Taking a cautious step forward: working capital and European corporates

For the top European companies tracked in REL’s Europe Working Capital Survey, 2015 was not a bad year. The average company’s cash conversion cycle (CCC) shrank 1.7% year on year as receivables and payables both improved.

However, there were some areas of concern. Revenues came at a higher cost than in 2014, with gross margins slipping an average of 13.8%. The earnings before interest and taxes (EBIT) margin fell steeply (-22.1%) and debt rose 8.3%, compared with a 2.9% increase in cash on hand, outpacing revenue growth (+2%) and Europe’s gross domestic product (GDP) (+1.9%).

Following the UK’s referendum in late June, we are now faced with ongoing uncertainty following the Brexit crisis – as well as no guarantee that interest rates will remain low. 2016 may be a particularly opportune time for companies to reduce borrowing and concentrate on generating cash through tighter working capital management.

Countries and sectors perform wildly

Country performance varied dramatically in the survey. Belgian companies in the ranking topped the list for CCC with -9 days, a 6-day improvement in overall performance in 2015, followed by Spain (9 days) and Portugal (10 days). CCC stragglers include Finland (77 days), Sweden (72 days) and Ireland (57 days).

Both Belgium and Spain have longer payment terms with suppliers, although Belgium has higher inventory levels than Spain but better performing customer payments. High inventory levels and less advantageous customer and supplier payment terms have given Sweden and Finland the highest CCC in Europe.

Nonetheless, it should be noted that the regional best performers have all improved in recent years. Belgian companies, for instance, saw their CCC rise to -9 days from -3, and the Spanish CCC showed a two-day gain to 9 from 11 days. Overall, only four of the 18 countries tracked by REL improved their CCC over the past five years: France, Portugal, Spain and Greece.

This is cause for concern, as it appears that these countries have focused on working capital only once they were in the midst of the European debt crisis. Companies based in other at risk countries should draw the right lesson from their example: pre-empt a problem rather than try and address it in full-swing.

The 1.7% average improvement of all the companies surveyed encompasses much sharper positive and negative sectoral and regional swings.

Industry leaders included companies in marine shipping, which saw their CCC improve to -9 days in 2015 from -1 day; Internet software and services, which rose to -5 days from 4 days; and household and personal care, which climbed to 2 days from 6 days. The largest nominal loss was semiconductors and equipment, which added 17 days to its CCC total, bloating to 157 days from 140.

The most dramatic negative changes were suffered by wireless telecommunications, which dropped to -75 days from -91 days; companies in Internet and catalogue retail, which fell to -3 days from -11 days; and wholesale distribution, which lost two days, rising to 14 from 12 days.

A trillion ready for release

When it comes to analysing net working capital, this improved relative to revenue growth, only 0.2% against 2% revenue. However, few companies have focused steadily on improving their working capital management. Overall, Europe’s largest and most sophisticated companies still have an opportunity to release nearly one trillion euros (€981bn) now tied up in working capital, the equivalent of 6.7% of European GDP (€4.63 trillion). Better management could represent significant benefits in each area of working capital (payables, €349bn; inventory, €328bn; and receivables, €304bn).

Despite the good macroeconomic news, only 13.2% of the companies surveyed managed to sustain improvement in their cash conversion cycle for three years in a row. Indeed 9% suffered deteriorating CCC performance for three years running. Nor did cash conversion efficiency (CCE, which measures operating cash flow/revenue) improve much. Indeed, CCE showed only marginal improvement for the third time around. Despite those slight gains, CCE is still down 3.4% from where it was five years ago, and the average European firm has yet to recover to its 2009 position.

Ultra-low interest rates (0.6%) on loans from the European Central Bank (ECB) are a key cause of their distraction. Total indebtedness has increased from €2.26 trillion to €3.13 trillion since 2010; and, in the last year alone, has risen by 8.3% as companies have taken advantage of the European Central Bank’s (ECB) nearly free money.

Much of this money went either into capital expenditures, mergers and acquisitions (M&As), or dividend payments. Capital expenditures (CAPEX) grew by 5% (€28 billion) in 2015, particularly in biotechnology (+78%) and Internet software and services (+54%), although there were declines in energy services and equipment (-23%) and metals and mining (-14%).

M&As were at a record high, particularly in the pharmaceuticals, biotechnology and consumer goods sectors. Dividend payouts grew by 5% year-on-year, increasing substantially in pharmaceuticals, telecommunications and beverages, and continuing a seven-year growth streak.

Companies currently hold the rest of the cash, the equivalent of 11% of revenue. They have a total of €833bn in cash on hand, but the holdings are far from evenly distributed: just nine companies account for €164bn, 20% of the total.

Yet as the many US companies that have also piled on low-interest debt this year are learning, even nearly free money comes at a price. European companies that added 50% or more to their debt in 2015 suffered a 20% increase in their CCC. Slower conversion and an upward trend in total debt (with above average overall debt and lower average cash on hand for these companies) suggest that European companies have put themselves at risk in the event of a major shock or disruption to their business.

The risks and rewards ahead

What should companies expect this year? The likeliest scenario is for more CCC improvement. As forecast in 2015, we believe that the trend toward faster cash conversion will continue. However, if as expected many of the largest European companies continue to gorge on debt, their overall risks will increase.

Improving working capital practices is always a good idea. At the very least, it seems prudent to strengthen internal processes and policies around working capital to enable sustainable cash flow improvement and to minimise the cash impact of any potential deterioration in trading conditions.

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