Insight & Analysis

Cash conversion: the key to healthy working capital

Published: Jul 2021

As companies emerge from the pandemic, many are shifting from capital preservation to capital deployment. It means efficient working capital management will play a critical role in funding expansion opportunities, making working capital management a key priority for treasury teams.

3d working gears

Liquidity trapped in working capital released in a timely manner can provide capital to fund future growth, says Gourang Shah, Global Head of Treasury and Working Capital Optimisation for Wholesale Payments at J.P. Morgan, who recently oversaw the bank’s latest Working Capital Index report, first launched in 2019 to help companies benchmark their working capital performances against peers. The latest report finds the working capital of S&P1500; companies at its highest level in over ten years, with more than US$500bn in liquidity trapped in corporate supply chains.

Cash conversion cycle

Improving cash conversion cycles (CCC) is one way to free up working capital to fund growth, says Shah. “This can equate to millions of dollars,” he says. The CCC equates to the number of days it takes to convert inventory purchases into cash flows from sales and helps quantify the working capital efficiency of a company. Companies can improve their working capital by effectively managing the individual components of their CCC via reducing inventory levels, extending payment terms with suppliers and speeding up collections from customers.

As a general rule, the lower the CCC the better the working capital efficiency. The CCC of the S&P; 1,500 companies lengthened by 6.3 days in 2020, representing the biggest increase in nine years, largely due to a rise in inventory levels. Weakened demand and supply chain disruptions resulted in the inventory build-up, prompting the days inventory outstanding to reach a new high where companies were carrying inventories for 6.1 more days on average.

For some industries, it can take two months to convert non-cash items into cash. In this case companies must find alternative solutions like financing to take the strain off their balance sheet. “Working capital is a key metric on how well a company is performing,” he said. Moreover, when supply chains get disrupted, working capital becomes less predictable and more uncertain, and Shah notes a spike in the number of corporates seeking much greater insight into their suppliers, receivable financing and requests for inventory financing.

Oil and gas upstream business groups have faced one of the biggest working capital crises. For some this amounted to an increase of 40 days in their typical cash conversion cycle, thanks to a double whammy of oil prices and demand falling. Other industries like airlines, aerospace and defence also saw a sharp drop in demand and sales. On the other hand, the semiconductor industry experienced the biggest improvement in its CCC, due to leaner inventories as a result of strong demand for data storage firms and personal computer manufacturers with most of the global workforce pivoting to remote work arrangements.

Watchful eye

Typically, companies only focus on their working capital when their cash requirement goes up but treasury should keep a permanent eye on working capital via automating processes and reducing idle pockets of cash. The first step to freeing up working capital is an awareness of how a company is performing versus the competition, looking at specific quartiles, he says.

Shah adds that when corporates lose their focus on working capital, corporate performance often starts to decline. “Companies that are focused here tend to perform well,” she said. “The return on capital is a very important metric. Companies should include working capital metrics into their KPIs and look at their working capital performance on a monthly basis, ensuing it is healthy no matter what the circumstances.”

He concludes that SMEs generally maintain higher cash levels than their larger counterparts, as bigger companies tend to have more efficient cash management practices and better access to external capital. During the pandemic, the propensity for lenders to provide capital to small companies relative to big companies reduced, prompting smaller companies to beef up their cash buffers even more.

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