Cash concentration is a key aspect of liquidity management and treasury operations. Utilizing this practice serves to improve organizational liquidity and reduce potential losses emerging from acts of fraud.
What is cash concentration?
Cash concentration is the transfer of funds from outlying depository locations (often at different banks and sometimes in different countries) to a central bank account at a company’s primary bank, commonly referred to as a concentration account.
Cash concentration is based on one core principle: to use surplus cash generated by one part of the business to fund the disbursements and working capital requirements of other parts of the business. Cash management is simpler and more efficient when a centrally located concentration account is employed. By pooling funds, an organization can easily move cash from one account to another and quickly disburse it as needed.
Most businesses hold accounts at more than one bank — and often in more than one country. When no attempt is made to move these funds, companies can have pockets of idle cash sitting in different accounts. And if they’re in multiple countries, that also means they’re being held in different currencies.
So, the goal of cash concentration is that as cash is collected, it is pooled into one or more concentration accounts (otherwise known as header accounts) in preparation for future use.
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Objectives of cash concentration
There are two primary objectives of cash concentration:
- To efficiently move cash from deposit bank accounts to the concentration account.
- To gain visibility over the organization’s cash position.
In addition to facilitating daily liquidity management, cash concentration allows a company to:
- Balance excess and deficit cash positions across multiple locations, entities and currencies.
- Optimize idle balances to offset fees or optimize earnings credits.
- Invest a larger amount of cash, potentially increasing interest income.
- Pay down debt faster and minimize borrowings, possibly reducing interest expense and reliance on external sources of liquidity.
- Use cash more efficiently, such as taking advantage of supplier discounts or reducing the cost of goods sold.
Can companies have more than one concentration account? Yes. If they have significant cash flows in more than one currency, it could be more efficient to operate currency pools for each major operating currency. Also, if they operate in different regions, it would likely be more operationally efficient to manage cash on a regional basis.
Cash concentration techniques
There are three cash concentration techniques, of which physical pooling and notional pooling are the most widely used. The third is the use of virtual accounts.
Physical pooling involves the automatic transfer of funds in separate subaccounts to or from a concentration account. This can be done across multiple legal entities located in the same country or different countries; however, the funds must be in the same currency. Movement of funds between participating entities is accounted for through intercompany loans, which must be at “arm’s length” or market rate and may have tax withholding implications.
With notional pooling, you make balancing entries on a set of accounts with no physical movement of funds to the bank accounts held by company entities. The bank that manages the notional pool provides an interest statement, which reflects the net offset, and intercompany loans are not required.
This method relies on banks’ ability to report loans and deposits on a net basis. Worthy of note is that where notional pooling is permitted, banks require all participating entities to provide a series of cross-guarantees to fund the pool in case any participating entity becomes bankrupt, which is difficult to implement. Plus, banks typically require credit facilities to support any negative balances in the pool.
Also, keep in mind that this technique has limited availability on a cross-border basis.
Technology has made it possible to achieve a similar effect as physical or notional pooling through the use of virtual accounts. Virtual accounts are not separate legal accounts. Instead, they are a set of internal ledgers, each with its own bank account number, with only the header account being a real, legal account.
Two variations of this technique exist: bank-operated virtual account structure and company-operated virtual account structure. The former has a header account, which holds the company’s balance with the bank, and there are a series of subaccounts representing each of the participating group entities. Transfers between the group entities are then recorded as internal ledger movements. The second variation is most often utilized when a company has an in-house bank; it makes use of payments-on-behalf (POBO) and collections-on-behalf-of (COBO) structures.
It should be noted that the use of a virtual account structure negates the need for a formal pooling arrangement.
Cash concentration practices
Companies that have significant cash flows in more than one country should consider a two-stage process when working to concentrate funds. First, concentrate cash on an in-country basis within that country. Then manage any necessary cross-border concentration.
Commonly referred to as a concentration account or header account, you’ll want to start by transferring funds from outlying depository locations to a central account at your primary bank. The process itself is illustratively known as sweeping. Given that it is more efficient for the company to have its core accounts all with one bank, in-country concentration can typically be achieved by simple internal bank transfers rather than more expensive interbank sweeps.
This step is much more complex. Why? Because you will need to juggle excess and deficit cash positions across multiple entities, regulatory environments and currencies. Because of this, multinationals will often employ a mix of different concentration techniques depending on the banking structures and regulations of the countries in which they operate.
When a company’s primary bank has branches in several countries, but the branches don’t provide a full range of domestic banking services, the company may choose to use a bank overlay structure. Other multinational companies may instead opt to use their direct access to the SWIFT network in conjunction with an in-house bank.
Just be sure that whichever method of pooling you opt to use, you involve your tax and legal teams in the decision-making — even little mistakes can result in large, unexpected fees and taxes.