Robert Haas, Senior Consultant, Working Capital Division, at The Hackett Group, discusses the need to prepare for changes in interest rates
Chief financial officers have exploited extremely low interest rates for years, but with signs of higher interest rates ahead and the uncertainties of Brexit, CFOs prepare for a shifting playing field. It’s more important than ever to make sure your financial house stays in order.
Amid the uncertainty of the 2007-8 financial crisis, central bankers dropped interest rates as they struggled to maintain liquidity. As the crisis dragged on, central bankers kept rates down to almost nothing, and in some cases, less than nothing. CFOs took advantage of this situation, borrowing trillions in “free” money to put their companies in a stronger position – and often using the money to buy back stock, issue dividends, or build enormous war chests for acquisitions.
For nearly a decade, this has been a winning strategy, but now some central bankers believe that the world’s economy is stronger, and interest rates can begin to rise again. The odds of a reversion to the mean now seem high enough that CFOs should actively prepare for a major shift.
End of the spree
Quantitative easing has increased corporate spending in several distinct ways. It has led them to:
- Spend more on capex. Capital expenditures for the top 1000 European companies has increased by 6% over the last eight years, topping €523 billion in 2016, despite a 5% reduction from the 2015 high.
- Plump dividends. Dividends increased by 21% over the last eight years to €234 billion in 2016.
- Buy back stock. More prevalent in the US but key players in the FTSE 100 are among the major European companies following suit.
- Purchase companies. 2015 proving to be a record year for the UK.
- Refinance maturing loans at lower rates.
But quantitative easing has side effects. Among the top 1000 European listed companies, debt levels are at historic highs. It’s encouraged purely financial investments, particularly dividends and stock buybacks. It’s also led companies to be incautious about cash management.
Low interest isn’t the same as no-interest. Pile on enough debt and interest payments begin to eat into profit margins, ratchet up debt ratios, and expose the company to unnecessary macroeconomic risks. If interest rates return to their mean, those loans may not be easy to refinance at the same low rate.
Impact of lax working capital practices
Reliance on debt financing has encouraged less vigilant working capital management, driving underperformance in each of the major working capital accounts:
Accounts receivable. Lack of focus on the revenue cycle can result in higher amounts of aged customer debt, particularly as older receivables become harder to identify and recover. Where the debt is a signal from an unhappy customer, neglecting it can exacerbate disputes, and lead to write-offs.
Inventory. In this fast-fashion era, inventory risk is bigger than ever. Particularly in retail and fast-moving consumer goods, companies try to maintain an agile supply chain that builds on ongoing, incremental product improvements. In such circumstances, stockpiles are not really an option. If inventory is misaligned with demand and consumer choices, organisations risk locking up cash in slow moving materials.
Accounts payable. Companies may not think much of giving their suppliers below- market standard terms, but if those suppliers have more favorable terms with competitors, the company may be essentially financing the competition’s working capital.
For now, most debt loads are tolerable. But in a highly leveraged company, if interest rates rise, even a relatively small bump could have an outsize impact on the company’s health.
Of course, that is a big if. It is possible that interest rates will stay where they are for some time. Certainly, some economists don’t see a substantial rise in the near future. However, market timing is generally not recommended as a strategy for the borrower any more than for the investor. How can you spend competitively even as your accustomed sources of liquidity dry up?
Some organisations are sitting on plenty of money: the top 1,000 European companies have locked up €1 trillion in liquidity. According to The Hackett Group’s 2017 regional working capital surveys, there’s also $1 trillion that could be released in the US, and potentially a further $2 trillion in the Asia Pacific region – and all it’ll take to release it is better working capital management.
Smarter working capital
Smarter working capital management can enhance performance. Analysts pay attention to the relationship of short-term share performance and working capital efficiency. The cash conversion cycle (CCC) in particular is one of the best indicators of a company’s operational health. The Hackett Group has estimated that reducing CCC by seven days can lead to an additional 1.2% in gross margin, 1.1% in EBITDA margin, and 0.8% in return on capital employed.
Smarter working capital management can lead to greater efficiency. It can enhance communication, break down silos and foster end-to-end productivity. Eliminating substandard processes can free millions in locked-up cash.
Finally, cash released from working capital is cheaper than debt and without any of the financial risks. It’s the company’s money and accordingly it’s nearly free and can be applied to any projects. This may be especially important in the next few years as companies struggle to keep up with a wide range of digital opportunities.
Prepare for a shift
Companies that have relied on cheap money should prepare for a major shift in rates. One of the best ways to prepare is through working capital optimisation. Better management frees cash and drives process enhancements that strengthen the organisation. Tighter working capital processes can reduce exposure to interest rate shifts by reducing the need for cash in the operation.
This might sound corporate equivalent of pinching pennies. However, the sums that can be freed through smarter working capital management are not trivial: As much as $4 trillion worldwide – roughly 5% of global GDP – would go a long way toward helping the world’s leading companies prepare for challenges ahead.
Best of all, your share of this cash is already there. You don’t have to cross your fingers in hopes that a central banker’s strategy doesn’t change. A smarter approach to working capital will leave your company with a better range of options.
Robert Haas is a Senior Consultant, Working Capital Division, at The Hackett Group.