Rethinking working capital in an age of attrition

While a lot of us are sick and tired of hearing about the Covid-19 Pandemic, we need to appreciate the gravity of the Pandemic and the financial impact that the Pandemic has caused.

We have moved beyond the fact that businesses around the world are facing disruption. Disruption (or attrition) is something that companies will face on a continued basis going forward. Because of this, disruption has become the new normal that companies have to deal with.

What does this mean for companies and those wanting to start companies? Working capital is a vital component for companies to survive, prosper and avoid financial distress. Deloitte recently released a report which discusses the future of these requirements.

Highlights from the report can be found below. The full report is downloadable at the end of the article.

Massive challenges
In recent months, the United States and other parts of the world have been facing supply chain bottlenecks across multiple industries, with the auto industry standing out as suffering the most from significant supply chain problems that are limiting production. The constraints experienced initially have turned out to be more severe, driven by a combination of rapidly increasing demand from the recovering economy, shortages in materials, goods impacted (ranging from raw materials to semiconductors) and labour shortages as the pandemic starts to abate.

Service industries are starting to see an acceleration in activity as indicated by rising purchasing managers’ indices, which suggests the possibility that consumers may shift from spending on goods toward spending on services. If that happens, it could relieve pressure on supply chains. On the other hand, even if ports can operate more efficiently and handle greater volume, they are only one piece of the puzzle. There is a shortage of truck drivers, and there remain challenges in operating warehouses and retail establishments.

The Federal Reserve recently stated that the US economy grew at a modest to moderate pace in recent months. However, it said that “the pace of growth slowed this period, constrained by supply chain disruptions, labour shortages, and uncertainty around the Delta variant of Covid-19It especially noted weakness in automotive sales, likely due to supply chain issues and rising prices. On the other hand, several areas of strength were noted including consumer spending and residential property. Manufacturing and distribution grew at a moderate pace.

The impact of the supply chain challenges is resulting in the International Monetary Fund decreasing its outlook on US economic growth for 2021 by 1% to 6%, the strongest adjustment to any developed country.6 In our latest working capital roundup, we will look at how all of this affects cash and working capital by comparing changes from Q1 2021 to Q2 2021, as well as the changes year over year from Q2 2020 to Q2 2021.

Key takeaways
All of this has continued to stress the importance of companies being able to manage their cash through accurate demand and liquidity forecasts and keeping a close eye on managing working capital processes.

• Doing a year-over-year comparison between Q2 2020 and Q2 2021 shows a 7.1-day decrease in the cash conversion cycle driven by improvements in days sales outstanding (4.9-day decrease) with companies collecting faster and DIO (8-day decrease) with companies holding less inventory partially due to supply chain challenges, and downward movement in days payable outstanding (5.8-day decline) as companies move closer to historical payment terms.
• Unfortunately, compared to Q1 2021, the overall cash conversion cycle for Q2 2021 has worsened by 1.6 days with negative movement in both days sales outstanding (increasing 1.1 days when compared to Q1 2021) and days payable outstanding (decreasing by 1.1 days when compared to Q1 2021). This was the first increase in days sales outstanding since Q2 2020 (after three straight quarters of positive improvements), while days payable outstanding has been more volatile over the last year with mixed results over the past year and a half.

Impact of the economic recovery on key financial metrics
Overall, revenue has steadily grown since Q2-20 with the steepest quarter over quarter hike (15.1%) taking place during Q3-20. Although the growth slowed from Q4-20 to Q1-21, it has picked back up again in the most recent quarter. As businesses and trade continue to figure out how to operate under the “new normal,” and vaccines continue to be rolled out, the financial performance of companies continues to improve.

Earnings before interest, taxes, depreciation, and amortization increased 1.2 times faster than revenue in Q2-21, down from a factor of 13 in the previous quarter. These strong metrics are likely an indicator of companies’ adaptability to the ever-evolving new world of work and many realizing significant expense savings from the continued reduction in business travel.

From a working capital perspective, the ash conversion cycle has continued to fluctuate each quarter, increasing and decreasing in an alternating pattern. These swings appear to be narrowing some, likely pointing toward a point of stabilization. The Q2-21 increase of 1.6 days is the lowest since Q2-20 while the recent decrease of 5.8 days in Q1-21 was the strongest decline.

