Published: February 01, 2010
Despite a great deal of research being done on classical working capital indicators (DSO, DPO and DIO), it seems that little attention has been paid to the relationship between working capital levels and profitability.
PricewaterhouseCoopers has conducted a European study analysing trends in working capital management but also its link with profitability (as measured by the return on net assets or RONA).
The study covered 969 listed companies from 11 European countries (see Figure 1) for the 2004-2008 period. Companies have been assigned to countries based on the location of their headquarters.
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As the analysis has only used public information, some inherent limitations need to be taken into account, mainly that:
2004 shows a major improvement in the working capital ratio compared to 2003 (see Figure 2). After the burst of the New Economy bubble, and after several years of lagging behind the US, Europe has made significant efforts to reduce working capital, with an overall average improvement of nearly 2%.
However since then, we have not seen significant reductions. Working capital ratios have only decreased by 1.4% since 2005 to an average of 21.7% in 2008, close to the levels of 2004. This indicates that working capital has not been the main concern of companies. This can partly be explained by the ease of access to liquidity and historically low interest rates during most of this period of economic growth. However, we observed as of the end of 2008 that many companies have launched working capital projects, whose first positive results should be seen in 2009.[[[PAGE]]]
Since 2004 we have not seen significant reductions in working capital, indicating that it has not been the main concern.
Looking at changes in the underlying components (see Figure 3), the most remarkable development is that the days’ sales outstanding (DSO) decreased by five days between 2004 and 2008, and by nine days as from 2005. This highlights the fact that companies have primarily focused on debtors to improve their working capital, striving to be paid quicker. Securitisation and other techniques have been used by companies over this period to accelerate their cash-collection processes. At the same time, average days’ purchases outstanding (DPO) has worsened by one day compared to 2004 and even by four days compared to 2007. This can easily be linked to the change in DSO. When suppliers reduce their DSO, it has a negative impact on buyers’ DPO.
The difference in the developments between DSO and DPO might be explained by the fact that the sample focuses only on big market caps. We do not consider smaller companies, which are less able to pass on to their customers the negative effect of reduced payment terms imposed by their large suppliers.
Finally, we see that days’ inventory outstanding (DIO) worsened a little over the period, by two days.
Although we have seen some progress in reducing receivables, the study shows that no major improvements of working capital have materialised over the last few years. We started to see the launch of working capital initiatives in 2008 that should materialise in 2009. The results of the study also tend to indicate that large corporates will now have to focus more on improving their forecast-to-fulfil cycle if they want to substantially improve their working capital. Indeed, while focusing on DSO and DPO remains a priority, there might be a limit to how far customers and suppliers can be squeezed in difficult economic periods.
Note - Further details are provided in the study related to industry specifics: evolution of average working capital ratios, lower, median and upper quartiles, standard working capital ratios (DSO, DPO, DIO), etc.[[[PAGE]]]
While reducing costs is still a necessity to surviving in the current environment, it should not be forgotten that the performance of a company is also influenced by balance sheet items and, more precisely, by working capital (see Figure 4). Focusing on working capital elements can not only support a company through the downturn but also give the positive message that the company is striving to eradicate inefficiencies and launch long-term, sustainable initiatives.
Based on our study sample, we have simulated the impact of an improvement in working capital on RONA for each industry group, with surprising results.
To estimate this improvement potential, for each industry we calculated the improvement in the WC ratio from the median to the upper quartile of the industry in a first instance. We then went on to estimate the impact of this improvement on RONA and the equivalent NOPAT increase that would be necessary to achieve the same effect (see Figure 5).
Significant industry differences are observed in this scenario. The positive impact on RONA is mainly linked to the relative possible improvement range of the industry and to the average level of working capital in the industry. Average revenue is also a factor to be considered in these types of simulations.
For example, improving working from the medium to upper quartile in the consumer goods sector could result in as much as a 15.5% improvement in the RONA.
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This study highlights the strong link between RONA and working capital. Even though NOPAT is one of the key drivers of RONA, it is also clear that working capital can have a positive impact on the performance of a company while sending a constructive message inside and outside the organisation.
This study does not purport to provide comprehensive answers on how companies should manage their working capital. It should instead serve as a support in benchmarking themselves to their peers and assessing the various solutions available for improving their performance. In doing so, every CEO or CFO will ensure that his or her organisation is adequately prepared to survive difficult periods and create the necessary conditions for sustainable growth.
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