European PwC research emphasises working capital as a lever of profitability

Brussels – 10 December 2009.  PricewaterhouseCoopers has conducted its Annual European Working Capital Research Study. The objective was to go beyond classic key working capital performance indicators (DSO, DPO and DIO) to highlight the relationship between working capital levels and bottom-line results.

Surprisingly, no major efforts were devoted to working capital throughout the 2004-2008 period (in other words, since the last major recession), with an average working capital ratio of 21.7% in 2008 versus 22.2% in 2004. Minor improvements in receivables management have largely been eroded through a reduced number of days’ payables and slower stock turns. Improving working capital from the industry medium to its upper quartile could result in as much as a 15.5% improvement in RONA (return on net assets).

This Annual European Working Capital Research Study does not purport to provide comprehensive answers on how companies should manage their working capital. It should instead serve as a support in benchmarking themselves to their peers and assessing the various solutions available for improving their performance. In doing so, every CEO or CFO will ensure that his organisation is adequately prepared to survive difficult periods and create the necessary conditions for sustainable growth.

The research sample

The study covered 969 listed companies from 11 European countries (Belgium, Finland, France, Germany, Italy, The Netherlands, Spain, Sweden, Switzerland, Poland, and the UK), only used data for analysis that is publicly available, with figures taken from 2004 until 2008 for the year-end assessment.

Part 1: Review of working capital performance

No significant improvement in European working capital since 2004, but we expect this to change in 2009.

Figure 1:  Average European Working Capital Ratio

 The last significant reduction in working capital was in 2004 and could be seen as a reaction to the last recession (figure 1). However, working capital ratios have only decreased by 0.5% since 2004. With a level of 15.4% in 2008, Belgian quoted companies have improved their working capital ratios by less than 1% compared to 2004.

This would tend to indicate that working capital has not been companies’ main concern. This can partly be explained by the ease of access to liquidity and historically low interest rates during most of this period of economic growth. However, at the end of 2008, we observed that many companies had launched working capital projects whose first positive results should hopefully already be seen in 2009.

Receivables have been the main area of focus

Figure 2: Change in average DSO, DIO, DPO

 Looking at changes in the underlying components, the most remarkable development is that the days’ sales outstanding (DSO) decreased by five days between 2004 and 2008, and by nine days as from 2005 (Belgian companies were able to reduce these figures by 6 days over the same period). These numbers vary across industries and countries as emphasised in the detailed survey, but this highlights the fact that companies have primarily focused on debtors to improve their working capital, striving to be paid quicker. And, on- and off-balance sheet techniques such as securitisation have been used by companies increasingly.

At the same time, average days’ purchases outstanding (DPO) has worsened by one day compared to 2004 (one-point-five days in Belgium) and even by four days compared to 2007 (almost three days in Belgium). This can easily be linked to the change in DSO. When suppliers reduce their DSO, it has a negative impact on buyers’ DPO.

Finally, we see that days’ inventory outstanding (DIO) worsened a little over the period, by two days (against the European trends, Belgian companies were able to improve by two-point-five days’ DIO).

Corporates will have to focus more on improving their forecast-to-fulfil cycle if they want to substantially improve their working capital.

Damien McMahon, Partner in Financial Management and Corporate Reporting, confirms:

“Indeed, while focusing on DSO and DPO remains a priority, there might be a limit to how far customers and suppliers can be squeezed in difficult economic periods. While, in the past, many corporations aggressively pushed payment terms, leveraging their market position, in the last year we have seen an increase of more collaborative approaches, also taking the supply-chain risk into consideration. This is certainly a trend that will continue in the future.”

 “The challenge ahead for European corporates is to achieve significant improvements in their supply chain and distribution models, leveraging on the investments made in information technology in recent years. While the crisis has made them realise certain quick wins, such as in collection processes, the real step changes in working capital now lie in optimising their supply chain, which requires underlying structural changes.”

Part 2: Linking working capital and profitability

Moving to upper quartile can impact on return on net assets by up to 15%

Figure 3: Working capital, NOPAT and RONA – impact analysis

While reducing costs is still a necessity to surviving in the current environment, it should not be forgotten that the performance of a company is also influenced by balance sheet items and, more precisely, by working capital. Focusing on working capital elements can not only support a company through the downturn but also give the positive message that the company is striving to eradicate inefficiencies and launch long-term, sustainable initiatives.

The study simulates the impact of an improvement in working capital on RONA for each industry group, and shows surprising results.

To estimate this improvement potential, for each industry, we calculated the improvement in the WC ratio from the median to the upper quartile of the industry in a first instance. We then went on to estimate the impact of this improvement on RONA and the equivalent NOPAT increase that would be necessary to achieve the same effect. For example, companies within the retail sector would improve their return on net assets by 8.5% if they achieved upper quartile working capital levels.

Significant industry differences are observed in this scenario. The positive impact on RONA is mainly linked to the relative possible improvement range of the industry and to the average level of working capital in the industry. Average revenue is also a factor to be considered in these types of simulations.

Didier Vandenhaute, Director in Financial Management and Corporate Reporting, adds:

“The simulation shows how powerful reductions in working capital can actually be. Why is it that companies so often tend to focus more on their income statement than on their working capital? Our experience shows that the answer lies in a combination of factors. Disparity in working capital management, top-management commitment, and insufficient resources are some of the most common reasons. While recent months have shown a significant increase in attention on working capital and cash-flow forecasting, this has not yet been visible in the year-end figures.”

For further information

If you would like to receive the complete research study, including detailed figures per country, please go to European Working capital study 2009.