Volatile times

    2017 saw the lowest levels of volatility since the financial crisis, however, the first few months of 2018 witnessed the two most significant point declines in the history of the Dow Jones – driven in part by trade tensions between the US and China (and others), rising interest rates and inflation.

    In June, European and US indices experienced a marked trade war sell-off exacerbated by ongoing uncertainty of trading conditions in a post-Brexit world and increasing oil prices. 

    Even traditional safe havens have been relatively unreliable with the price of gold showing marked fluctuations.

    Value creation

    At a corporate level, trading conditions in many sectors have created unprecedented challenges for management teams seeking to drive growth, maintain yields and create value.  With constant pressure on margins, CFOs and Treasurers understand the importance of strengthening balance sheets and maximising cash flow.

    Analysis shows that Return on Invested Capital (ROIC) is often a reliable proxy for value creation – and more indicative than margins alone. Allowing for the fickle nature of the markets, companies which generate strong ROIC typically trade at higher multiples. This is particularly true in certain sectors (e.g. Consumer Products) where there is a strong correlation between ROIC and Enterprise Value.

    Dataset based on 159 global Consumer Products companies with a Market Value of USD10 billion+

    In appraising financial health and value creation opportunities, investors and analysts focus not just on earnings but also the capital consumed in generating those earnings.  For sectors characterised by low margins, the ability to drive higher ROIC depends on efficient capital management.  Conversely, organisations with low capital turnover need to focus on earnings to deliver high levels of ROIC.

    ROIC is a function of operating margins and capital efficiency.
    Dataset based on 159 global Consumer Products companies with a Market Value of USD10 billion+

    Importance of working capital

    One of the most significant components of a company’s overall capital base is working capital – often accounting for over 30 per cent of invested capital.  Efficient management of operating working capital (i.e. receivables, payables and inventory) has many benefits including improved free cash flow and greater capital efficiency.  In many companies the potential capital release can represent an increase in ROIC of 1-3 per cent. Other direct advantages of improved working capital are:

    • Reductions in debt levels for leveraged companies – leading to potential improvements in borrowing headroom, credit ratings and the cost of borrowing;

    A more cost effective means of funding organic growth, future acquisitions, share buy-backs and dividends;

    • A greater likelihood of companies surviving difficult trading conditions or having to weather an economic downturn; and
    • Improved cash flow forecasting.

    It is no accident that high growth, value accretive organisations typically apply significant focus on sustainable working capital improvement – particularly, if they are highly leveraged.

    Working capital is often a sizeable component of a company’s overall capital base and sustainable reductions can yield significant improvements in cash flow and ROIC – in turn driving future growth and higher valuations

    Challenges of delivering sustainable improvement

    On face value the fundamentals of improving working capital are reasonably straightforward:

    • Collect cash from customers as soon as possible, avoiding bad debts;
    • Keep as little inventory as practically possible to meet orders; and
    • Agree longer payment terms with suppliers – without counteractive price increases or damaging relationships.

    All of this is common sense, but deceptively difficult to achieve due to the level of complexity involved, particularly for large, global businesses with sophisticated supply chains. Working capital touches nearly every part of a business, combining the physical and financials supply chains. This brings together many internal processes and stakeholders – with very different (and often conflicting) outlooks, priorities and objectives.

    Click to download full chart

    Invariably the most difficult challenge arises from a cultural gap between the drive for revenue and earnings growth and the need for reliable cash flow.

    Embedding a cash focused culture & planning for success

    The first step is to accept that a clear focus on sales, profits and liquidity are all crucial and it is usually just the balance that needs to be adjusted. In certain sectors (e.g. media and professional services) this is often harder to achieve in the short term given the way senior management have been incentivised traditionally.

    The following framework is a useful tool in determining how to initiate the rebalancing exercise and designing a successful working capital improvement programme:

    • Visibility – how has the company, including its business units, performed over time (and relative to its peer group or sector) in terms of credit and collections, inventory holdings and supplier payments?
    • Outcome – what are the ultimate objectives and how are these to be translated into phased performance targets? How does the company embed the cultural shift so that it becomes business-as-usual?
    • Support – who is going to sponsor the programme? How does senior management achieve the ongoing buy-in and support throughout the organisation?
    • Planning – how to prepare and agree a comprehensive plan to achieve the objectives?
    • Execution – implementing the plan
    • Review – reporting, reviewing and revising the plan and execution strategy in light of issues identified

    Reduction or optimisation?

    Setting out to reduce working capital is often the overarching goal but, depending on the point in the financial year, the company’s current cash position or recent trading performance may not be appropriate at the time.

    For example if, towards the end of a quarter it looks like revenue or profit targets might be missed, it may be appropriate to tempt customers to place orders with a temporary extension in payment terms. Similarly, if the order book is full, it might be sensible to selectively increase inventory levels. Both these scenarios increase working capital levels but, given the circumstances, might be worthwhile trade-offs.

    Size of the prize

    In estimating the potential for working capital improvement and resulting capital release there are a number of common approaches. In each case receivables, inventory and payables are analysed separately.

    1. Benchmark against the industry top quartile – making sure that the companies in the sample are broadly comparable in terms of size and geography;
    2. Compare against the top quartile of the company’s immediate peer group;
    3. Compare against the company’s own historical best – presuming that the business model hasn’t changed significantly; or
    4. A 15-20 per cent improvement in each area – considered by specialist consultants to be achievable in most industry sectors.

    A 20 per cent improvement in receivables, payables and inventory typically delivers a significantly higher improvement in net working capital, as illustrated below:




















    Applying these techniques to large multinationals will often result in potential cash release figures of over USD3-5 billion.

    Taking our earlier example of Large Cap Consumer Product companies, if each company achieved sector top quartile performance in all three areas, they would generate collectively over USD260 billion of additional cash flow.

    In pure cash flow terms this is a sizable figure but, relative to the company’s operating profit, total debt or capital expense budget its relevance is even more significant.

    Future proofing

    In times of ongoing market volatility and uncertain trading conditions, few Treasurers would question the value of additional cash flow and the insulating effect it delivers. Working capital is often a sizeable component of a company’s overall capital base and sustainable reductions can yield significant improvements in cash flow and ROIC – in turn driving future growth and higher valuations.

    Improving working capital performance might not be easy to achieve but it is certainly high on many Executive Team’s strategic agendas.

    Data source for all charts: FactSet & HSBC analysis


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