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REL Working Capital Survey 2012

ASSUMING THAT THE RECESSION ever comes to an end, the ability to deploy working capital efficiently and effectively will serve as a harbinger of whether UK plc has the agility necessary to capitalise on the upturn when it eventually arrives.

A study of the 1,000 largest listed European groups by sales suggests that the omens are not good. The balance sheets of Europe’s top businesses are bloated by billions of euros of excess capital, while billions more are being wasted as a result of inefficient cash management.

Working capital consultancy REL’s annual cash management survey – known as the REL 1000 – found that working capital performance deteriorated in the past year as businesses have failed to sustain the improvements made during the recession.

According to the study, days working capital (DWC) – the number of days it takes to convert working capital into revenue – improved marginally by 0.7 days. However, overall working capital performance deteriorated by 0.1 days – or by 0.8% – while companies’ capital efficiency decreased in 2011 when compared to 2010. Operating expenses increased by 10%, gross margin decreased by 1.2% and profitability decreased by 0.04%.

The figures represent a stark departure from recent performance as the recession served to sharpen companies’ focus on running tight cash management processes. No wonder, as it is a lack of liquidity rather than a lack of profitability that so often causes corporate failures at ostensibly well-run businesses.

“Without efficient working capital processes, businesses can go under,” says Arif Kamal, group finance director at construction business GL Hearn. “When businesses fail, 70% of those are profitable organisations. It happens when working capital is not managed effectively.”

Dramatic improvements

Company cash positions - source RELLast year’s study found that constituent companies had overseen dramatic year-on-year improvements to their working capital performance, reaching a five-year low in DWC. Between 2005 and 2012, European companies demonstrated an ability to more efficiently convert their working capital into revenue. But despite the bright picture, it was clear – even then – that a combination of excess and inconsistencies could threaten a long-term improvement. One year on, this fear appears to have been borne out.

Indeed, of the 1000 companies examined by REL – when looking at their three-year performance – 69% were unable to maintain their working capital performance as it deteriorated by more than 5%, while only 11 companies were able to maintain performance in all three components of working capital – namely payables, receivables and inventory – to less than 5% deterioration.

The study also shows that only 99 companies, representing less than 10% of those covered, were able to sustain an improvement in working capital over three years. During a five-year period, only 1% of the surveyed companies maintained or improved their cash management.

“What surprised us, given the improvements made during the recession, was to find that companies are reverting back to normal habits. The focus goes away from efficient cash management,” explains REL principal Gavin Swindell.

Empty rhetoric

Industry DWC - source RELYet the figures published by REL don’t necessarily chime with noises coming from finance departments. The rhetoric from finance directors is certainly there – a recent survey by Deloitte found that CFOs believe that increasing cashflow and reducing costs should be key priorities – but the dynamics of a competitive market has led many businesses to focus on prioritising growth opportunities and hoard cash reserves to fund working capital, leaving cash flow as a secondary concern.

As a result, the amount of money companies are wasting is simply staggering. According to REL, as much as €886bn (£698bn) of working capital opportunity, which equates to 9.4% of EU GDP, is being wasted because of ineffective processes, of which 36% is from receivables, 32.5% from inventory and 31.5% from payables

Although UK companies are individually more efficient than their continental counterparts, poor working capital management has still managed to cost UK business £125bn over the past five years. Research carried out by PwC, which analysed the largest 4,000 European companies (with a turnover of £150m), found that each large UK business could have generated average cash to the tune of £248m if they had run efficient processes.

Is cash still king?

Average days working capital - source RELBut why are businesses returning to cash management performance levels that are close to pre-recession levels, and is that really what is happening? Over the past five years, companies have gone some way towards hammering their processes into shape; cash is king as the hackneyed refrain goes. The initial shock of a financial crisis – the likes of which the economy had not experienced for 80 years – served to focus minds on cutting costs, squeezing suppliers and generally running a tight operation.

The latest round of deeply uninspiring growth figures – a shock 0.7% contraction for the second quarter of 2012, according to figures from the Office for National Statistics – prove that the economy has some way to go before clambering free of the financial wreckage, yet there is a faint optimism among businesses that better times are just around the corner.

Consequently, attention on cash management is starting to drift among company boards – although finance directors remain as focused as ever – as focus shifts to the P&L statement while businesses put an ever-increasing amount of effort into growing sales and revenues amidst fierce competition and with new business opportunities thin on the ground.

Politicians are trying to talk up the recovery, and government is trying to boost growth, so it is only natural that executives would begin to position their companies for an upturn in fortunes. But when growth and revenue are the order of the day, REL’s Swindell says that it is the FD’s job to make sure that this does not come at the expense of cash management.

“The problem is that cash management transcends lots of functions. The FD has to be very visible in the project to make it work; they can’t do it on their own. The key thing is that working capital is multi-functional,” he explains.

Driving the ethos

Debt cash flow - source RELKamal agrees that it is the job of finance to corral management into taking efficient working capital management seriously, but adds that “it is not just finance” that has to drive the ethos through the company. Without the right members of the board on their side, finance directors risk sounding like a stuck record or, even worse, like a Cassandra.

“We happen to have a chairman who never misses talking about working capital. Right through it is an agenda item,” explains Mike Richardson, strategic finance director of road services business FMG.

There is also added complacency towards cash management due to the amount of cash hoarding going on. According to Deloitte, UK plcs were sitting on £64bn of excess working capital earlier this year, while many finance directors aim to run higher cash balances than before the financial crisis. Because of this, the amount of excess working capital is still rising.

After an increase since 2008, REL found that cash on hand and free cash flow are coming down by €22bn and €50bn, respectively. Yet the numbers remain inflated and represent businesses’ inherent caution and desire for a safety net against market volatility.

