Working Capital Management…

As the economy attempts to return to business as usual, their approach around working capital management will require more in terms of planning, forecasting and measures.

The aftermath of a global shock and its impact on supplies can be catastrophic for certain industries. The pandemic exposed the risks of highly concentrated supplier bases. Rapidly changing supply and demand in the semiconductor industry, that caused global shortages and delays in many related supply chains and ongoing lockdowns in China have demonstrated this.

Reviewing supply management strategies

In addition to the ongoing U.S.-China trade war, which reignited under the Trump administration, the war in Ukraine and associated sanctions and embargoes further exposed the vulnerability of global supply chains. Structural shortages in commodity markets, and especially energy prices, are increasing inflationary pressures. These impacts are rapidly building downstream in many supply chains as can be seen in the increasing producer price indices and can be felt by anyone who recently visited a supermarket. Rising prices further increases uncertainty which impacts interest rates and the availability of funds.

It is unlikely that any significant unclogging of global supply chains will happen very soon. Many corporates are reviewing their supply management strategies and practices. The longer a supply chain, the higher the risk of disruption. Western economies have become overly reliant on goods produced and sourced in Asia and with these rising geopolitical tensions, we have already seen countries and multinationals shift their sourcing to mitigate these risks. A great example is Intel’s investments in semiconductor plants in Germany.

Increased requirement

From a working capital perspective, a higher interest rate environment calls for a more efficient working capital performance – corporates would like to offset the higher cost of borrowing by improving their cash flows and reduce their capital requirements. Borrowing funds is becoming more expensive for both short- and long-term loans. Many lines of credit are repriced monthly and therefore higher interest rates hit corporates almost immediately.

Higher interest rates raise businesses’ cost of capital and negatively impact cash flow. Even if a corporate is not highly leveraged, upstream and downstream operational debt, accounts receivables and payables, will have an impact on its liquidity. With higher inflation, increased sales figures, even at constant quantities, means a higher level of balance in trade receivables. Higher purchase prices have a similar effect on the total inventory on the company’s balance sheet. For companies with a positive net working capital, where the sum of accounts receivables and inventory are greater than accounts payables, the extra investment needed in current assets means an increased requirement of working capital financing.

These are some of the main reasons why in these challenging times, focusing on working capital practices, preserving liquidity and cash flow optimization are paramount.

Working Capital Policies

Not in all corporates Treasury is responsible for working capital management. However, to ensure sufficient cash to fulfill all obligations, the impact lies with Treasury.

The working capital management concept pertains to how firms manage their current assets and liabilities to ensure continuous day-to-day operations. An important aspect of Working Capital Management is setting the policy, or set of rules, that best suits a specific corporate or industry.

The working capital policy comprised of two elements: (1) the level of investment in current assets and (2) the means of financing current assets. When selecting the most suitable policy, firms try to obtain an optimal level of working capital dependent on the trade-off between risk and return.

When examining these Working Capital Policies, three general approaches can be distinguished:

1. The conservative policy, where firms aim to maintain high levels of working capital (high investment in working capital), as they rely more on long-term financing compared with short-term financing, decreasing both risk and return.
2. The aggressive working capital approach, where the financing mix of a corporate leans more to the use of short-term capital to finance its investments, which indicates lower structural investment in working capital. Increasing risk and return.
3. The hedging or matching policy, where short-term assets are matched with short-term liabilities and the permanent amount of short-term assets is financed by long-term financing resources. Thus, the investment in working capital may increase or decrease according to the firm’s activity.

Corporates that employ the conservative or hedging approach are least likely to be affected by the recent challenges of higher interest rates as the cost of capital has been locked in for a longer period of time. Companies that have taken a more aggressive stance are among the first to witness the inflationary impact in their overall cost of capital. Although the Working Capital Policies are mainly driven by business strategy and industry complexity, it might be worthwhile for businesses to reconsider these policies now capital structure is becoming a more important factor.

Working capital is often measured by the Cash Conversion Cycle (CCC): Days Sales Outstanding (DSO) + Days Inventory Outstanding (DIO) – Days Payables Outstanding (DPO). It indicates how long each net input currency is tied up in the production and sales process before it gets converted into cash received. It considers the time needed to collect receivables and the time it has to pay its bills without incurring interest or penalties. The cash conversion cycle is optimized (lowered) by increasing DPO and decreasing DSO and DIO.

While profitability is often the key focus point of many companies and managers, working capital and cash conversion are both the heart and the blood of a company. It is an undeniable truth for many Treasurers and CFOs: ‘Cash is king’. Businesses need cash to soldier on, build strategic alliances, propose items that will elevate its competitive stature over time and increase future profitability.

Unique times

Over the course of the last decade, corporates have grown accustomed to low, and even negative, interest rates and high availability of cash in the market and many have taken an aggressive stance in their working capital investment strategies. Especially corporates that operate in the lower margin and highly competitive industries. These recent challenges impact the way a corporate should manage its working capital and to maybe reconsider its working capital policy.

