Karan Lal of REL explores the impact of Brexit on working capital, and how businesses can adapt to a new economic environment in the UK
The referendum vote taken on June 23, 2016 makes a mark in British history, as the United Kingdom has taken the decision to leave the European Union. Though Brexiteers will welcome the sovereignty that is likely to return to the UK, businesses have been amongst the most nervous, as both the next steps to take and the resultant impact upon the UK economy are not clear and have therefore created a bubble of uncertainty. The fact that Article 50 of the Lisbon Treaty has never before been put into action is adding further to the uncertainty, as forecasting and predictions have been made more difficult. This difficulty has also raised huge questions for foreign investment. New and existing investors look to rethink their decisions and await political reassurance from the government on the process and procedures of Brexit and the likelihood of retaining the single market.
Brexit’s impact on the UK economy
Standard & Poor’s (S&P) had been the only major agency to maintain a AAA rating for the UK prior to the referendum. However, the unpredictability created by the decision to leave the EU, as well as the forecasted “abrupt slowdown,” has triggered the decision for S&P to cut the UK’s credit rating from AAA to AA.
From the latest GDP figures published by the Office of National Statistics (ONS), the UK GDP grew by 0.5% in the third quarter following the referendum. Though a weaker pound has impacted the UK’s purchasing power on the import side of things, the UK has become a more attractive proposition for international exporting, which has been a contributing factor for the growth in GDP. While the UK GDP data make positive readings on first look, this has come at a price. The pound sterling has lost significant purchasing power, falling approximately 18% against the US dollar. Having a strong currency is vital for such a huge importing nation to retain its purchasing power as well as for closing in on deficit gaps, which the current and previous governments have been attempting to achieve.
Although it can be argued that the UK economy looks resilient despite voting to leave the EU and the fall in sterling, the fact that for the moment the UK still remains a member of the EU needs to be taken into consideration. Recent growth in exports may well have been made difficult without the benefits of the single market and the various legislation and procedures behind EU membership.
Looking forward, the UK continues to have access to the single market as a full member until the end of the two-year negotiations, which are due to start around March 2017 when Britain will formally look to activate Article 50. Although the exiting process is relatively clear, questions and uncertainty remain over how long the exiting process will actually take. It is currently expected that the UK will formally be out of the EU in 2020. Such timelines are likely to cause further delays to investment decisions and future trading relationships between countries in the EU as well as with the rest of the world.
The long-term economic consequences are heavily disputed by Brexiteers, though many predict a negative long-term impact. It is for this reason that both EU and UK companies should take a deeper look into their working capital and bolster up their cash reserves in preparation for the uncertain direction of both economies and the potential negative impact, as both the EU and UK may well face negative consequences one way or another.
Importance of working capital and cash
Working capital is the amount of cash that is tied up in a company’s day-to-day operations. All three components (accounts receivable, accounts payable and inventory) must be in focus to free up cash otherwise tied up and to obtain maximum cash benefit opportunities, in addition to identifying and tackling inefficiencies in processes and procedures (Fig.1).
FIG. 1 To free working capital into cash, accounts receivable and inventory are decreased and accounts payable increased
Working capital = (AR) + (Inventory) – (AP)
- Capital employed is also known as working capital
- Working capital is divided into three major categories
- External accounts receivable (AR)
- External accounts payable (AP)
- AR and inventory are the components that consume capital and AP is the component that releases capital through the terms given by the suppliers (they finance company’s capital)
Especially in times of economic turmoil, companies rely on their cash reserves as a means of security. It is therefore imperative for companies to have good total working capital management to free up cash from their working capital and improve their cash position. This will help them stay resilient towards unforeseen circumstances such as exchange rate fluctuations, increasing interest rates and a decrease in sales.
Although Brexit cannot be directly compared to the global financial crisis of 2007-08, key working capital lessons can be learnt from that experience. At that time, poor total working capital management was a key factor in several liquidations, as cash reserves were not sufficient to run operations and were tied up at the same time banks were being reluctant with credit lines.
Even though the Bank of England (BOE) has reassured that stress tests have been successfully carried out far beyond the potential impacts of Brexit, this does not guarantee that businesses themselves can stay resilient to the potential impacts of Brexit and other external impacts that Brexit may bring.
