Risk & Economy » Regulation » Emerging markets: Mind the working capital gap

THE SOURCE of future growth for many European companies will occur across a set of culturally and geographically diverse countries, which include Brazil, Russia, India, China, Mexico and South Korea (BRICMK). As HMRC figures show, British organisations have increasing exposure to these countries, with growth occurring mostly in manufacturing sectors, which tend to be more working capital intensive. It is therefore becoming increasingly important to study their impact on net working capital (NWC) performance and how companies are managing processes to adjust to this change.

Across the BRICMK, total working capital consumption is similar to that of EU based companies. However, within the BRICMK, performance varies considerably, particularly in China and Mexico, with working capital performance at 39 and 30 days respectively, better than that of EU companies at an average of 47 days.

In fact, there is a significant gap both in days sales outstanding (DSO) and days payable outstanding (DPO). DSO across these markets shows a wide variance, from as low as 35 days in China and up to 57 in Brazil. Overall, DSO for the combined BRICMK markets is 14 days or 25 percent better than for EU companies. Particularly efficient are Mexico and the large-value markets of India and China, which appear to be very effective at collections.

Trade with these countries is partly driven by the increased sourcing by European companies in south east Asia, with the major focus being price arbitrage rather than cash advantage. Shorter payment terms to Asian suppliers, often from date of loading or shipping, result in a negative DPO impact for European firms. When considering the growth rates for imports in these markets over the last few years, the pressure on DPO within European firms is set to continue and even accelerate unless European-based sourcing will recalibrate to more clearly focus on cash optimisation. A similar gap is visible when looking at the accounts payable performance utilising the days payable outstanding key performance indicator (KPI). From a payables perspective, lower purchasing costs are typically offset by shorter payables performance. For example, merchandise from a Chinese or Taiwanese payment term is usually freight on board (FOB), that is, advance payment, thereby negatively impacting the overall DPO for European firms.

Overall, European payment performance towards suppliers is not that different to that of the BRICMK countries. The payment performance of the large export markets of India and China are at a comparable level. Based on this, one could conclude that an increased trade with these export markets will not have any significant impact on European firms’ DSO.

That is, however, not the entire story. For Russia, payment terms are considerably shorter, driven by historical insistence on prepayment for export sales to the region. As the market matures, this requirement usually decreases, and thereby it is likely that the DSO of EU exports into these markets will actually increase.

Sales within these markets come with local challenges that impact the way receivables are managed and measured – everything from ideological to procedural differences. In Brazil, for example, historical experience with inflation has led to clear and enforced rules on late-payment penalties. However, timely invoicing is another matter entirely. Invoicing can be withheld to allow for “unrecorded” payment terms that are not measurable in methods typical in the UK, such as invoice date to due date. Further, fiscal requirements for when local VAT is payable directly influence the time of billing, with pro-forma invoicing common in some markets to avoid a cash gap. This requires strong invoicing controls, measure of milestones and detailed measurement of the unbilled process, rather than trying to control overdue receivables percentage as a measure of performance.

In some countries, undertaking strict cash collection is culturally frowned upon. With the emphasis placed on personal interaction, especially in Asia, telephone collections or letter writing simply does not have the same effect as in Europe. For this reason, processes and responsibilities for chasing outstanding debts need to be adapted accordingly.

Moreover, we have seen that the eagerness of European firms to take a slice of the pie in new growth countries can outweigh all other considerations.

The impact goes beyond the change in relative NWC performance. It also affects the way working-capital-related processes need to be managed. There are supply chain risks in dealing with all markets. The first and most obvious ones are in managing the supply chain challenges when sourcing from the BRICMK countries. Trading with geographically distant markets increases the working capital required, as supplier lead times and time-to-deliver (increased transit times) must also be factored in. Shipping times can be 30 to 40 days at sea, so if ownership is transferred at the time of the loading date, that has an impact on the level of work-in-progress (WIP) inventory.

Inventory levels in the supply chain tend to increase to cover fluctuations in demand and the potential for delays along the extended supply route. Requirements for accurate forecasting may suffer, as schedules must be firmed up further in advance to cover the extended shipping time. The time to react and flexibility needed to absorb short-term changes in customer demand is reduced. As a result, many firms are tempted to increase safety-stock levels as well as suffer the inevitable increase in levels of slow-moving and obsolete stock.

What the NWC indicators do not clearly show is the potential for increased levels of risk that can directly impact the ability for accurate forecasting. These risks can include political ones, infrastructure, currency and even the quality and reliability of transport. While the effect of these is understood, in working capital terms they can spell uncertainty in the supply chain and an urge to create larger buffers against these risks.

There are a number of strategies that firms can consider.

Supplier relationship and communication
Partnership approaches should be adopted when dealing directly with suppliers in emerging markets.

Payment terms
Initial supplier terms may be by documentary credits or bills of exchange; moving as soon as possible to an open account with extended payment terms will ease cash flow problems and reduce transactional costs.

Supply chain financing
Employing supply chain financing enables the supplier to receive invoice payments early whilst the buyer can enjoy the cash flow benefits of extended payment terms.

Inventory control
A higher level of safety stock may be essential; however, initial levels held can be reduced as confidence in the supplier and the supply chain is gained.

If the goods being imported are subject to import duty or VAT and are not required immediately, it may be an option to store in a bonded warehouse to delay payment of the import duty or VAT until the goods are needed.

While there are clear differences, the guiding principles of managing working capital effectively are larger than the level of required customisation. The uniting factors that can be implemented everywhere are process discipline and clear rules, roles and responsibilities. In our experience, defining a blueprint outlining the key principles that should be in place to manage working capital ensures that the needed continuity and transparency are in place across a multinational organisation. Getting the right balance between local customisation and groupwide harmonization of process execution is the trick.

Daniel Windaus is a senior director at working capital specialists REL