To mitigate the risk of disrupted supply chains, a corporate might first choose to have higher inventory levels that increase their DIO in their cash conversion cycle and their respective capital requirements. Although generally suboptimal, for companies with an aggressive stance, short-term and flexible credit were sensible temporary alternatives to overcome these challenges. In times of rising interest rates however, a corporate’s natural reaction is to decrease its overall capital requirements and reduce the effects of the interest component in their margin metrics.

Now both the challenges of disrupted supply chains and rising interest rates collide, their unique combination presents extra complications to corporates and their Treasurers as typical solutions for one problem are now counterproductive in tackling the second challenge. Furthermore, corporates tied to leverage covenants are faced with a double challenge as these circumstances simultaneously lower the profitability and extend the balance sheet, negatively impacting their leverage metric and consequently increasing interest charges.

What should the treasurer do?

Where in high times working capital management and its financing is ‘just’ a component in a business and corporates can concentrate on the happy flow, crises challenge us to think differently and creatively to overcome our problems. Instead of pushing the issues up and down the supply chain on the short term, a corporate should re-assess its capital structure and financing mix to check its robustness. It is the role of the Treasurer, during times like these, to raise company broad awareness of its impact, gain improved insight in all related processes and to find alternatives.

Businesses are looking for solutions to free up additional funding for their working capital. It is vital that Treasurers look to leverage every tool available to convert sales into cash. The longer that cash is uncollected, the longer it is effectively funding another business rather than the creditors.

Improve on data gather and information

The starting point of successful working capital management is improved insight in cash flows. Treasurers should invest time and resources to optimize cash flow forecasting using the correct data and metrics, which is a challenge on its own. In many instances, existing tools deployed do not take into account deviations from payment terms at a client’s level and the actual flows of cash. Corporates should cross-check credit terms captured in their systems against actual flows to improve their forecasting. Under normal circumstances, reconciliation between the two is already important, but even more so during times of uncertainty that could impact your counterparties and their payment behavior.

While standard practice for a credit insurer, continuously reassessing credit risk of clients and suppliers is something overlooked quite often by corporates. Shipping that order across the globe to your once best customer can become a costly affair when you are unaware of its most recent financial challenges. It is important to have this insight in your supply chain to avoid unpleasant surprises.

Without having a precise and complete insight when cash is coming in and needs to be reinvested, pinpointing your future capital requirement, and where to find these funds, is no simple matter.

Supply Chain Finance solutions to consider

While improving insights, Treasurers should also investigate flexible solutions specifically designed to overcome short-term funding shortages such as factoring and reverse factoring programs.

Factoring programs are initiated from the seller’s perspective within a supply chain and enable the corporate to sell its accounts receivable balances to a financial institution or an investing firm (the factor) for cash advances. This immediately improves the cash conversion cycle by decreasing the DSO component.

Reverse factoring caters to the other side of the supply chain and is focused on financing the downstream flow, initiated from a buyer’s perspective. Invoices to the supplier are paid early or against the originally negotiated credit terms by the factor party. Leveraging the creditworthiness of the buyer, smaller suppliers might benefit from these programs as the discount on the funds received will be lower than factoring programs initiated from their side and extend credit terms could be given. Using reverse factoring solutions increases the effective DPO for the buyer while simultaneously decreasing the DSO from the supplier’s perspective lowering their overall cash conversion cycle.

Whether factoring or reverse factoring is put into practice, the highest mutual benefits can be achieved by initiating the programs by the party with the highest credit rating as their cost of capital is generally lower.

As for everything in this world, it holds in both cases that there is no such thing as a free lunch. Payments are discounted and the costs of finance are similar to short-term loans, but offer increased flexibility on top of existing financial debt. Many of these programs are very user-friendly and most accompanying portals allow for direct integration with many ERP systems to automatically upload invoices to be factored.

Collaborate with key partners in your supply chain

Seek collaboration within your supply chain and adjust planning and mutual initiatives. When considering supply chain finance solutions, do not only investigate initiating your own programs, but reach out to your key suppliers and customers to see whether they are open for collaboration. It is possible that your company can be included in already existing (reverse) factoring programs initiated by your business partners.

Apart from programs involving a third party to finance the supply chain, static and dynamic discounting are other solutions to be investigated. It allows a corporate that is less cash constrained to make direct payments to their supplier at a discounted purchasing price. With static discounting, the discount rate is set in advance, whereas with the dynamic variant, the discount is adjusted to the actual date of payment.

These solutions not only optimize your cash inflow and/or honor the payment terms negotiated, it could also strengthen business relationships in the supply channels through improved cooperation.

Conclusion

In times where both disrupted supply chains and rising interest rates present corporates and their Treasurers with a unique combination of challenges, it is important to gain insight and knowledge about the particular position and needs of your company. Although the solutions to overcome the supply chain disruption by increasing inventory might naturally be counterproductive to lower capital requirements and financing costs, many flexible supply chain finance solutions exist to help a corporate with their cash constraints and to optimize its financing mix.

To gain a better understanding of your company’s working capital position, the potential risks and financing possibilities, Zanders can help you gain insight, explore supply chain finance solutions and make educated decisions.