustment can be more sizable.

Overrides can be made due to a variety of reasons, which is generally carefully separated in the model. Reasons for overrides generally include adjusting for country risk, industry adjustments, company specific risk and group support.

It should be noted that some overrides are mandated by governing bodies. As an example, the OECD prescribes the overrides to be applied based on a country risk mapping table, for the purpose of arm’s length pricing of intercompany contracts.

Combining all the factors and considerations mentioned in this article, applying weights and scoring functions and applying overrides, a final credit rating results.

Model Quality and Fit

The model quality determines whether the model is appropriate to be used in a practical setting. From a statistical modeling perspective, a lot of considerations can be made with regard to model quality, which are outside of the scope of this article, so we will stick to a high level consideration here.

The AUC (area under the ROC curve) metric is one of the most popular metrics to quantify the model fit (note this is not necessarily the same as the model quality, just as correlation does not equal causation). The AUC metric indicates, very simply put, the number of correct and incorrect predictions and plots them in a graph. The area under that graph then indicates the explanatory power of the model. A more extensive guide to the AUC metric can be found here.

Alternative Modeling Approaches

The model structure described above is one specific way to model credit ratings. While models may widely vary, most of these components would typically be included. During recent years, there has been an increase in the use of payment data, which is disclosed through the PSD2 regulation. This can provide a more up-to-date overview of the state of the company and can definitely be considered as an additional factor in the analysis. However, the main disadvantage of this approach is that it requires explicit approval from the counterparty to use the data, which makes it more challenging to apply on a portfolio basis.

Another approach is a purely machine learning based modeling approach. If applied well, this will give the best model in terms of the AUC (area under the curve) metric, which measures the explanatory power of the model. One major disadvantage of this approach, however, is that the interpretability of the resulting model is very limited. This is something that is generally not preferred by auditors and regulatory bodies as the primary model for creditworthiness. In practice, we see these models most often as challenger models, to benchmark the explanatory power of models based on economic rationale. They can serve to spot deficiencies in the explanatory power of existing models and trigger a re-assessment of the factors included in these models. In some cases, they may also be used to create additional comfort regarding the inclusion of some factors.

Furthermore, the degree to which the model depends on expert opinion is to a large extent dependent on the data available to the model developer. Most notably, the financials and historical default data of a representative group of companies is needed to properly fit the model to the empirical data. Since this data can be hard to come by, many credit rating models are based more on expert opinion than actual quantitative data. Our Corporate Credit Rating model was calibrated on a database containing the financials and default data of an extensive set of companies. This provides a solid quantitative basis for the model outcomes.

Closing Remarks

Model credit risk and credit ratings is a complex affair. Zanders provides advice, standardized and customizable models and software solutions to tackle these challenges. Do you want to learn more about credit rating modeling? Reach out for a free consultation. Looking for a tailor made and flexible solution to become IFRS 9 compliant, find out about our Condor Credit Risk Suite, the IFRS9 compliance solution.

The European Central Bank (ECB) recently completed another important step in the supervisory process to assess the management of climate-related and environmental (C&E) risks by European banks. On 2 November, they published the results of their thematic review on C&E risks performed earlier this year.

Do you have difficulties setting out your treasury technology requirements (both from a functional as well as IT perspective), or matching those to the latest capabilities of a modern Treasury Systems? Are you wishing for a technology selection process that is less cumbersome and time consuming? If you said ‘yes’ to any of these, then we might have the solution for you!

Introducing Zanders’ Treasury Technology Selection Service powered by Tech-Select, our proprietary cloud-based Treasury Technology Selection tool designed to give you an easier, quicker way to select a new treasury system that best supportis your specific needs, or to evaluate your current system against other alternatives. For over 30 years, Zanders has been helping organizations globally to select treasury management systems and other related treasury technology. As an independent and unbiased expert, we have built extensive experience into how best to assist our clients to select, implement and deploy the most appropriate solution for their technology needs – it is this insight that drove us to develop a system to modernize the commonly used RfP process.

