Treasury Today Country Profiles in association with Citi

Working capital: have you been taking the easy road?

Straight road heading towards sunset

As the European economy starts to return to growth, the 17th edition of REL’s Working Capital Survey analyses practices of the 1,000 largest publicly trading companies by revenue in Europe. The results show that corporates continue to be divided between making the most of cheap debt and optimising their internal cash generation. Treasury Today talks to Derrick Steiner, Senior Manager, REL Consultancy, on what should be learnt from the study.

Uncertainty lingers across Europe, but there is (apparently) a silver lining. It has prompted some corporates to scrutinise their working capital practices and to focus on maximising internal cash flows. Indeed, REL’s Europe Working Capital Survey for 2015 revealed some positive improvements that European corporates have been making to decrease their cash conversion cycles (CCCs). But, with the focus on optimising working capital management far from widespread, the central message from the report is: “What companies must not forget is that you can only run out of cash once.”

Changing with the times?

Given that there is no substitute for cash, European corporates certainly don’t want their companies to be caught short. But REL’s survey has some encouraging news – in 2014, the average cash conversion cycle (CCC) improved by 5.5% (a decrease of 2.1 days) demonstrating that cash management on the continent is being optimised somewhat. For some, the 2014 performance continues a positive trend seen since the recession, with an 18.5% improvement in CCC compared to 2007.

Chart 1: Cash on hand increases 62%
Chart 1: Cash on hand increases 62%

Source: REL 2015 Europe Working Capital Survey

Managing working capital, of course, helps corporates place themselves in a better position should uncertainty swing in an adverse direction once again. And looking at the change since 2007, cash on hand has increased 62%. “The problem with that number, however, is that it’s a little misleading,” explains Derrick Steiner, Senior Manager, REL Consultancy. “You don’t necessarily know what the source of cash flow is. If you take cash on hand as a percent of revenue, it normalises out to an increase of only 2%. So, have companies learnt the importance of cash reserves since the crisis? Have they put additional cash on their balance sheets? Our argument is that it’s been pretty minimal.”

Chart 2: Companies are not hoarding cash

Cash on hand as a % of revenue

Chart 2: Companies are not hoarding cash

Source: REL 2015 Europe Working Capital Survey

Increased debts

During the years from 2007, the report also found that investments have been on the rise: capital expenditures have gone up 21% and dividends by 25%. “It is also well reported that mergers and acquisitions (M&As) have been increasing to all-time high levels,” says Steiner. These investments have largely been funded through increased debt levels (40% increase from 2007). Given the European Central Bank’s (ECB) sharp decline in interest rates – from 4.3% in 2007 to 0.01% at the end of 2014 – it is unsurprising corporates have taken advantage. “Quite honestly, if a company didn’t take advantage of that ECB interest rate, shareholders might start asking questions,” notes Steiner. It is around the topic of borrowing, however, where the disparity between European corporates’ priorities starts to become apparent.

According to the report, “companies increasing their debt 100% or more since 2007 had an 800% increase in cash on hand, although their CCC worsened by 51%. The companies that decreased their debt since 2007 have, on average had a 225% increase in cash on hand but their CCC improved 27%.” In other words, just because a company has more cash doesn’t mean that the CCC will improve. Moreover, the rising presence of debt shows a “worrying increase” according to the survey results and corporates should be concerned about the long term risks.

“Some companies have taken on debt instead of focusing on cash flow management techniques to optimise cash internally,” says Steiner. In fact, working capital is only a corporate focus for 124 companies (13%) in REL’s study. “There are talks of a rate hike happening in Europe next year and that’s a cause for concern because what is going to be the source of capital expenditures and dividends for some corporates? You can’t simply continue borrowing and become overleveraged,” he notes.

Limited frontrunners

As mentioned above, REL’s results show that companies with large debt had the worst cash management performance, and those focused on reducing debt saw improvement to their CCC. Nevertheless, there are few companies that improve their CCC consistently year-on-year. “If we take the REL 1000, there are 124 that improved their CCC every year for the past three years (only 13%). If you go back a further five and seven years, there’s only 33 companies (3%) and four companies (less than a percent) respectively. The point is that the weeds grow back; sustaining improvement is pretty rare,” explains Steiner.

It seems therefore that many European corporates would do well to reflect on their cash management techniques and capital structures. “Be wary of simply taking the easy road and increasing debt. There is a balance somewhere in between borrowing and committing time and resources to maximising the internal generation of cash,” notes Steiner. Furthermore, “those companies that are currently poor performers are going to have a longer road ahead and more challenges to generate cash internally when the external finance markets aren’t as viable or attractive.”

Starting points for improvements

Although Steiner believes “it’s going to get worse before it gets better” as companies will continue to take advantage of market conditions until that interest rate hike comes, what should treasurers with a longer-term view be thinking of? According to Steiner, there are a few good starting points:

  • Metrics, metrics, metrics.

    “We have a lot of clients that don’t have an understanding of the different working capital components,” says Steiner. Knowing where you are as an organisation in terms of days payables outstanding (DPO), days sales outstanding (DSO) and days inventory outstanding (DIO) is critical before you can look at improving the CCC.

  • Comparison with peers.

    Once you have these metrics, it is also useful to understand where your peers and competitors are. Steiner explains: “The two biggest areas that impact those peer benchmarks are the country you’re located in and the industry you operate in.”

  • Determine benefits.

    Understanding your performance internally (metrics) and externally (peer comparison) will illustrate where opportunities could lie. “Knowing the ‘size of the prize’ helps dictate whether or not it’s something that these companies should focus on.”