Published: May 04, 2011
The study shows that the 1200 European companies unnecessarily tie up €475bn in their working capital. It also reveals that little structural change has been made in relation to working capital. This article contains highlights of the study. A complete version of the study report is available directly from PwC.
In 2010 PwC conducted their Working Capital Management study for the third time. This year, the study aimed to understand how the global financial crisis and subsequent economic recession have affected the liquidity of corporates and the way they manage working capital. For this purpose, PwC analysed over 1,200 listed companies from 12 European countries. For each country the top 200 companies based on their market capitalisation were taken into account, and were grouped in 10 different industry categories.[1]
The study gives an indication of the current market trends in the analysed sectors and countries, and provides an initial external benchmark with peers. The key findings of the study are:
We analysed companies’ working capital ratio—the relationship between working capital and annual turnover, and discovered an average of 20.8% across Europe in 2009. The 2009 levels represented a rise of 0.4% over 2008 and a clear break from the downward trend that had established itself over the previous five years (see Figure 1).
The old myth of countries with long payment terms also carrying higher levels of working capital turns out not to be true.
The working capital ratio is the net working capital divided by annual sales. This easy ratio ultimately gives an indication on the flexibility of the supply chain of the company in question, and efficiency of the underlying processes. This means, in an environment with decreasing turnover, is the organisation also able to adapt its level of working capital?
It seems that these results show once the heat of the credit crisis had started to cool off, companies started loosening their tight grip on working capital management. Were the improvements that had been made in the heat of the crisis just temporary or rather patchwork solutions?
The observation above led to the following two conclusions, as Martin Böhme, Manager, PwC, Finance and Treasury Solutions, explains: “Firstly, the crisis had large impact on liquidity of large, listed companies. With strong focus on cash and liquidity we would rather expect an overall improvement rather than deterioration by 0.5% especially that the crisis is not over yet. Secondly, it seems that creation of sustainable improvements turns out to be illusive. The ratios are not yet back to the 2007 or 2006 levels but the overall trend is at least worrying as it means that improvements haven’t been implemented sustainably and have been done in a patchwork manner.” This would require more structural change to underlying core processes, something of which companies have not invested significantly so far.
The old myth of countries with long payment terms also carrying higher levels of working capital turns out not to be true. Some of the southern European countries, where traditionally longer payment terms are prevailing, have been able to realise some significant improvements: Spanish companies improved their working capital ratio by 1.3%. Also, Belgian companies by 1.1%, and French firms by 0.8% (see Figure 2).
One of the key reasons could be the increased attention devoted to cash due to recent regulatory changes. In the course of 2009 new legislation restricting payment terms has been introduced in France and in 2010 in Spain. The transition period in Spain is going to last until 2013, after which payment terms are limited to 60 days. [[[PAGE]]]
Switzerland shows improvements by 0.4% at the level of almost 25% of cash tied in working capital being significantly higher than above mentioned Spanish, French and Belgian companies with around 18% of their cash stuck in working capital. The high Swiss level of working capital ratio can be partially explained by the relatively high proportion of manufacturing and pharmaceutical companies in the Swiss sample.[2]
In 2009, the average European cash conversion cycle (CCC) was 76 days, a rise of one-and-a-half days year on year and, moreover, the first increase since 2005 (see Figure 3). The CCC is an important indicator for measuring how efficiently a company manages its working capital. It’s the sum of the average number of days that businesses have to wait for their payments (DSO, or days’ sales outstanding) and the average number of days that a business needs to convert its stocks into sales (DIO, or days’ inventory outstanding), less the average number of days that businesses wait before paying their suppliers (DPO, or days’ payables outstanding).
Looking at the underlying factors, we receive an unpleasant surprise: deteriorations were noticeable in relation to not only debtors (DSO) and creditors (DPO) but also inventory (DIO).
Receivables as traditional starting point remain under control
The DSO was the focus of 2008 for many companies resulting in a sharp improvement from 2007 to 2008 as this has always been perceived as the most obvious starting point to improve liquidity in the short term. In 2008, this led to the cycle being shortened by four days year on year in terms of receivables (DSO) (78.4 days in 2008 against 82.0 days in 2007). These improvements have largely been sustained in 2009 indicating that the pressure in their collection and credit departments had been maintained to keep clients paying on time.
What's now needed is optimisation of firms' own supply chains and ditrsibution models.