Zanders Tech-Select is the driving force behind our Treasury Technology Selection Service and accelerates your treasury system selection project by addressing the traditional challenges faced by organizations when choosing treasury technology solutions and introduces several other benefits as follows:

• Provides a broad overview of the systems market, giving you access to a wider range of potential vendors that can provide systems supporting your needs, and the most up-to-date insights on their current capabilities and new product developments
• Allows you to easily identify and define your functional needs, short-list suitable vendors, and automatically create and issue your RfP, by providing access to our comprehensive library of functional and technical requirements alongside our curated database of vendors, system functionality and capabilities
• Facilitates and accelerates multi-user assessment and evaluation of vendor responses, by utilizing workflows for scoring, the ability to assess user scoring differences, and the opportunity to determine final scores for each vendor
• Helps you to understand key differentiators between services and functionality on offer from each vendor, using our pre-defined results analytics and drilldowns
• Helps to streamline and accelerate the RfP process from end-to-end within a single cloud-based platform, removing the need for multiple emails, spreadsheets or complex scoring models, and
• Reduces the resource and time investment required to engage with multiple vendors, freeing you to focus on key analysis and value-add activities

Let’s take a deeper look at how Zanders Tech-Select achieves this:

• Once you’ve chosen from Zanders Tech-Select’s comprehensive library of functional and technical requirements, these are matched to our curated database of system functionality and capabilities in order to present you with a shortlist of systems and vendors that are suited to your specific needs. You can then select which of those vendors you would like to invite for your RfP process, utilise our templates to create cover letters and other attachments, and specify deadlines for acknowledgement, Q&As and final responses.

• When you are ready to launch your RfP, you simply click the ‘Issue’ button to automatically generate RfP invite emails quickly and easily to all chosen vendors. Once they receive the invite, vendors can use Zanders Tech-Select to access all document attachments, view your requirements, ask any questions, and respond to the RfP. 

• Once vendors have completed submitting their RfP responses, multiple users from your treasury, finance, IT and procurement teams can use Zanders Tech-Select to independently compare each vendor’s responses to each requirement in a consolidated view, and can assign scores to each. When all users have completed their scoring, the system automatically consolidates their scores and provides you with the opportunity to review and moderate the final scores before moving forwards to analyze the results. 

• At the final stage, Zanders Tech-Select’s interactive results analytics provide you with several ways to view and drill down into your results. Simply hover over data points to see more detailed information, check or uncheck to include or exclude vendors, sections and subsections, or most importantly click on specific scores to drilldown and quickly understand the reasons behind any scoring differences between vendors.

Based on experience from our clients, Zanders’ Treasury Technology Selection Service powered by Tech-Select drastically improves the current RfP processes many corporates are using today.

Zanders is unique in offering a system selection solution that includes an extensive library of the most common technology requirements alongside pre-populated and curated responses from over 90% of the leading treasury systems currently on the market. The structured, end-to-end process helps to streamline and automate your selection project and is applicable to a wide variety of use cases, enabling a consistent approach to vendor selection based on objective and rigorous evaluation.

Zanders Tech-Select uniquely provides the most efficient, thorough and cost-effective digital selection service within the treasury space, with Zanders experts to guide you throughout. If you would like to find out more about how Zanders can help to streamline your next technology or service selection process, get in touch now.

Article updated in May 2024

With year-end approaching quickly it is a natural moment to look back, zoom-out a bit and look forward to the coming year(s). Last year was, for most treasurers, a bumpy road. We witnessed another year with uncertainty and volatility in the financial markets due to the residual effects of the pandemic; the impact of the War in Ukraine; and rising inflation, interest rates and commodity prices. In this context, Corporate Treasuries are continuously facing internal and external challenges, and therefore need to operate in an increasingly complex and uncertain environment. Based on these challenges, we have identified four main Treasury themes for the year 2023 which are interlinked with each other and will be addressed in more detail in this article:

On one hand, the trend towards ERP system consolidation has progressed, most companies have centralized all their global entities and processes in a single environment with unique master data. At the same time, the trend towards cloud solutions has brought innovation and increased competition also to the TMS area. In this context, we are often asked: should the treasury function follow into the centralized ERP solution as well, or does a separate TMS instance have its justification?