Uncertainty and a weaker pound
The vote to leave the EU has not only left the UK filled with uncertainty but also brought a weaker pound. The pound falling to historic low levels against major currencies has significantly dented the purchasing power of the UK. As the UK is predominantly an importing country, buying goods, services and raw materials from outside the UK has become costlier since the decision to leave the EU. This has brought further weight onto companies’ total working capital requirements.
Accounts payable balances are amongst the working capital factors affected, as these are naturally increasing due to the weakness in sterling. Because companies passing on such currency-related costs to consumers have already received bad press from the public, many companies are being forced to bear their own costs of Brexit. Using working capital optimisation tools such as supplier payment term improvement seems to be one of the few options for companies to hedge the effects of a weaker pound on their accounts payable. Such Brexit-related costs are also forcing companies to look further into optimising stock levels to adapt to the current situation to reduce costs where possible, as well as to cut out any inefficiencies in processes and product lines within the business.
Although in the public’s eye the weakness of the pound has caught negative headlines, UK exporters are becoming more competitive in the international market. Such uncertain circumstances are also putting more pressure onto accounts receivable balances, which are increasingly becoming more important – the cash is needed not only to fund the exporting growth but also to keep as a reserve to tackle near-future changes within the UK economy, which remains and will remain uncertain for the next few years.
Therefore, analysing and evaluating accounts receivable balances, with special emphasis on collections, are key steps towards a healthier cash flow in the short term to face uncertain economic environments. Implementing improved and more efficient accounts receivable processes and procedures will be key for medium to longer term healthier cash flow. Managing customer payment terms and creating an overall cash culture within a company are key to a more sustainable cash flow, even in times of economic stability.
A cloud of doubts
Questions remain over possible UK and EU trade deals and access to the single market. Doubt also remains over whether the “hard Brexit” model is the correct model to be implemented for the UK, with current political vagueness around plans for negotiations adding to continued uncertainty. This political vagueness is forcing UK companies to focus their procurement and sourcing domestically, where possible, to potentially avoid any future complications.
When changing suppliers, big emphasis and focus are put on the negotiation procedures to obtain the best deal possible for both sides. Change in suppliers in current circumstances will require a much clearer strategic approach to contract management, which should be tailored to face future uncertainties and also focus on factors related to working capital.
It is therefore useful to have a set of trade-off tools prior to negotiations with suppliers to ensure the right deal is made despite tough counter negotiations, as UK-based suppliers, in particular, will expect these changes and use the leverage to their advantage.
Outlook on base interest rates
According to the National Institute of Economic and Social Research, UK inflation rates are predicted to rise up to 4% by the end of 2017. This prediction is predominantly based on the assumption of a continued weaker sterling as well as the uncertainty of the UK future lying ahead once Article 50 is activated in March 2017.
Such rises in inflation are likely to influence the BOE decision to raise base interest rates, taking away the ability for many UK businesses to borrow at the low levels they currently are using and from which they are benefiting.
Whether companies are borrowing at low levels or high levels to fund their day-to-day activities, having a well-worked and healthy total working capital proves to be the less risky option, especially in times of economic uncertainty. With healthy working capital, companies can stay cash-dynamic despite any negative external factors thatvmay influence the willingness of banks to lend. Therefore, initiating total working capital improvement programmes covering accounts receivable, accounts payable and inventory are strongly recommended.
With major Brexit-related uncertainties lying ahead – currency, trade deals and interest rates – it is important that companies have their total working capital in check and sufficient cash balances to sustain short and long-term periods of potential political and economic uncertainty.
Though life after a “hard Brexit” is predicted to be challenging, new opportunities are likely to be on the horizon as the rest of the world will look to capitalise from Brexit. UK businesses will welcome such new opportunities, hoping to transform the uncertainty and negative predictions into a success story. Being able to capitalise on new opportunities will, however, require investment.
It is therefore imperative for businesses to have a well-managed working capital and a well-embedded cash culture for a smooth adaptation to the new economic environment the UK is set to face, as well as for funding new opportunities.
With uncertainty remaining over future interest rates, having the ability to better generate cash from day-to-day operations may well prove to be preferable to external lending, further making the important shift from retroactivity to proactivity. In this situation, continuous improvement and implementation of best practices should become part of any company’s DNA.
In a cash-centric business, working capital is at the centre of operational and strategic decisions, as it is well understood that cash released from operations offers tremendous benefits: financial flexibility, strategic agility, competitive advantage, sustainable growth and operational efficiency, all helping toward a winning corporate culture.
Karan Lal is a consultant at REL.