Competing for Cash: Working Capital to Fund Expansion and Drive Returns

Maintaining or improving corporate financial profile, while driving returns is still critical to companies, their shareholders and the credit-rating agencies. Even if the economic recovery is gathering momentum, corporate credit quality remains fragile and uneven entering 2004, with important challenges and uncertainties ahead.

The unbalanced pattern of global growth poses questions, while the US economy could start running into more headwinds going into 2005, currency appreciation remains a big risk to both the euro-zone and Japan. And while the corporate cash-flow picture is getting better, companies are spending again and dividends are rising, putting pressure on free cash-flow generation. In addition, interest rates have probably bottomed out, while pension liabilities are still a cause for concern.

1 Improved economic outlook

The global economic recovery is gathering momentum. In the US, GDP grew by 8.2% in Q3 and Q4% in Q4 in 2003, with latest job data suggesting that stronger economy growth was now feeding through into labor market. Capital outlays soared in Q3, 2003 by a hefty 11%. In Japan, unemployment has fallen, while business confidence is also on the rise. The UK economy is showing discernible signs of faster growth. Even the euro-zone economy is finally beginning to pick up speed.

The US economy has strong momentum heading into 2004. Economists see GDP growth exceeding 4% this year compared with 3.1% in 2003. Rising business spending and an improving labor market are coming just in time, while tax cuts will continue to support consumer and business spending into 2004. Inflation is still subdued and the Fed is unlikely to tighten monetary policy before a ‘considerable time’. Going into 2005, the US economy could start running into more headwinds on huge trade and budget deficits, the end of tax cuts and less accommodative monetary policy.

In the euro-zone, the 2004 outlook is also getting better, with forecasters calling for a 2.5% GDP growth versus a mere 0.5% in 2003. With inflation pressures still weak, the ECB is unlikely to raise rates before well into the year. The euro appreciation against the dollar (20% over the past twelve months) is however a big cause for concern which may derail economic recovery at a time when growth is still weak.

2 Issues around corporate liquidity

2.1 Current situation

The global corporate liquidity picture in 2003 has improved on 2002. Even if the operating performance across sectors are still pressured by economic conditions and in the euro-zone by the weakness in the dollar, free cash-flows are higher, mainly on reduced operating costs, lower capital expenditure (down a further c.10% in 2003E in both the US and the euro-zone) and improved working capital. Stronger debt and equity markets have also helped companies raising cash and refinancing the old debt, locking in lower interest rates (corporate debt issuance was up over 20% in 2003 on 2002 for European and US non financial companies). Focus on core activities has been pursued, with significant asset reallocation (through acquisitions and disposals) occurring across sectors. Telecom operators and electric utilities in Europe are among the sectors which have shown the biggest improvements in corporate liquidity on the back of a sharp increase in free cash-flows and substantial disposals.

REL has carried out a study based on 2002 year end and 2003 interim data, covering the corporate liquidity situation of the top 2,000 European and US companies (by sales). The study shows an improved corporate liquidity picture in both regions in 2003 compared with 2002, with a substantial drop in net debt to EBITDA ratios (from 1.8x to 1.5x in the US and from 2.0x to 1.7x in Europe) and higher free cash-flow generation (CF/Capex reaching 1.5x in Europe and 1.8x in the US). Gearings are now down to just above 50% in both regions. US corporate is also likely to report improved return on capital employed on a combination of stronger economic growth, cost-cutting and weak currency, while in Europe, only stability may be expected. Working capital should show modest reduction in Europe, with a flat performance in the US on sales recovery and the need to rebuild inventories.

2.2 Corporate liquidity prospects for 2004

The global corporate liquidity picture should improve further in 2004. Economies are getting stronger, corporate earnings are rising, credit conditions are easy and the time for corporate exuberance – excessive capital expenditures and M&A – is probably gone.

The corporate cash-flow picture is getting better, but companies are spending again and dividends are rising, putting pressure on free cash-flow generation.
The prospects for capital expenditure are much improved since the beginning of 2003. There are now signs that the pickup in business spending is slowly broadening beyond high tech and small companies (“An increased number of CEOs describe themselves as having the wind at their backs” recently said Cisco CEO John Chambers). There is however still large excess capacity room (US capacity utilization was up to 75.8% in December 2003 for the industrial sector, back to the September 2002, but still well below the 81% 30 year average), suggesting a likely scenario of a gradual recovery (more pronounced in TMT). Forecasts for capital expenditures are more optimistic for the US (double-digit increase) than for Europe. In addition, extra working capital will be needed to cope with the faster pace of a demand (with US inventories are at a low in relation to sales – far below the adjusted long-term trend), while dividends are rising on the back of higher profit and favorable dividend tax changes in the US.

On the basis of those assumptions, corporate balance sheets should be stronger in 2004, with net debt to EBITDA ratios falling further to 1.5x in Europe and 1.2x in the US and gearings approaching 40% in both regions by year end. Free cash-flow generation (CF/Capex) will be marginally up as increased cash-flow will be partially offset by higher capital expenditure. The returns on capital employed will improve further on rising profitability and asset optimization, while working capital could deteriorate in relation to sales on higher activity and inventories reconstitution.