Nowadays, all established TMS solutions are also available in the cloud or have disappeared from the market. The cloud technology brings disruption to the TMS market – high scalability of the cloud solutions has brought a number of new players to the global market – originally regional leaders seek to expand their footprint in other regions, some of them challenging the traditional market leaders. Established cloud TMS providers expand their functional covering in a very high pace and at relatively low marginal costs, which leads to increased competition in both functional capabilities and pricing.

In the segment of companies with more than USD 1 billion revenue, SAP occupies a special position among both ERP and TMS vendors (see numbers here) – it offers both a leading ERP system and a TMS with very broad functional coverage.

Benefit areas

In what areas can you find the benefits from integrating the TMS into ERP? We list them for you.

1. Process integration

Treasury is usually involved closely in the following three cross-functional processes, with the following implications:

(a) Cash management

Short- and mid-term cash forecast reflects accounts payable and accounts receivable, but purchase and sales orders can also be used to enrich the report. Even when commercial accounts are cash-pooled to treasury accounts, expected movements on these accounts can be used to plan cash pool movements on treasury accounts.

(b) Payments

Various levels of integration can be found among the companies. While some leave execution of commercial payments locally, others implement payments factories to warehouse all types of payments centrally. Screening against payment frauds and sanction breach is facilitated with centralized payment flow. Centralized, well-maintained bank master used at payment origination helps to avoid the risk of declined payments.

(c) Exposure hedging

FX and commodity hedging activities are usually centralized with the treasury team.

In case FX or commodity exposure arises from individual purchase and sales orders or contracts, the treasury team needs tools to be directly involved in the exposure identification and hedge effectiveness controlling.

2. System integration

Streamlined processes described above have implications for the required system integration. Depending on frequency and criticality of the data flows, different integration approaches can be considered.

All TMS on the market support file integration with the ERP systems in a reasonable way. They are also often very strong in supporting API integration with trading platforms and bank connectivity providers, but usually lag behind in API integration with the ERPs. Claims of available API integration need to be always critically reviewed on their maturity. API integration is preferred.

What are the benefits of API-based integration?

• It offers real-time process integration between the systems and empowers treasury to be tightly integrated in the cross-functional processes. It can be important when intraday cash positions are followed, payments are executed daily or exposure needs to be hedged continuously.
• It keeps the data flow responsibility with the users. Interfaces often fail because of master data are not aligned between the participating systems. If message cannot be delivered because of this reason, user receives the error message immediately and can initiate corrective actions. On the other hand, file-based interfaces are usually monitored by IT and errors resolution needs to be coordinated with multiple parties, requiring more effort and time.

Figure 1 Usual data flow between ERP and TMS

3. Parallel maintenance of master data

Integration flows require harmonization decisions in the area of master data. Financial master data (G/L accounts, cost centers, cost elements) are involved as well as bank master data and payment beneficiaries (vendors). TMS systems rarely offer an interface to automatically synchronize the master data with the ERP system – dual manual maintenance is assumed. Using one of the systems as leading system for the respective master data (e.g. bank masters) is usually not an available option.

4. Redundant capabilities

Both the ERP and TMS systems need to cover certain functionalities for different purpose. ERP to support payments and cash management in purchase-to-pay and order-to-cash, while TMS supports the same in treasury process. Both systems need to cover creation of payment formats, reconciliation of electronic bank statement, update of cash position for their area. These functionalities need to be maintained in parallel, or specific solution defined, to avoid the redundancy.

Conclusion

So, should the treasury function follow into the centralized ERP solution as well, or does a separate TMS instance have its justification? The answer to this question depends strongly on your business model and the degree of functional centralization. If functional centralization and streamlined business operations across your global entities is important in your business, you are probably already very advanced in ERP centralization as well. You can expect benefits from integrating the treasury function into such system setup.

On the other hand, if the above does not apply, you may benefit from the rich choice of various TMS solutions available at competitive prices to fit your specific needs.