Inventory still remains the biggest challenge
Given these results, how can companies make additional improvements in sustainable way? According to Didier Vandenhaute, Director, PwC, Finance and Treasury Solutions, better supply chain management is the key factor that needs more attention. “Above all in the forecast-to-fulfil cycle, with inventory management at its core, little change has been noticeable in recent years. The last study already showed that substantial improvements could be made by better managing the forecast-to-fulfil cycle, providing much needed flexibility. That would enable better, quicker reaction to fluctuations in demand. We’d expected stock levels to drop over the last 12 months, but nothing could be less true. Because of the crisis, companies have been able to realise certain quick wins, mainly in receivables. But what’s now needed is optimisation of firms’ own supply chains and distribution models.”
Limited take-up of supply chain financing
The DPO seems to be more or less stable at an average of 46.7 days and showing slight increases in 2008 and 2009. Payables have not been a particular area of focus since 2007. Although we see supply chain financing solutions more and more on the market, these figures indicate that few companies have taken the opportunity to consider using the more alternative financing solutions to better manage their payables, such as supply chain financing to further extend payment terms, without necessarily damaging the supplier relationships.
When assessing the working capital performances by sector, we see a broad segmentation of the sectors into two major groups:
Pharmaceutical and retail companies show biggest overall improvements
For pharmaceutical companies, the relatively extensive cash conversion cycle is caused mainly by longer production cycles and research and development initiatives that form an essential part of the business model and strategy. Given their stock intensity, European pharmaceutical companies were still able to achieve the largest relative improvements of 4.6% (see Figure 4). However, this was only an improvement back to levels from 2006 and 2007.
Typically the retail sector shows the lowest working capital ratios which did not come as a surprise. This sector was also able to make improvements in 2009 comparing to 2008 levels with a relative reduction of 5.2%. European technology companies also improved results by 1.2%. [[[PAGE]]]
Improvements in oil & gas and basic materials – but are they sustainable?
An interesting pattern was seen in oil & gas and basic materials producers – we have seen an impressive improvement in 2008, followed by a worsening of the ratios in 2009. This strong dip was caused mainly by the commodity price peaks in the third quarter of 2008 which led to higher turnover levels as prices increased, and hence the working capital ratios looked much better. Once the prices came down to normal levels, the ratios dramatically worsened and reached again levels of 2007, showing that little of the underlying processes have changed.
In fact, the study shows a wide spread between best performers and worst performers within sectors. The difference between the lower and upper quartiles indicates that there is still a significant improvement potential left (see Table 1). Whilst underlying business models in a given sector can partly explain the gap, it gives an indication where best practices from some companies can be replicated in others.“Some sectors are indeed doing better,” says Damien McMahon, Partner, PwC, Finance and Treasury Solutions, “but, even within a given sector, we see that there is still great potential for improving working capital management. An example is consumer goods. There, high-performing companies need nearly three times less working capital than other companies that are doing much less well.”If the biggest European companies were to do as well as those in the top quartile within their sector, they could release no less than 30% of their net working capital. “Extrapolating that over the 1,200 companies in our study would represent as much as €475bn. Cash resources that are currently tied up in the working capital cycle but that could be used for other things instead. Certainly, in the current economic climate, with external financing becoming harder to get and more expensive, reducing working capital levels is certainly worth the bother,” says Damien.Another example is the services sector, where the ratio varies from 1% to 18%. This spread is enormous, meaning that more efficient companies are able to operate less than a tenth of working capital compared to their peers in the lower quartile.
As a second step, the study looked at the impact that better working capital management can have on the profitability of companies. For this purpose, the Du Pont model is being used. This is a technique that can be used to analyse the profitability of a company using traditional performance management tools and integrates elements of the income statement with those of the balance sheet, ultimately calculating the Return on Net Assets (RONA). The main reasons for using the RONA in this context are the following:
The balance sheet elements of the Du Pont model are net assets, combined of the working capital and non-current assets. The model combines this with the return on sales (ROS) which is the income statement dimension combined of the net operating profit after tax (NOPAT) and revenue, to ultimately give an efficiency of profit generating assets (see Figure 5).[3]
The underlying assumption of the model is a positive correlation between the company’s performance and the economy.[4] [[[PAGE]]]
In more challenging times such as the recent credit crisis, finance departments and company management tend to focus on profit and loss accounts by trying to reduce expenses and maintaining revenues. While more than often, cost reduction initiatives are necessary actions, they also tend to create some negative perception within, and possibly also outside the organisation. In contrast, looking at working capital management and creating improvements in a sustainable manner does not have this negative perception. Ideally, both sides in the Du Pont model are being addressed simultaneously, so that the company is able to optimise its working capital at the same time as it is improving its cost structure, to maximise the impact on profitability.