“Cash is king is something people say, but at present the actions don’t match the words,” says Swindell at REL. “If you are a strong company, the risk of running out of cash is minimal.”

However, the seemingly healthy cash positions of companies are misleading. Many are taking advantage of low interest rates to accumulate more debt; total debt increased by €95bn year on year, though cash on hand decreased by €60bn year on year.

Sustaining investment

In many instances, that debt is actually being put to use. Companies are re-investing the money in anticipation of growth; capex increased by 7% and is above pre-recession levels, indicating that companies are using debt to finance capital expenditures. However, it is likely that companies will have to generate the cash internally, to sustain the levels of investment that they have started.

Bobby Lane, partner at Shelley Stock Hutter, suggests that although it is fine to take on cheap debt – provided that companies have the confidence in their revenue streams and their ability to pay it off – turning to the banks should not be seen as the only recourse.

“The key to all this is to make sure you have an appropriate cash flow forecast. The cheapest way of funding capex is out of cash. But make sure you do not leave business short of working capital in future,” explains Lane.

If a company’s revenue stream does not materialise, and its debt positions have increased, it will be in the same position that it was pre-crisis. Interest rates would eventually go up and companies would need to generate enough cash from operations to sustain the level of investments that are going into the capital expenditures hat.

Richardson at FMG has had to oversee a £4m capex in his business’ central Ingenium system, which he describes as a “sizeable chunk” for a £90m turnover operation.

“You get capex around growth, then you get capex where you need the latest version to continue,” he says. “In either case, you have to invest in an incremental way that works in a scaleable business.”

Richardson adds that capex to get new customers up and running is low, which makes for a payment pattern for new business that is working capital positive. “You have to commute the cost of bringing new business in so there is a working capital neutrality of new business,” he explains.

Kamal at GL Hearn says his strategy is to fund capex from internal cash as well as cash from retained profits, and urges businesses not to “shy away” from making investments.

“When the economy turns, you have to be prepared to look at what comes your way. If you cut too thin, you will not have the ability to meet market demand,” he says.

Get lean, get mean

So how can companies be more efficient? The simple answer is to get the basics right – such as nailing on forecasts for operational staples like inventory, receivables, payables and the underlying cash requirements to support them.

Surprisingly, businesses are failing in this area. According to a separate study by REL, the typical company will potentially miss quarterly working capital forecasts (including inventory, receivables, and payables) by as much as to 23%, which amounts to up to $600m (£387m) for a company with $29bn annual revenue.

Recommendations on how to improve forecasting include reconciling functional and strategic operations, incorporating working capital performance such as employee rewards, as well as improving staff training.

Richardson at FMG says he “tweaked” his working capital processes, which helped keep the relevant KPIs constant over the past three years.

“I now have a proper 13-week cash flow forecast, a working capital committee and regularly sit down with our credit control and people on the payment side to look at our KPIs,” he says.

On the key metrics of inventory, receivables and payables improvements made during the recession – collecting from customers faster, paying suppliers later and getting rid of excess inventory – are not being sustained.

According to REL, things are in fact falling back to where they were pre-recession. In 2011, DSO – the amount of time it takes to turn receivables into revenue – decreased by 1.1 days or 2.2% from 2010, marking the second consecutive decrease, which indicates that companies are better at managing their receivables management processes.

However, inventory management appears to have lost traction after the credit crisis. Inventory improved in 2010, but since then has worsened with DIO increasing by 0.4 days or 1.1% from 2010.

In 2011, DPO (days payable outstanding) stabilised, remaining pretty much flat from previous year. But companies have been unable to make further improvements to better their payables performance.

Neil Davidson, UK managing director at software provider Deltek, explains that many professional service firms are accepting payment terms that were unacceptable several years ago as a condition of winning new business. For existing clients, terms are also being stretched further and further.

Dire consequences

The consequences of such late payment terms can be dire. Recent data from Clydesdale and Yorkshire banks, for example, revealed that one in ten business owners believe that they would have to scale back operations or even shut down if their customers took more than 90 days to pay invoices.

By conceding on payment terms, or sending inaccurate or late invoices, business are, in effect, providing interest-free loans to customers, and Davidson argues that businesses are involuntarily acting like a bank by ‘loaning’ their services.

“Companies are under pressure to grant extended payment terms because of the onslaught of procurement departments. Some are providing 45-60-day terms to win business,” he says, adding that these ‘loans’ put a strain on cash flow, cost the business money, and could lead to a situation where there are plenty of orders in the book but no money in the treasury.

While conceding on payment terms should be avoided, Davidson says that, at the minimum, it should be used as a key negotiating tool in the sales process in gaining various concessions – such as on price, or in order to get the customer to assist in in marketing.

“It’s about getting something in return. It’s fair to ask customer to agree to provide a statement that you won a project, which helps win more business and attract new clients,” he says. “In return for supplying extended terms, you should look at the rates being charged for the work.”

Paying up

Davidson also says that efficiencies can be achieved through better project management and improved timekeeping. In large projects with greater complexity and a large number of project team members, it is important to have project management and resource management tools that keep projects on schedule and on budget so businesses can get paid on time for the work completed. In addition, having foolproof timekeeping systems in place – which work in tandem with project- and resource-planning systems – ensures all time is captured and billed quickly and accurately.

“You need to provide commercial accountability in your project managers. They are in the best position to tell customers that they should pay,” he says.

Having an effective working capital process should not only be about leaning on customers and squeezing suppliers. Kamal says it is all about having a “sustainable relationship that is flexible enough to cope in situations where you need to delay payment terms as a consequence of the customer.

“As long as the business can manage a delay in payment from the client, you should work with them to find a strategic way forward. If you act badly, they will not be a client for long.” ?

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