Every business runs differently. We are happy to support you in your specific situation.

Having to do this as part of a transaction where part of an existing business is being sold adds a major challenging element: time.

Time pressure together with the uncertainty of who will be the ultimate buyer (Financial Investor vs. Strategic Investor with an existing treasury function) requires many key decisions to be made under uncertainty. One of these key decisions is the one about the Treasury Management System (TMS) and the corresponding functionalities that have to be available on the closing day of the transaction. This decision has two components: costs and time to go-live.

Considerations

Technical developments in recent years have led to a situation where basic functionalities can be provided in-time by deploying a standard TMS at a cost not higher than any individual spreadsheet-based solution provided by consultants. Therefore, it has become a standard that an integrated TMS is a must-have for Day-1. It provides cash visibility and forecasting, captures both internal and external financial transactions and valuates them for period-end closing, therefore a TMS is the main Treasury Enabler.

With the time remaining until closing usually being quite short (often not more than 3-6 months) the question regarding the long-term strategic fit however has been one of minor relevance. This was and still is the case when the ERP-System is SAP-based. Until now, SAP treasury and risk management and cash and liquidity management components have not been part of the shortlist for transaction related TMS requirements. Three major (valid) arguments have been the reason for this:

• Cost,
• Complexity and therefore the longer duration time for an SAP implementation
• & Usability, especially by treasury staff that are not necessarily familiar with SAP logic.

But every major technical development requires us to question existing narratives and ask whether certain arguments are still valid.

Making the Right Strategic Choice
Usually, SAP has been dropped from the discussion when an implementation time constraint of between 3-6 months exists. The same applies if the future ERP landscape hasn’t been decided upon. This uncertainty often leads to the decision to opt against SAP. Let’s start with this element. A feasible solution to overcome this uncertainty is that of a Treasury Sidecar, i.e., implement a separate SAP instance with the SAP Treasury components. This allows connection to the existing (SAP) landscape, as well as providing the option of a future migration into a single S/4HANA environment and mapping treasury to the new General Ledger. This means that there should be no strategic or technical reason not to consider SAP.

We also looked at the latest SAP Treasury developments regarding the cloud-based SAP S/4HANA Treasury components from a time perspective. We specifically looked at the Private and Public Cloud Solutions from two angles: What is the minimum implementation time considering that SAP Best Practices are applied and secondly what are the consequences when looking at the integration into either an existing SAP ERP Central Component (SAP ECC) environment or a future S/4HANA platform? What our evaluation revealed is quite astonishing.

Public or Private Cloud?
When looking at the tight timeline argument against SAP we should examine the two main alternatives: the public cloud solution and the private cloud alternative. The private cloud can be considered similar to an on-premise installation, with the main difference being that the private cloud solution can be hosted by SAP or built within in your own data center. A private cloud could also use one of the Infrastructure-as-a-Service (IaaS) providers, such as AWS, Azure, GCP, or Alibaba Cloud.

These alternatives have the advantage of a fixed timeline (3-6 Months) for their implementation based on SAP’s Best Practices approach, together with SAP’s Activate. A requirements gathering is still the starting point to call out what is included in the first phase during its 3 months of implementation. This phase delivers a comfortable solution based on an 80/20 approach and covers what is usually required on Day-1.

Pros & Cons of the Cloud Options
A typical question is: what can’t we do if we opt for either the public or the private cloud? The answer is quite simple: The public cloud is a common environment with restrictions on building what is not already there – i.e. a gap identified is a real gap (and remains so). The private cloud is much like an on-premise solution with certain variations – like the SAP hosted option – where additional restrictions apply in terms of how far you can go about extending functionality.

Building a treasury side car and applying SAP Best Practice and the SAP Activate methodology, and following them closely, leads to similar implementation times for both public and private cloud (or on-premise) options, given that the same functionalities are to be implemented. This means, that implementation duration is not a major decision point. This leaves one key decision element: the question is, what type of flexibility & functional requirements – beyond what’s available in the public cloud solution – are required in the future?