Days sales outstanding has been performing well with an overall decreasing trend over the period of review except for Q2-20, in which a minor increase of 1.1 day was noted. It indicates that companies are potentially falling behind on working capital management efforts compared to the strong revenue growth.

Days inventory outstanding has been experiencing a decreasing trend overall, with little change in the most recent quarter. Aside from Q2-20, which represented the height of the pandemic, days inventory outstanding only increased again in Q1-21, likely in anticipation of further vaccine rollouts, translating into higher future demand and companies wanting to be prepared to respond.

Days payables outstanding has experienced quarterly up and down swings with large declines in Q3 and Q4 2020 followed by an 8-day increase into Q1 2021. From Q1 2021 to Q2 2022 there was a small decline (1.1 days) as companies continued to stabilize their payment behaviour.

Overall, even with a strong revenue and earnings before interest, taxes, depreciation, and amortization performance in Q2-21, the WC metrics from Q1-21 to Q2-21 shows some marginal deterioration and opportunity for companies to remain focused on their balance sheets.

Working capital performance in the new normal
Reflecting on the cash conversion cycle trends over the last 10 quarters to the left, you can clearly see the seasonal impact with peaks during the fourth quarter of each year and low points in the second quarter (with the exception of Q2-20 when the pandemic hit).

Overall, the cash conversion cycle shows a general downward trend since Q4-19, with the latest swing in Q2-21, fluctuating minimally, and with the lowest best performance noted in Q1-21.

The main drivers for the reduction in the cash conversion cycle since Q2-20 can likely be attributed to a decrease in days sales outstanding of 6 days and days inventory outstanding improving by 9 days. These improvements are offset some by days payables outstanding deteriorating by 9 days, from a high point of 78 days in Q2-20.

When breaking down the companies and their cash conversion cycle results by industry, we can see that the technology, media, and telecommunications industry as well as the energy, resources, and industrials sector remained unchanged overall. The consumer and life sciences sector, as well as the health care sector deteriorated and resulted in an overall two day and four-day increase, respectively.

Between Q1-21 and Q2-21, the Consumer industry saw a 1-day improvement in days inventory outstanding, while days sales outstanding deteriorated by three days and days payables outstanding remained unchanged. The deterioration of days sales outstanding and reduction in inventory may have been a result of supply chain constraints dampening demand.

Energy, resources, and industrials experienced the most significant changes from Q1-21, where both days inventory outstanding and days sales outstanding improved, and days payable outstanding deteriorated significantly by four days. The weighting of this industry in the overall population by revenue resulted in the strongest impact on overall WC performance. The improvements are a strong indication that demand has increased resulting in more turnover and reduction in inventory levels. At the same time, the industry was leveraging payment delays to suppliers to preserve cash. Now that revenues are growing again cash is being brought back into circulation of the supply chain, and payment timing is decreasing.

The life sciences and health care experienced an overall deterioration in days sales outstanding and days inventory outstanding, while days payable outstanding remained unchanged. This was mainly driven by the Life Sciences sector.

Technology, media, and telecommunications ended up net neutral with no change in days sales outstanding, while a 1-day deterioration in days inventory outstanding was balanced out by a 1-day improvement of days payable outstanding, underscoring the continued solid performance of this industry in terms of working capital metrics.

Looking Ahead
Working capital metrics have stabilized some during Q2 2021 with small changes as compared to Q1 2021, and some significant improvements versus Q2 2020. While there still remains some uncertainty due to supply chain challenges and labour shortages, companies should strive to maintain the discipline they had around managing working capital over the past year.

Companies should continue to move from short-term reactive behaviour to medium- and longer-term strategies with an opportunity to create positive long-term changes to their balance sheets and working capital practices. One way that companies could do this is by building cash flow scenario models against possible future economic outcomes where they would assume optimal liquidity levels against any lead time for the relevant adjusting factors.

It’s essential that decision-makers understand the vital importance of protecting liquidity. Building a cash culture means more than highlighting cash as a metric; a cash-conscious culture needs to permeate through the entire organization, so everyone assesses every decision through a liquidity lens.

Companies have an opportunity to create long-term value and a competitive advantage versus their peers through focused effort to improve working capital processes.