Corporate Finance » Working Capital Survey reveals improvements

Working Capital Survey reveals improvements

Improvements in receivables, inventory drive best working capital performance in a decade, says Paul Moody, Associate Principal REL Consultancy Group, member of the Hackett Group

In many respects, 2017 was an anxious year for Europe, but not when it came to the economy. Every European country experienced an economic recovery and improvements in their labour markets.

Investments strengthened on the back of favourable financing conditions, strong global demand and the need to expand capacity. The improved conditions reflect a global upswing in advanced economies and emerging markets alike.

Growth rates for the European Union (EU) and the eurozone beat expectations in 2017 to reach a 10-year high of 2.4%, and the good times are forecast to keep rolling into 2019.

This strong performance enabled Europe’s top 1,000 non-financial companies to improve their cash conversion cycle (CCC) by 7.2% year-on- year – their best performance since 2008, according to REL’s 2018 Working Capital Survey.

Overall, however, the absolute total of net working capital still grew. Collectively, this meant that for another year, Europe’s companies again lost the use of over 1 trillion euros.

While 2017 saw a robust performance in cash conversion overall, payables performance fell but was offset by strong performance in inventory and receivables. Overall, across all nonfinancial industries:

  • Days inventory outstanding (DIO) improved by 6.1% or 3.9 days, reversing the upward trend since 2013
  • Days sales outstanding (DSO) bettered itself by 5.2% or 2.6 days
  • Days payable outstanding (DPO), the third component of working capital, dropped by 4.9% or 3.6 days – a substantial decline that dampened overall CCC improvement

The performance was markedly different than in the US where among the top 1000 DIO stayed flat, DSO deteriorated by 4% and DPO improved by 6%.

Not all these improvements are driven by macroeconomic trends. Some companies seem to have understood the advantages of better working capital management. In 2017, the upper quartile performers were seven times faster at converting working capital into cash than the median performers.

The positive record of the top performers should suggest to the lagging three-quarters that working capital management is just like any other aspect of business in that much more depends on strategy and execution than luck. Their success suggests that much more can be done to reduce the mountain of 1.1 trillion euros currently tied up in excess working capital.

Last year, this amounted to 7.3% of FY2017 European GDP of 15.3 trillion euros. Of that, the receivables opportunity represented 353bn lost euros; inventory, another 367bn euros; and payables, 394bn euros.

To be fair, however, businesses faced some unusually powerful headwinds in 2017. As we have seen in the past, there is typically a lag between legislation going into effect and the payment practices on the ground changing, and this softening appears to reflect a delayed response to some earlier regulatory changes.

In this case, new regulations, particularly the European Late Payment Directive and related initiatives by several important member states, appear to have softened payables performance.

In 2014, the German legislature finally implemented the European Late Payment Directive as national law after an extended debate on how stringently to interpret the rule. In the end, Germany opted for a strict interpretation of the directive. As a result, payment terms in Germany are assumed to be 30 days, unless explicitly contracted at a longer credit period.

And while terms greater than 60 days are technically allowed, the German Civil Code states that a payment term longer than 60 days will only be valid in exceptional cases.

Additionally, 2017 saw the rollout of the UK’s Duty to Report regulation, which aims to create transparency of payment practices. Under the new government guidelines, all medium and large companies operating in the UK have a statutory reporting duty to provide statistics on payment performance, narrative descriptions, and statement of policies and practices.

The Netherlands also introduced new payment term legislation in 2017 aimed at protecting small- and medium-sized enterprises (SMEs). Under the new Dutch law, buyers cannot offer SMEs payment terms of more than 60 days. Past agreements with payment terms longer than 60 days are no longer valid and automatically convert to 30 days, after which the supplier can claim interest. This interest claim is enforceable for five years.

These three initiatives may have made buyers wary of falling foul of legislative requirements and led them to shy away from payment term optimisation programmes. While this is a very understandable reaction, the reality is that many companies can still improve payables performance within the current legislative constraints by looking at payment runs, payment terms model and the payment clock – before evaluating further gains, which could be achieved through using supply chain finance. At the same time, where companies are backing off longer payment terms with suppliers, the natural result is to see improved DSO performance.

Sustainability stays out of reach

Despite the payment term legislation, one thing stayed the same in 2017: almost all companies had difficulty extending their gains in CCC. Since 2010, only six companies have managed to improve their CCC every year – revenue and cash on hand are up by 52% and 73% respectively, far ahead of the growth rates of their peers. Additionally, CCC cycles have fallen by an impressive 49% – well above the 6% improvement seen by others – and all this was done while decreasing debt levels by 25% compared to a 40% increase in debt by the average company in the survey.

On the flip side, 75 companies in the 1,000 deteriorated for three years in a row. More worrying still, six companies have deteriorated for five years in a row and four of these for seven years in a row. These 4 companies have taken on much more debt (91% increase compared to 40%) and watched their cash on hand rise only 22% compared to the other companies. However, their revenue growth did improve, climbing 59.5% compared to the average of 27.4%. Overall, their CCC has slipped by 92.8%.

Outlook: Robots and revenue

The next big game changer for working capital management will undoubtedly be the digitalisation of business. Companies have traditionally relied on enterprise resource planning reporting with limited insights into working capital outcomes, but now a whole new world is unfolding that makes it easier to understand the impact of certain business decisions on key cash-related processes. In particular:

  • Better forecasting and optimisation software is helping forecasting and replenishment teams make smarter supply decisions. The new technology is enabling supply chain teams to process historical and incoming data faster and analyse it in real time.
  • This quicker access to real-time data is making it easier to introduce appropriate corrections on the fly. Advanced machine learning and optimisation algorithms can look for and exploit observed patterns, correlations, and relationships among data elements and supply chain decisions (e.g., when to order product, how much to order, where to
    put it).
  • Robotic process automation (RPA) looks for ways to automate and streamline repetitive processes. For example, RPA can greatly reduce the time it takes to create an accurate invoice.
  • Further automation of transaction processing, such as self-service portals and automated approval processes, is also gaining momentum.

Historically, the most fruitful area of improvement for payables has been through the optimisation of payment terms and conditions with suppliers. However, the European Late Payment Directive limits how much can be achieved with this lever.

For European companies, the way forward for payables is still to look first to optimising payment terms and conditions and only then to supply chain finance. Here, too, however, technology may provide a solution.

While still in its early days, blockchain technology is expected to transform supply chain finance solutions. Blockchain-based supply chain finance solutions will contain smart contracts to enable all parties in a supply chain finance platform to act on a single, shared ledger.

A supplier, customer, and every other participant will update their own parts of the transaction, adding efficiency and an unprecedented level of trust and transparency on a secure and immutable ledger.

Blockchain will give companies and banks increased control, speed and reliability at a fraction of the cost of their current infrastructure. By giving buyer and seller more visibility and control, blockchain will create more robust supply chains in the long term.

In 2017, a number of leading companies in the survey demonstrated that they are well ahead of the curve in working capital optimisation. We expect that as the decade draws to a close, the laggards will be trying harder to catch up. For some, the adoption of these new technologies may give them the extra capacity they need to make a significant move forward.

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