Debt is King: REL Working Capital Survey 2015

THE old adage that cash is king is being replaced by a new corporate monarch: King Debt.

Companies in Europe have more cash on hand than ever before, with cash up 6% from 2013 and 62% over the past seven years. For the 947 non-financial public companies features in the REL 2015 Working Capital Survey, cash on hand at the end of 2014 had risen to €800bn (£566bn).

More cash is available and is being spent – capex investment rose 21% to €512bn (£362bn) over the same seven-year period – but where is the cash coming from? Debt, it seems, is a large contributor: there has been a worrying increase of 40% since 2007, according to the working capital consultancy’s 17th annual survey of cash management practices among Europe’s largest businesses.

Corporate debt has soared to €3trn (£2.1trn). Borrowing increased by 5% in 2014 alone as top European corporates take advantage of low interest rates – European Central Bank interest rates sat at 0.01% at the end of 2014 – and have used cheap debt to reward shareholders through dividend pay-outs and share buybacks.

However, companies should be concerned about the long-term risks of a change in interest rates, debt dependence or pressured cash flow, warns Dan Georgescu, working capital senior consultant at REL.

“Interest rates won’t stay this low forever. What will be the impact then? You can only run out of cash once,” he says.

A terminal issue

The amount of debt available to corporates has somewhat surprisingly failed to harm working capital performance across the piece. Last year, the cash conversion cycle (CCC), a measure that expresses the length of time it takes for a company to convert revenue into cash, improved by 5.5%.

However, those companies that rely on debt the most are the worst in terms of working capital performance. Two-thirds of companies increased their debt over the past seven years – out of which 28% saw their debt levels increase more than 100%. Those companies had an average CCC deterioration of 51%.

Nevertheless, there are companies that understand the importance of strong free cash flow. Dieter Bellé, CEO and CFO at cable technology business LEONI, says it is of “key importance” to its investors and provides the business with the “necessary financial scope for both expansion through internal growth and acquisition”.

Mears Group FD Andrew Smith goes a step further. For a support services business like Mears, which operates a low-value, high-volume business, having an efficient working capital process is absolutely imperative.

“The difference between success and failure is quite stark in our sector. If you don’t have processes that can manage thousands of small jobs, it become less about competitive advantage and more of a terminal issue,” he tells Financial Director.

Thankfully for Smith, Mears is one of the better performers in this area. In 2014, it was able to improve its CCC to such an extent – a staggering 657% improvement on 2013 – that it was able to bank receivables 41 days before payables were due. How was such an improvement achieved? Having an in-house IT system that was “written by accountants” played its part.

“The cornerstone of our system is that it is accounts-focused,” he explains. “The business is dealing with thousands of small jobs and we are able to review costs, margins and invoices down to an individual level. The IT system is key to that.”

Cash culture

As with previous iterations of the survey, maintaining a corporate focus on working capital has proved a challenge. Only 13% of companies have managed to improve their CCC every year for three years, while only 3% achieved year-on-year improvement over five years. Since 2007 that figure is even worse, with only three companies able to demonstrate continuous and sustainable CCC reduction over the period.

“Companies go for short-term working capital improvement and, once they have achieved their goals, the foot comes off the accelerator,” says Georgescu at REL.

Companies, such as Unilever, that are able to maintain improvements over the long term are those that can get C-level support for working capital as part of the company’s overall strategy. “Operationally, there is a good understanding of working capital in other parts of the business,” says Georgescu.

LEONI was one of the 124 companies that improved CCC for three consecutive years. “Along with profitability, working capital is an essential component”, and management at LEONI “has the responsibility to sustainably improve working capital by managing the key improvement levers through the operational process,” says Bellé.

But what does this mean in practice? Many businesses introduce incentive schemes that reward individuals for enforcing strict payment terms and run efficient collection departments. But Smith at Mears says it must run deeper than that.

“If you take your eye off for a week, it can take three months to get it back in line. You have to create a cash culture that goes through every level. The job must only be seen as complete once the invoice has been paid and the cash collected,” he says. “I work on the basis of getting in people who care about cash culture.”

Tactical buying

Another way is to get the balance between payables and receivables right.
Westcoast is a privately owned UK company (so not featured within REL’s survey) which distributes electrical equipment to retailers and resellers. The sector is typically risk averse, so suppliers offer short credit terms that are payable by direct debit. For example, one large supplier offers Westcoast payment terms of 14 days. However, customers invariably want to pay on 30, 60 or 90-day terms.

As there are longer payment terms for its customers than is offered by its suppliers, Westcoast was keen to ensure it could steer clear of incurring hefty rates of interest while still meeting customer demand for stock. The business turned to an alternative payment term – in this instance American Express – to supplement its traditional invoice process and complement its existing credit and insurance structures.

The payments solution means Westcoast can pay its suppliers promptly, but it doesn’t have to part with the cash for a further 58 days. This significant improvement has had a direct impact on future growth prospects.

Sunil Madhani, Westcoast’s finance director, says: “We have the flexibility at any time to access funds through American Express, so it has had a very positive impact. Improved working capital gives us the opportunity to buy more and then sell more.”

Alan Gillies, VP sales at American Express Global Corporate Payments UK, says companies like Westcoast are able to turn flexibility in their working capital processes into tactical buying opportunities with suppliers.

“They can buy from different suppliers in the same space for the
same product and then decide how to utilise the line of credit for individual suppliers,” concludes Gillies.