The answer to this may lead to adopting an implementation approach very much like public cloud but in a private cloud (or on-premise) environment in order to get the flexibility needed to extend and expand for the future.

So yes, there is a new kid on the block, and it has to be taken seriously.

Greg Williams, senior manager at Zanders, tells us what this is, how it can accelerate implementations, and informs us about new developments in 2023.

In previous articles we covered a perspective on the different types of deployment options available for SAP S/4HANA – i.e. On-Premise, Public Cloud and Private Cloud. In this article we look to provide insight into how to leverage SAP’s Activate implementation methodology and Best Practice content to accelerate your adoption of SAP’s S/4HANA treasury capability.

Previously, SAP had what they used to call ‘rapid deployment solutions’ (RDS) and content to aid implementation. But the replacement SAP Activate approach is a far more complete way to build and deploy systems. It has also evolved and matured over the years, since the first release in 2015, so it is important to keep up-to-date. The offering is now supported by very rich and mature Best Practice content that includes detailed business process documentation and test scripts.

Implementation Methodology

SAP Activate is an agile methodology that leverages the various accelerators mentioned above. In reality, most implementations will not necessarily adopt the full methodology completely, only taking what is relevant to them. However many aspects of it should be leveraged in formulating some type of hybrid agile / waterfall methodology for a treasuries implementation project – based on all of the complex real-world factors that any given organization has to accommodate.

In this article we will provide some insight into the SAP Activate elements and methodology and then look at it from a treasury perspective, examining the treasury specific scope items included in SAP’s Best Practices run-through. We will drill down into the specific detail so that you get a feel for both the breadth and depth of what SAP has to offer.

This will be like a visual tour from the highest level, with lots of graphs to come, through to the lowest level of detail. The key thing to remember is that the Best Practices content and SAP Activate methodology is applicable to the full array of system functionality and herein lies the benefit in that all parts of the business embrace this same content and approach.

SAP Activate

First let’s have a brief look into SAP Activate. Starting with the elements that are included and then looking at the phases in the project lifecycle, which will give greater insight into the methodology. The elements are:

• the methodology,
• tools, which are very much supported by SAP’s Solution Manager,
• & then the content, including for example the Best Practices advice, which we will unpack a bit later.

The elements provide the project team with ready-to-use templates and accelerators, which can be used in the entire Activate journey with the help of step-by-step guidelines. We will cover what needs to be delivered in each phase and how to deploy the solution in Cloud/On-premise, according to the business needs.

Figure 1: SAP Activate elements.

Source: SAP

In SAP Activate, there are six phases. At the end of each phase, quality gates are present to make sure respective deliverables in each phase are completed, as per the standards.

This methodology is an agile framework and hence all these phases are run in an iterative manner in order to build a solution. The six phases are: Discover, Prepare, Explore, Realize, Deploy and Run.

Figure 2: SAP Activate phases.

Source: SAP. 

SAP Best Practices Content

The SAP Best Practice content is currently accessed through the SAP Best Practices explorer. This application is planned to be discontinued by end of June 2023, whilst it will not be replaced SAP will provide an entirely different application that will also cover SAP Best Practices solutions. The first release of the new application is planned prior to the end of June 2023.

Turning to the SAP Best Practices advisory content next, there are two diagrams below that show all the lines of business and business areas included in Best Practices approach for SAP S/4HANA. These diagrams are logically split between what the vendor calls Operational ERP and Administrative ERP. Treasury Management forms part of the Finance subset under the Administrative ERP side.

Figure 3: SAP Best Practices – Operational & Administrative ERP.

Source: SAP. 

Here you can view the diagram (Figure 4: Treasury Management’s position in SAP’s Best Practices implementation methodology. (Source: SAP)). that shows the full set of Treasury Management scope items included in the coverage. From here we will then select a specific scope item to demonstrate some of the detail that is included for every scope item.

Treasury Management Scope Items, are important aspects of SAP’s Best Practices implementation methodology. We will now focus Debt and Investment Management, diving into the details. Scope Item 1WV (Debt and Investment Management) is shown on the Best Practice Explorer module below, Including Process Flows and Test Scripts.

