In economic theory, a lower interest rate environment is associated with cheaper money or cash, and a higher interest rate environment is associated with higher borrowing costs and a higher cost of cash or capital. Thus, from a standpoint of working capital (receivables, inventory and payables), a higher interest rate environment would seem to call for more efficient working capital performance – companies would want to offset the higher cost of borrowing or financing by improving internally generated cash flows.
However, the data show that an increase in interest rates is associated with an increase in working capital. This fact has important implications that suggest it is even more important to focus attention and effort on working capital and cash flow management as interest rates rise.
By analysing the relationship between interest rates and working capital since 1991*, a few a few conclusions can be drawn:
- Interest rates and working capital levels show a strong positive correlation.
- Increases in working capital can be the result of either an upturn or a downturn in business activity.
Figures 1 and 2 above show the movement of working capital and interest rates from 1991 to 2012 in the US and Euroipean Union (EU), respectively. As can be seen in the charts, working capital and interest rates have generally moved in the same direction since 1991. Figure 3 displays working capital and interest rate combinations as data points in a scatter plot in both the US and the EU from 1991 to 2012. It shows a positive correlation between working capital and interest rates.
There are several possible reasons for this occurrence. In periods of increasing interest rates, an increase in working capital could be a positive sign for business, as it may signify that economic activity is expanding, or has expanded, and working capital is needed to support sales and growth efforts.
Conversely, working capital may increase because higher interest rates cause a decline in output, which causes an unanticipated fall in sales, thereby decreasing collections and increasing inventory unexpectedly. In times of low interest rates, working capital levels may be lower due to decreased growth and a less positive business outlook, resulting in firms creating leaner operations and tightening credit policies. Whichever the scenario, in order to realise the benefits associated with optimal working capital levels, firms will need to have in place an overarching working capital governance plan with effective policies, processes, tools, training, awareness and metrics.
Implications and Solutions
If firms are not prepared or equipped for the pending onset of rising interest rates, then cash flows will be lower at the very time the opportunity cost of cash is amplified and prudent cash management is needed.
On the inventory side of working capital, many firms assign a carrying cost associated with holding a given level of inventory. These costs include charges for obsolescence, storage and the cost of capital. The cost of capital encompasses the opportunity cost of inventory, or the alternative use of cash tied up in inventory. All else being equal, rising real interest rates will increase the opportunity cost of holding inventory, which will require an enhanced focus on inventory management and optimisation. Additionally, as the cost of holding inventory increases, forecasting sales and the associated specific inventory requirements grows more important. The margin of error for having excess inventory on lower-selling products and too little inventory on products with higher demand narrows greatly.
On the receivables side, collections become even more important, because cash inflows may degrade as customers attempt to hold on to cash longer. Consequently, credit risk can increase as the creditworthiness of customers may be impacted, resulting in an increase in bad debt expense and interest expense. On the payables side, the efficiency, control and timing of payments to trade partners becomes key to a successful working relationship with the supply base. Aligning all sourcing activities – contracts, inventory ownership, Incoterms, storage and handling charges – to minimise the impact of a higher cost of capital turns into a top priority.
In order to embed a cash culture within a company, particularly in times of rising interest rates, there are a variety of working capital improvement processes and procedures that firms should implement. From an inventory management perspective, firms should apply processes to align demand, supply and financial forecasts such as sales and operations planning (S&OP). Further, order planning (in terms of size and timing) and sequencing tools can be used to optimise inventory levels, reduce costs and improve service. For customer-to-cash management, firms should implement processes to ensure the efficient and optimal collection of receivables, such as segmentation and payment channel offerings and expansions. For accounts payable (AP) improvements, the trade-off between extended and discount payment terms needs to become part of the company’s DNA, and all related initiatives such as supply chain finance and dynamic discounting should be reviewed and refined in light of these changing external factors.
Working capital decisions always have financial impacts and are important irrespective of interest rates. As interest rates rise, the financial impact of poor working capital management is intensified through higher borrowing and capital costs. In a lower interest rate environment, there are still crucial financial and operational advantages to strong working capital management not associated with the cost of capital that have a profit and loss impact. By implementing stronger working capital management practices and forecasts now, firms can obtain a competitive advantage by having the right products, services and cash flows available when needed most.
*The interest rate used is the yield on 10-year government bonds in the US and the EU, and working capital is measured using days of working capital (DWC). Interest rate data is from the Federal Reserve Bank and the European Central Bank. Analysis comprises the 1,000 largest companies in both the US and the EU by revenue, excluding financial firms.
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