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REL Working Capital Survey 2013

Working capital has risen up the agenda of Europe’s largest companies, but represents little more than a token effort, finds Richard Crump

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WHEN LOOKED AT in its simplest form, the management of working capital – making sure money comes in fast enough to service the money going out the other end is, as one finance director drily puts it, “not rocket science”.

Yet the world is littered with businesses that have collapsed as a result of liquidity seeping out of the business when it has been needed most, despite being – for all intents and purposes – profitable, healthy and growing. It is an area in which all too many corporates have struggled. Not least because of the fine balancing act it represents.

“It is the oxygen supply to the business – too little and the company will struggle and fail to service its debt, too much and it can go to waste by not effectively generating a return,” explains Karen Penney, vice president and general manager UK at American Express.

Cash management is moving up the corporate agenda, however. Though the latest GDP figures, closing trade deficit and improving employment data show an economy slowly on the mend, there have been many false dawns since Lehman Brothers filed for chapter 11 bankruptcy protection on 15 September 2008.

DSO graphSince then, most businesses have been forced to adapt to the new normal of slow growth and restricted access to finance. Finance functions are under pressure to tighten up their organisation’s working capital processes. And, after a startlingly poor performance in 2011/12, it has finally caught the attention of management at Europe’s largest listed companies.

However, improvements remain minimal and are unlikely to be sustained, while businesses are still struggling to convert sales into cash. Such is the conclusion from the latest working capital survey of the 800 largest listed European groups by REL Consulting.

“Cash conversion performance has been declining for three years in a row, showing that efforts in working capital management have not been sufficient to counteract the squeeze on cash generation,” says Daniel Windlaus, a managing director at REL.

Europe’s largest companies are sitting on about €762bn (£650bn) in excess working capital – equivalent to 6% of EU GDP, according to the consultant’s annual examination of their ability to collect from customers, manage inventory, and pay suppliers. Sitting on corporate cash piles and – for those that can access it – supported by cheap debt on low interest rates, processes have become flabby and inefficient as evidenced by a failure to convert sales into working capital.

While revenue increased by 6% year on year (and 35% over a three-year period), there were clear signs of difficulty in converting these sales into actual cash as cash conversion efficiency (operating cash flow/revenue) deteriorated three years in a row from 13.4% in 2009 to 10.6% in 2012.

“Many companies are looking to extend payment terms and creditor days wherever possible and this is seen throughout the supply chain, thus affecting the cash conversion cycle,” says Penney.

In addition, free cashflow – the cash a company is able to generate after laying out the money required to expand its asset base – reduced by 18%, year on year. An important indicator of the health of corporate cashflows, free cashflow allows a company to increase shareholder value by pursuing acquisitions, develop new products, and reduce debt.

DPO graphHowever, it’s not all doom and gloom. Days working capital (DWC) – a measure of the average number of days of tied-up working capital in the operating cycle – improved 6% year on year, while credit collections and inventory management also improved. Nevertheless, businesses are struggling to sustain the improvements they have made. Only 12% of companies improved DWC performance for three consecutive years. Even when allowing for flat performance or slight deterioration – of 5% – extends this group to just 27%.

“Companies are more conscious of the importance of working capital in the post-crash era, but they represent little more than a token effort in the grand scheme of things,” says Windlaus.

The problem for finance functions in sustaining such improvements is that most organisations are driven by revenue and operating profit – despite the sometimes loud protestations from finance. As a consequence of this, creating a cash culture throughout the organisation is hard to achieve.

Robert Smid, working capital partner at PwC, agrees that cash culture is hard to achieve. “Businesses don’t always care that much about cashflow or the balance sheet,” he explains. “You want to achieve a dual awareness of the P&L, balance sheet, cashflow and profit.”

Sloppy processes aside, difficulty in sustaining working capital performance is also a result of a recovering economy. “When cash is tight, you tend to look at your working capital closely – when it is less tight, there tends to be less of a focus on it,” says Smid.

It is not surprising, then, that cash on hand has continued to increase £36bn year on year, or 9%, while debt increased by $93bn – indicating that companies are taking advantage of the low interest environment. The borrowed cash is apparently being put to use, with capex increasing by 9% year on year, and 18% over a three-year period, with annual dividends paid out also rising 5% year on year.

Ross Paterson, finance director of Stagecoach – picked out by REL as a top-quartile performer within the road and rail sector – is all for putting cash to work. There is little benefit, he says, in leaving it to gather dust on the balance sheet.

“If we feel the group has become under-leveraged and we don’t have an opportunity to reinvest that cash, we return it to shareholders,” Paterson says. “There is a danger if you hold too much cash that it engenders a lazy approach to management because you know you’ve got a cushion.” However, he adds that the business retains enough to remain investment grade for the purposes of funding and winning government contracts.