Figure 5: An example of a scope item – for debt & investment management – in SAP’s Best Practices content.

Source: SAP.  

There are 13 Process flow diagrams for scope item 1WV – Debt and Investment – alone in SAP Best Practices. A view of the debt and investment management overview process flow diagram is provided in figure 7. The process steps in the Debt and Investment Overview include: (1) Create Debt and Investment Contract; (2) Correspondence; (3) Principal Payment; (4) Period End Closing; (5) Interest Rate Adjustment; (6) Interest Payment; (7) Nominal Amount Adjustment; (8) Reclassification; (9) Terminate Deposit at Notice; (10) Transaction is Premature; (11) Transaction is Mature; (12) Reports. Scope Item 1WV also has a 188-page word based test script document. Additionally, a test script template for Cloud Asset and Liability Management (ALM) risk purposes is also included in the same content.

A view of the debt and investment management overview process flow diagram is provided below:

Figure 6: Debt & investment management process flow.

Source: SAP.

Conclusions: Solution Builder

When you embark on the initial phases of your treasury implementation you can also use the SAP Solution Builder to deploy the Best Practice content into a working sandbox test system.

You need to select the scope items for inclusion in the solution build option. It will then build the system, including configuration and master data, such that you will be able to follow the test scripts, and run the business processes. This means you can quickly and easily explore the system according to the documented functionality very early on in your project.

A good approach is to keep a dedicated Best Practices sandbox client in your development environment where you can deploy and explore content at the start of your project, and also use it for future initiatives.

It is clear that you should be able to leverage significantly faster implementation times and to get value quickly, using as much of this vendor provided advisory content as possible. In addition, it is going to be crucial to have a consistent approach for all lines of business and business areas within the project. All areas need to embrace what is on offer in a universal manner, so that the benefit of a more unified approach to your transformation journey can be fully realized. As ever, good project management and perhaps consultancy advice if it is deemed necessary, can improve any implementation template so bear in mind some thought power will still be needed by the project management team.

At Zanders we are striving to embrace the new approach to SAP S/4HANA implementations discussed in this article, while still drawing on the depth of experience and knowledge we’ve built up from both a treasury business and technology perspective over the years on more traditional approaches we’ve used in the past. This can and should be seen as a healthy tension – comparing what has worked previously with what is possible now to find the best pathway forward. This synthesis allows for the benefits of both schools of thought to be leveraged when guiding our customers through their treasury transformation journeys on SAP.

From there, the financial consultant further expands its track record in the global market for treasury, risk and finance services.

As capital of the United Arab Emirates, Abu Dhabi is home to large corporates, investment banks, fintechs, private equity firms and venture capitalists, asset managers and the largest sovereign wealth funds in the world. ADGM is one of the region’s hotspots for financial services.

“We’re excited and very proud to host the launch of Zanders in the region. With various clientele, including multinational corporations and fintechs, Zanders’ roots in Abu Dhabi will roadmap a progressive journey forward thanks to the nation’s strategic location and ADGM’s robust global connections,” stated ADGM.

Laurens Tijdhof, CEO & Managing Partner at Zanders: “We are committed to enriching the region’s financial services sector and serving the growing need for independent treasury expertise within corporates in the region. ADGM is the ideal launch pad for our growth. This is a great opportunity for us to provide treasury thought leadership to the regional community.”

Zanders is an independent consultancy firm with a track record of innovation and success across the total spectrum of treasury, risk and finance. As a thought leader within these areas of expertise, Zanders combines thought leadership with a high-quality approach and client involvement ‘from ideas to implementation’. The company currently has over 250 specialist treasury and risk consultants globally who work from offices in Europe, the US, Asia and now the Middle East.

Zanders’ team for the Middle East consists of Fernanda De Genaro, Constantine Tyraskis, Sander van Tol and Mark van Ommen.

For direct questions related to this press release, please reach out to:

Sjoerd van Zoelen
+31 6 55 89 09 00
[email protected]

or

Laurens Tijdhof
+31 88 991 02 00
[email protected]

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