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Working capital bounces back

As the recession eases, European businesses are bouncing back with the biggest working capital improvement for five years. But are these gains sustainable, asks Brian Shanahan

06 Sep 2011

By Brian Shanahan, REL

Graph showing working capital

EUROPE'S BIGGEST companies have seen the most significant revenue growth in five years. However, this rare piece of good news is tempered by the fact that these same companies are hoarding their cash and, in many cases, borrowing to do so, while smaller companies remain starved for capital.

The 1000 largest Europe-headquartered public companies (excluding the financial sector) that make up the study have overseen dramatic year-on-year improvements to their working capital performance. They have reached a new five-year low in days working capital (DWC), according to the 13th annual working capital (WC) survey by specialist consultancy REL.

To fully understand the improvements, we must look back to the same survey in 2005. Back then, the Europe 1000's DWC was 46.5. Five years on, in 2010, the same figure has improved by 7.6% to 42.9 days (and by 5.9% from 2009). Through this period, Europe's companies are demonstrating an ability to more efficiently convert their working capital into revenue. Despite this bright picture, a combination of excess and inconsistencies could threaten a long-term improvement.

The survey results demonstrate that Europe's largest companies have increased revenue by 14.9% in 2010, and either maintained or increased their margins, which can be connected to their working capital management.

Looking deeper into the statistics, we see that improvements across receivables (days sales outstanding, DSO) of 3% as well as inventories (days inventory on hand, DIO) of 2.9%. Meanwhile, payables (Days Payable Outstanding, DPO) deteriorated only slightly by 0.1% from 2009.

Even though the 2011 survey clearly points to a healthier working capital picture across the Europe 1000, there is still room for improvement. By comparing a company's performance by working capital component to that of the upper-quartile performance for its given industry, REL can calculate the proportion of the working capital that may be considered excess.

For 2010, this figure is an alarming €724bn, which represents 31% of the gross working capital of companies within the survey. REL estimates that elimination of this excess could affect earnings by as much as 5% of the reported EBIT numbers (based on a 5% finance cost).

So what drove the 2010 improvements? Growth in revenue does have a pervasive effect on all aspects of operating cash. While increases in revenue provide cash flow, increases in associated operating expenses consume cash. So the net effect of revenue growth should be an increase in operating cash flow for those companies with positive operating profit margins. Below, we break down some of the specifics for this year's results.

Inventories: The survey results show an increase in the absolute value of inventory, but increased sales and revenue have enabled inventory to be turned more quickly, hence a lower DIO. The slight deterioration in gross margins combined with increased revenue may suggest favourable pricing and a sacrificing of margins, although we should note that the deterioration in gross margin is very modest (-0.6%).

Receivables: The increased absolute value we see in the survey is due to increased revenues, but also a lower DSO, which is likely due to an increased focus on volume and therefore increased movement or turns within receivables. The risk of customers unable to pay has also reduced in 2010.

Payables: These have remained relatively flat because companies are using inventory just as fast as they are receiving it, which is evidenced by price cuts and the increasing volume of sales.

Companies often price products more favourably to increase revenue and improve working capital performance. This allows them to achieve revenue growth at the same time as improving their inventory and receivables performance. However, this could be detrimental to gross margins. The survey results clearly demonstrate that this approach is popular among the Europe 1000, which has resulted in increased revenue, improved DSO, DIO and DWC and a deterioration of gross margins.

Europe versus US

Comparing the same European figures with their 2009 revenue decrease of 12.4% percent, the 2010 increase is certainly a dramatic one. However, we should compare like-for-like metrics drawn from both the REL Europe 1000 and the REL US 1000 to better understand this return to form. Across this same period, the US companies surveyed showed only a 2% improvement in days working capital. US company receivables (DSO) remained flat at 0.1%, while inventories (DIO) and payables (DPO) demonstrated only marginal improvements at 1.1% each.

Working Capital Fluctuations

Despite the relatively rosy picture of improvements, the 2011 survey does reveal that working capital performance is fluctuating up and down for some companies, year after year and cycle after cycle. The concern is what this inconsistency could do for a comprehensive recovery for these businesses during this most important period of recovery. This set of companies risks losing any gains in cash on hand by a combination of three factors: revenue being bought back through terms and discounts, a reversal of destocking and an inability to sustain management attention and focus.

As this same research has been produced for 13 years, it is understood that some sectors and industries are simply more susceptible to economic fluctuations than others. These include cyclical (non-defensive) sectors and industries like consumer discretionary, energy, industrials, information technology and materials. Conversely, non-cyclical (defensive) sectors and industries such as consumer staples, healthcare, telecommunications and utilities are less prone to fluctuations.

Analysing this, we see a DWC trend with a statistically lower level of variability than for the cyclical industries when we look at the DWC trend for non-cyclical industries. Viewed over the long term, there is evidence that certain industries have avoided this up-and-down trend.

Overall, as Europe moves into a period of recovery and revenue growth, the issue is whether the changes made are sustainable and whether companies are truly creating a cash culture. Although 60% of the companies featured in the survey improved their WC in 2010, based on previous survey results, only 40 to 50% of these can be expected to sustain this improvement in 2011.

Only 5% of companies have achieved upper-quartile performance within their industry and have managed to improve in all three working capital elements over a five-year period to 2010. And just five companies in the survey have improved their DWC every year for the past five years and are in the upper 50% in all three elements of working capital.

So what can companies and CFOs do to ensure ongoing focus and sustainability?

Measurement and accountability: Establishing a good measurement system is critical. It must align measurement with accountability, reflecting and balancing all elements. However, such a system should not exist just at the top level, but throughout the entire organisation.

Incentives: The idea of an incentive sounds easy, but it is actually very hard to implement. The elements driving behaviour of the company's revenue, profit and cash must be balanced not only at management level, but across process owners and sales teams.

Organisational alignment and collaboration: It is critical to replace the perception that working capital is just a finance issue with an understanding that working capital comes from an amalgamation of cross-functional policies and processes. Companies must balance objectives, margin, cash and sales, as well as ensure pricing (for example the discount terms trade off) is properly understood and managed. The organisation that succeeds will create structure through in-company committees that help to build awareness and promote best-practice policies and processes.

Brian Shanahan is an associate principal at REL - A Hackett Group Company

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