In 2009 all sectors faced decreases in overall profitability. In order to simulate the potential impact of improved working capital management, PwC conducted scenario analysis for each sector.
Table 2 shows to which extent a movement to the upper quartile could impact the RONA. It also shows what increase would be required from the NOPAT to achieve the same improvement in RONA. For example if a retail company could improve its working capital levels from the medium to upper quartile of its sector, this would lead to an increase of 1.6% in RONA. This company would need to improve the NOPAT by 14.1% to achieve the same RONA impact. This clearly evidences the important leverage working capital potentially can have on the bottom line, a factor that is more than often overlooked. Furthermore, the reduction in financing costs has not been included in the scenarios above, so this would have an additional positive impact. In summary, this means that even though the NOPAT is one of the key drivers of RONA, it is also clear that working capital management can have a very positive impact on the performance of a company.
Why does good working capital management still remain a challenge?We believe that part of the problem has to do with the fact that different parts of working capital management functions are spread out around the company and there is often a lack of co-ordination of efforts at global level. However, given their role at the end of the financial supply chain, treasurers are always impacted by poor working capital management. Why not take increased control of the financial value chain?
[[[PAGE]]]
The treasurer can step up in the role of co-ordinating and controlling the performance of different departments since at the end of the day all of these efforts and activities are needed to efficiently manage cash and liquidity within the company. There is a need to have a person in charge that can manage all of the aspects that often have conflicting targets and the same time have overlapping roles. Logistics, information and financial flows are highly linked and all of these different drivers have some impact on cash, which is usually managed by the treasury department. It seems that the treasury is well positioned to have holistic end to end view and approach for cash optimisation as it is not directly involved in the operations of specific departments and can bring new approaches by challenging the old ones. Critical to success is the transparency of roles, actions and segregation of responsibilities as it is always very difficult to avoid conflicts of interest of different departments.
The treasury should be involved to greater or smaller extent in the following activities in order to properly manage working capital within the company:
By playing a leading role in managing these activities, the treasurer will increase his control of the financial value chain, which in turn will give the treasurer advanced warning and increased control in his role as a provider of working capital. Increased control will allow the treasurer to help reduce the overall working capital requirement.
When asked in the PwC 2010 Global Treasury Survey what activities treasurers have implemented to reduce working capital usage, there were some interesting answers. The initiative seen as having the biggest overall effect on reducing net working capital has been the reduction of stock on hand and the lead times of materials (see Figure 6). This reiterates our position earlier of inventory being the area of most promising improvement. The sector analysis shows that this has been especially true for companies in the automotive (71%) and manufacturing (58%) sectors. However, it is interesting to note that nearly 40% of respondents have not made, or are not aware of, a reduction in their slow moving and obsolete stock.
Payables initiatives are among the top three items. This is probably due to the relative ease of implementing change, along with the perceived degree of control. Unsurprisingly, many companies have started renegotiating payment terms with their suppliers. From our study through published accounts, we see that these initiatives have not yet materialised.
Finally, the PwC 2010 Global Treasury Survey confirms that during the crisis the importance of the working capital rose significantly, with the proportion of respondents rating it as a high priority doubling to some 72%. Even post crisis, more than 70% of the respondents expect the importance of working capital management to remain high. The growing focus reflects both the pressure on external funding and banks’ own preference for offering working capital-type funding when their balance sheets can no longer support traditional lending. The fact that this focus is set to continue indicates that the impact of the crisis on liquidity within many companies has yet to be fully addressed. Treasurers struggling to access liquidity may well find it among the €475bn we estimate remaining trapped in working capital.
Notes
1. Excluded from the study were companies operating in the sectors real estate and financial services as well as companies with non-consolidated or incomplete data over a 5-year period. Removed were also companies that underwent large mergers and acquisitions due to large year-on-year variances. Due to the selected scope, there are some limitations of the study:
2. It should be noted that there is a possible discrepancy between headquarter location of a given company and the geographical spread of its turnover, which could be very European or even global. This fact might somehow bias the validity fo country-specific trends.
3. Given the low complexity of the model, it can be used as a mapping tool to explain to various departments how they can contribute to the bottom line of the company and it can also be linked to compensation schemes.
4. This is not always the case for all sectors, notable exception is for instance the tobacco industry: cigarettes turnover typically increases in a worsening economy.
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