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In the last few months, we have seen how important liquidity is: as the COVID-19 crisis hit, a threat to the survival of many companies surfaced within the first few weeks. More than ever, this shows the importance of working capital management as an existential element to the financial health of your business. This article kicks off our series on working capital management. In the next weeks, we will take a deep dive into working capital management and its most important aspects. This week: the impact of economic downturn on working capital management.
There are numerous internal and external factors influencing working capital and, as a result, require a holistic working capital management (WCM). Next to developments in the current economy and financial climate, global events influence your working capital and may require additional action.
Why working capital management is important in uncertain times
To maintain a form of stability in these uncertain times, working capital becomes increasingly more important, as it is the cheapest source of cash. However, the management of working capital is more challenging in uncertain times as global events affect your supply chain. We are currently living through a severe example of the influence global events can have on working capital and the supply chain as a whole: COVID-19. Demand changes, the supply chain is affected (see our earlier posts on the bullwhip effect), and workforce reliability drops as quarantine and isolation measures are introduced.
Working capital management challenges in economic downturn
When it comes to WCM, crises bring a new set of challenges. As demand drops or becomes more volatile, supply chains are impacted by this uncertainty. Especially in times of economic downturn, WCM is important to keep liquidity at a good level. Bad liquidity management on the side of the customer can lead to issues collecting outstanding receivables, and in turn issues fulfilling payables on the side of the company. Bad liquidity management can impact the risk of survival a business has in economic crises.
As the COVID-19 crisis is not solely an economic crisis, we see other challenges arise, such as limited capacities due to local shutdowns, or product shortages. As a result, supply chains may break due to lack of unoptimized inventory buffer. These challenges show the importance of inventory management as a part of WCM.
There are not many industries, if any, that have not experienced changes to their supply chain due to COVID-19. As an event, it could and should trigger businesses to rethink their supply chain model. Of course – there are industries that have quite visibly collapsed, like for instance the airline industry or hospitality industry. In general, the effect here is twofold: on the one side, fractures in supply chains emerge and lead to shortages in industries. On the other hand, dropping demand hits industries in a similar way as an economic recession would.
How does this influence working capital?
WCM is an area of tension: the lower the inventories, the earlier customers pay their invoices, and the later payments to suppliers are processed, the higher the liquidity. As inventories are bound capital and do not yield interest but must be financed by interest-bearing capital, from a financial point of view lower inventories are preferred. However: higher inventory means higher flexibility in production and shorter delivery times, increasing the service level.
In economically uncertain times, the goal is to minimize risk. This means that WCM at the same time is risk management. Reducing liquidity risks in economically difficult times and still maintaining operations through internal WCM measures that are independent of economic developments creates flexibility. Next to liquidity risks, changes in prices, demand or exchange rates can have a significant impact on the value of inventories and receivables; successful management can therefore significantly limit depreciation risks.
Optimizing Working Capital Management
The goals of WCM are to
- Avoid liquidity bottlenecks to ensure liquidity supply and prevent threats to the company's existence. Because a company without the liquidity to meet financial obligations cannot survive, even if sales might increase.
- Optimize affected balance sheet items to improve financial structure and optimizing tied capital.
- Make future cash flows more secure.
- Detect and eliminating weaknesses in processes and structures.
- And ultimately, to increase profitability and company value.
Done successfully, the effects of WCM are higher liquidity; and higher profitability through savings in capital costs and higher return on the total capital employed, leading to an increase of company value. This happens through the release of liquidity lowering external financing requirements, resulting in better net interest income leading to better credit rating and better financing conditions. There are three fundamental ways to increase liquidity: through reducing inventories, the reduction of receivables, or an increase in liabilities.
What optimizing working capital looks like, depends on various factors. Working capital optimization involves various stakeholders with a different outlook than financial optimization. As mentioned before, from a financial standpoint it is preferrable to keep inventories as low as possible and utilize working capital as the cheapest source of cash. From the perspectives of sales, service, production, or buyers this may look differently:
- sales and service value higher inventories to service customers quick and avoid lost sales.
- production values higher parts inventories to avoid disruption in production processes.
- procurement can negotiate better rates and terms when buying more at once.
To keep this holistic view in mind is important, as WCM is more than just the ‘CFO view’.
What chances do crises offer
Of course, it may be hard to see the chances that economic downturn offers, as it is most of all a challenging time for most. Looking at working capital, however, we can distinguish two events that in the long run will be a positive development: we see which processes are not optimized or which are over-optimized.
Crises mean that companies that do not actively ‘optimize’ working capital are forced to do so to increase liquidity. This, of course, is a process that will also benefit you after the crisis, as WCM gives you the chance to identify weak spots in processes and is a great starting point for further optimization. On the other hand: a number of businesses go into a crisis overoptimized. They may experience an opposite problem, where small disruptions in inventories or payments immediately break the supply chain. Here, the crisis offers the possibility to rebalance processes.
The future: returning to normality
Crises and economic downturn show the weak spots of industries, businesses, and individual supply chains. Therefore, those that manage to get through a crisis successfully will have an easier time growing afterwards. On the other hand: industries that were already stagnating before a crisis hit will definitely show their weak spots, and they will have to live with a new normal that may consist of seriously smaller business.
WCM and the optimization of working capital are essential in times of economic downturn. Increasing liquidity is vital for many businesses to manage crises. However, WCM is more than just reducing inventories, increasing payables and reducing receivables. Factors like lost sales, service levels and supplier relationships should be considered.
Optimize your working capital with aioneers, following up analyses with targeted execution of optimization measures and realizing 'real' quick wins with our Cash Taskforce. Contact us today and find out how.
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