2.3 Pension liabilities

The REL corporate financial performance scenario does not factor in the impact of under-funding pension among companies. Pensions have become a major cash issue for some companies with liabilities rising dramatically as a result of past poor equity markets performance and falling long-term interest rates. In 2003, the pension funding black hole in the US has continued to grow despite a recovery in global equity markets as interest rates have continued to fall. According to the latest S&P research, pension under-funding among companies in the S&P 500 grew from just over $210bn in 2002 to $260bn in 2003. In the UK, according to the actuarial consultant, Watson Wyatt, the under-funding in employers’ schemes is now roughly equal to that at the start of 2003, with an aggregate deficit of £60bn among FTSE companies and probably twice that amount across the country. Bringing onto the balance sheet the net liability for un-funded pension obligations would increase total net debt of non-financial companies by roughly 15% in both the US and the UK.

2.4 M&A

An improved economic growth outlook, easier credit conditions, stronger equity markets and higher free cash-flow generation all mean that the prospects for M&A are also much improved. Global merger volumes were up only 7% to $600bn in 2003 on 2002, but with an acceleration in the past few months and with upbeat comments from bankers on actual deal pipelines. The time for M&A exuberance is probably gone, but any pick-up in M&A activity given the numbers magnitude may substantially affect global corporate operating and financial performance going forward.

3 Why working capital is such an attractive opportunity for corporations to fund renewed expansion while driving returns?

In this improved but still fragile and uneven corporate liquidity picture, working capital continues to be largely ignored. While the focus is still on optimizing capital expenditures and keeping tight operational expenses, we feel that companies are not giving enough attention to working capital management as a way to squeeze substantial cash to fund renewed organic and acquisitions expansion and to drive returns. Working capital offers huge cash opportunities that could be released with sustainability within a relative short period of time and as it is generated internally, it is also the cheapest form of finance.

3.1 What is Working Capital?

Working capital typically accounts for 15% of sales and 20% of capital employed. Working capital is defined as the difference between current assets and current liabilities. Current assets consist of cash and other assets that are reasonably expected to be realized in cash or sold or consumed during the normal operating cycle of the business. Current liabilities are commitments which will soon require cash settlement to the creditor during the operating cycle. Operating working capital comprises operating cash, trade receivables, inventories, less trade payables. Factors influencing working capital requirements include the nature of the business, the seasonality of operations, the market and the supply conditions. Working Capital accumulates in 3 interrelated core processes in businesses;

• The Customer to Cash process (C2C), the processes from a salesperson’s first customer contact, through credit risk assessment, order taking, order entry, billing, cash collection and in the case of errors, dispute management and eradication
• The Purchase to Pay process (P2P), from assessment of suppliers, internal demand origination, purchasing and payables
• The Forecast to Fulfill process (F2F), from demand management, forecasting, make to order or stock, production, warehousing, logistics, supplier and customer collaboration

3.2 Huge opportunities in this untapped liquidity market

For the top 2,000 European and US companies, REL has calculated a figure for excess working capital, each company being compared with the performance of others in its peer group. The excess figure can be defined as the extra working capital used by a company compared with the top quartile of its sector. Essentially, this excess liquidity is tied up in invoices not being paid by companies’ customers, suppliers being paid too early and inventories lying unsold on warehouse shelves.

According to this analysis, the top 1,000 European companies have just over €600bn of cash tied up in excess working capital, corresponding to nearly half of total net debt. The figure is $620bn for the top 1,000 US companies while total sales are one-third bigger, equivalent to 38% of total net debt.

3.3 A good measure of corporate management

Working capital is a key value driver. Failure to deliver on working capital and looking externally when big internal cash opportunities are sitting in the balance sheet is destroying shareholder value. Companies should look at the working capital processes, Customer to Cash (C2C), Purchase to Pay (P2P) and Forecast to Fulfill (F2F) as a way to improve cash-flows and impact COGS, SG&A and customer service.

As described above the 3 interrelated processes touch on the core elements of a business’ performance in terms of customer and supplier relationships and as such poor working capital process performance impacts not only impact cash-flows, cost levels and customer/supplier service but is a measure of a business’ overall market performance, corporate management and control and achievement of strategic achievement.

4 Impact of Working Capital on company operating and financial performance

Working capital management dramatically affects company’s operational and financial returns. Optimizing working capital increases cash and reduces costs, therefore strengthens balance sheet, boosts earnings and improves return on capital employed.

In the table below, we have tried to quantify the working capital cash opportunity impact on corporate balance sheet, P&L and ROCE for both Europe and the US, using on one hand the figures for excess working capital calculated above and on the other hand, typical results (20% reduction in receivables, 15% improvement in inventory turns and 10% increase in payables) for companies focusing on working capital (based on REL experience).

Based on those assumptions, addressing working capital for European companies would reduce total net debt by between 27% and 49%, increase net profit by between 7% and 20% and improve ROCE from 8.5% to between 9.3% and 10.0%. For US companies, this would translate into a 23% to 38% reduction in net debt, a 3% to 5% increase in net profit and improved ROCE from 13.8% to between 14.8% to 15.6%.

Conclusion

The global corporate liquidity picture has improved in 2003 on 2002, and with the economy’s recovery gathering momentum, further progress can be expected this year. At the same time, corporate credit quality remains fragile and uneven entering 2004, with important challenges and uncertainties ahead. In this context, working capital continues to be largely ignored. While the focus is still on optimizing capital expenditures and keeping tight operational expenses, we feel that companies are not giving enough attention to working capital management as a way to squeeze substantial cash to fund renewed organic and acquisitions expansion and to drive returns. Working capital offers huge cash opportunities that could be released with sustainability within a relative short period of time. Addressing these opportunities would dramatically improve corporate operational and financial performance.

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