Focus on the task
Of the £650bn of working capital tied up in company operations across Europe, the biggest opportunity for corporates lies within receivables – approximately 36% of the total opportunity and 33% of the total working capital on the balance sheet. And while generating free cashflow from operations, or operating cashflow from sales, has proved a struggle for many, there are companies – such as Stagecoach – that are getting it right.

According to REL, Stagecoach was able to cut its days sales outstanding – a measure of the average number of days that a company takes to collect revenue after a sale has been made – by 12% to 15 days. Not bad considering lower-quartile performers take upwards of 60 days to collect their cash, while the median for the sector is 24 days.

“If you look at our operating cashflow, our conversion rate is 100%,” says Paterson. “There’s no magic to it other than a strong focus on cash and attention to detail.”

The bus and train operator has a central treasury function that monitors its cash balances on a daily basis and forecasts cashflow over the short term – the next couple of weeks – and longer term – over a year or more – while Paterson is charged with closely monitoring any variances between what the business was expecting and what actually happened.

“It’s something I have to be quite focused on. If we ever have a review meeting or a budget meeting with one of our companies and spend the whole meeting talking about the P&L account while not mentioning cash, I will always make a point back in terms of their expectations about cash,” says Paterson.

Not reinventing the wheel, perhaps, but finance taking a lead on pushing a focus on cash is a common denominator of the companies with the best working capital conversion rates. The FD of recruitment consultant and IT outsourcer Harvey Nash, the highest ranked UK professional services firm in REL’s analysis, takes a similar approach.

“It’s about what you focus on,” explains finance director Richard Ashcroft. “We are very focused on our whole credit maintenance and credit control procedures. I get copied into the debtor reports every week, the board gets a detailed report every month, and it is an ongoing process at an operational level.”

The approach is clearly paying off. The company achieved reductions in DSO, days payable outstanding (DPO) – a company’s average payable period – and days working capital. DSO was cut by 11% to 54 days, versus a sector median of 67 days and a lower-quartile performance of upwards of 112 days.

“We place a lot of investment on that area,” says Ashcroft. “We have got a full team working on collecting money – we don’t skimp. Our credit risk is too much to do otherwise.”

No surprises
Ironically, though, despite finance’s attention on working capital, it is not a finance issue. It always ends up with finance but it is driven by operational processes. For improvements to be made – whether in stock, payables or receivables – that culture has to cascade down throughout the organisation.

“It’s all about cross-functional operational processes,” says Smid. “To make it sustainable comes down to how well processes are defined and how well they are adhered to.”

That necessitates breaking down silo mentalities, something that is not always easy to do. KPIs and targets have to cascade down through the organisation. Employees work to targets that relate to them and their responsibilities.

For instance, getting sales teams to focus on payment terms can be a challenge. Customer billing frequently sits within the sales function. Encouraging sales to think about improving working capital performance requires tying incentives to performance.

“Sales people are motivated by commission and bonuses, so if the debt is not repaid that will have consequences for bonuses,” says Ashcroft at Harvey Nash. “A sale is not truly made until the cash is in the bank.”

That shouldn’t mean turning your sales team into a collections team, spending hours chasing payments from difficult clients. It’s about getting that cross-functional communication right and, just as importantly, communicating payment terms to the client early on in the process.

“We look at the way the credit control team and finance department liaise with the front office,” explains Ashcroft. “We make them aware of the importance of clarity with our clients and make sure our sales people don’t shy away from those tough conversations.”

Ashcroft says this relates to the principle of no surprises – a lesson he says he learned almost 30 years ago when he started out at PwC. Despite invoices being sent, he was still receiving calls about when payment should be expected.

“I will never forget that first lesson. It’s about no surprises,” explains Ashcroft. “No clients should be surprised when they get a bill including documents about what the payment terms are. You need client agreement as to what payment terms are. Just sending the bill out doesn’t work. It’s about developing relationships and rapport.”

DIO graphMeanwhile, a considerable amount or excess working capital, €257bn (£219.5bn), remains tied up within corporates’ inventories. Though days inventory outstanding (DIO) – how long it takes a company to turn its inventory into sales – improved by 3% across the companies surveyed, it remains a “complex area” that goes “right into the core of the business”, according to Windlaus at REL.

Windlaus has the classic view that more inventory equals more availability and will result in more revenue is wrong. “Imagine having 3,000 different products and you decide to have everything on stock – you need to understand where the demand is. Where is that volume of demand?” he asks.

Admittedly, the economic slump affected order rates, meaning businesses had to adjust production models to take account of the change in demand. Companies that have performed well are the ones that have developed ways of improving inventory management, whether that is lean manufacturing, in time production, forecasting techniques, production planning or inventory tracking tools.

Techniques to improve overall working capital performance – from credit risk policies to consolidated spending – may be common sense for many. But, as Smid at PwC points out, companies that get these right can end up being able to “finance their own growth requirements”. And in these cash-constrained times, having the ability to do that is priceless.

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