As multiple interest rate rises squeeze consumer and business budgets, boards will benefit from a sharper strategic focus on cash flows and the working capital cycle.
Securing growth presents a challenge in 2023, with sharply rising capital costs and a squeeze on domestic and business budgets. It’s a time when directors will benefit from seeking greater visibility on their organisation’s working capital performance and the data it reveals, says Jason Ireland MAICD, a partner at McGrathNicol.
A former non-executive director of ASX-listed Boart Longyear and a self-described working capital nerd, Ireland argues that a board focus on working capital efficiency should be equal to organisational strategy. “If you’re growing, working capital is just as important as if you’re falling behind. And in the current uncertain conditions, the person you’re selling to might have a cash issue themselves.
Three years on from the start of COVID-19, many of the measures that temporarily boosted cash flows have ended or need to be reversed, while the Australian Tax Office is also stepping up collections of director tax liabilities after its pandemic moratorium.
“So the things that are in your control, like your working capital cycle, are more important than ever,” says Ireland. “If it’s going to be hard to make a profit, then you better make sure the profit converts to cash more quickly. It’s something that is inside your walls. If you can generate more cash internally, it provides a bit of a buffer to the external impacts on your cash flow.”
The capacity to turn sales into cash faster reduces the cost of running a business and provides material competitive advantage.
McGrath Nicol Advisory analysis of the working capital performance of 139 ASX listed companies across seven sectors in its 2022 Working Capital Report found that 78 per cent of companies surveyed reported a lengthening in working capital cycles, highlighting the challenges organisations have had in managing working capital over the past two years, during a period where shifting demand, supply chain constraints and inflationary pressures have been common.
The report included a survey of more than 300 MDs, CEOs and CFOs from companies with 100- plus employees, which revealed that respondents expected the current challenges to continue for the year ahead.
McGrathNicol’s analysis of four working capital measures — days sales outstanding (DSO), inventory (DIO), payables (DPO) and overall working capital — showed that DWC cycles lengthened by 5.3 days in 2022, the largest in a decade, “locking up” an additional $11.1b in cash.
expect cash flows will become even more difficult to manage over the next year
will delay or downsize growth/ expansion plans
will reduce costs/consider restructuring to help manage cash flow
say lack of liquidity is their biggest concern over the next year
of larger companies will need additional capital/finance over the next year
have agreed to longer customer terms
Australian companies increased inventory holdings by three times international average
Source: McGrathNicol Working Capital Report 2022
In the building products, retail and agriculture sectors, the lengthening resulted from companies holding higher levels of inventory, with $25b more inventory held as companies adjusted from a just- in-time inventory model to a just-in-case model. In the tightest sector, construction and engineering, the increase was due to slower debt collection. Ireland says this is a red flag in a sector that already has a structural funding gap, which explains a lot of the recent failures.
On average, companies also collected from their customers more slowly.
There is a “huge” spread in the data between the best and the worst within the sectors, with sometimes 100 days difference, notes Ireland. Survey respondents who had made changes to improve their working capital management had also seen results.
The report also benchmarked sectors against the US, Asia and Europe, showing that the average of Australian sector participants was up with the global best.
Company process issue
Cash might be the lifeblood of a business, yet Ireland says he has had to search for the relevant information too many times when reading board papers. “You get all of this great stuff on the profit, customers and revenue pipeline, but where’s our cash? Where’s our working capital? Are we selling to good payers? Are we buying from reliable people? Is the inventory going up because the inventory is bad? Working capital is a window into the future of the business. It’s one of the few accounting outputs that can tell you what might happen in the future. Yes, it’s a point in time, but it causes you to ask forward-looking questions.”
Ireland emphasises that directors need to be quite process-driven about working capital.
“It’s easy as a director to think that it’s working capital and the finance function has to fix it,” he says. “But working capital metrics are a result of what the company does — it’s all a business issue. If you sell to a poorly paying customer then the working capital metrics go up.
“The finance function didn’t sell, it’s the sales team. If you decide to invest in inventory or your inventory processes are inefficient, the finance function isn’t fixing that. This is an all- encompassing company process issue. Having sales teams incentivised on collections is just as important as the actual sale.”
Ireland says working capital management is actually about working the debtors and the inventory, not creditors. “If you’re starving your suppliers of money, two things can happen — they could fail, which is terrible, or you get deprioritised as you’re considered a bad payer.”
Responsibility, accountability and visibility are key levers when approaching working capital.
“You need to have a very clear sense of who is doing what on working capital,” says Ireland. “For example, who’s responsible for the sales and who’s responsible for collection? Why is that different? It means you’re assigning and telling people what to do and by when, and you’re tracking it.”
Ireland says cash flow forecasting and tracking with variance analysis is important.
“A good cash-flow forecast can teach you what you’re working with,” he says. “For example, we might collect 95 per cent of our cash monthly, but our cash outflows are weekly. Or, here are our top 10 customers by revenue. Put the DSO next to them and then you can start to ask how are they as payers.”
For management, raising organisational awareness of the procedures and the part everyone plays helps. “Many businesses have a procedures manual on how to clean the kitchen on a Friday night or what you should do on a monthly basis with the fridge, but there’s not often a good procedures manual on working capital.”
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