Treasures are usually found in hidden places—but in many companies, there are treasures that could be uncovered through a thorough business analysis and the implementation of appropriate measures. One of these treasures is working capital.
“Companies neglect the issue of working capital,” says Joachim Englert, Partner in the Advisory division of the auditing and consulting firm PwC. “Companies aren’t making the most of their capital. They’re tying up too much money in current assets—money they need to invest in growth,” says the financing expert. This is also confirmed by the latest findings of PwC’s annual “Cash for Growth” study.
High Working Capital Is a Warning Sign
The study is based on data from the 7,368 largest international companies. Working capital refers to all liquid
funds that can be used in the short term. These include cash in accounts, raw materials, work-in-progress, finished goods, provisions,
that are due within one year, and outstanding invoices. Liabilities that must be settled within one year are deducted from this total. The working capital ratio is defined as the percentage ratio of working capital to revenue.
This ratio is an important indicator of the quality of a company’s management. “Using the working capital ratio, a company can compare itself with other companies in its industry and with firms outside the industry,” says Englert. “If this percentage is too high, it serves as a warning sign that a company’s financial management needs to be improved.”
As a general rule across all industries, a working capital ratio of more than 20 percent is considered a first indicator that action is needed
. This is also supported by the findings of the PwC study on the topic. An important finding: Companies that consistently focus on maintaining a healthy working capital ratio have seen their earnings before interest, taxes, depreciation, and amortization (EBITDA) increase in recent years and also perform exceptionally well on other indicators.
“This makes it all the more puzzling that many companies are not making the necessary efforts. Active working capital management is an ideal method for freeing up liquidity reserves,” emphasizes Hanns Dobringer, Senior Manager, Advisory at PwC. The customer-supplier relationship is crucial when measuring and improving the working capital ratio. However, it is important to consider the balance of power between the parties. For example, a supplier with a powerful customer will not be able to agree to longer payment terms.
Accounts Receivable and Inventory Are Crucial
Therefore, alarm bells should go off for companies if the proportion of outstanding receivables exceeds ten percent of revenue and if approximately 40 percent of inventory is between 30 and 90 days old. “There are a variety of levers companies can pull to improve these ratios,” advises Dobringer. The primary goal must be to reduce working capital in order to free up funds for other purposes, such as financing investments or repaying credit lines.
Over 270 billion euros can be freed up
Longer payment terms for settling supplier invoices should also be pursued. Under certain circumstances, it may also be advantageous to arrange bridge financing through a bank or to sell receivables via factoring. Dobringer also recommends placing greater emphasis on just-in-time production. It is highly uneconomical, for example, to keep expensive, rust-resistant material in inventory for eight weeks. “The automotive industry and its suppliers are often ahead of other sectors, which frequently have a lot of catching up to do in this regard.”
However, the general rule is that working capital management is an ongoing process. Yet surveys of companies conducted as part of the study revealed that such optimization measures are often only implemented when external circumstances force companies to do so. One such circumstance was the financial crisis that began in 2008. As a result, banks tightened lending. Companies responded by improving their working capital ratio so they could finance investments with their own funds. When conditions improved the following year, the issue fell out of focus.
The result: Since 2009, an additional 500 billion euros has been tied up worldwide instead of being used for investments. The 972 European companies analyzed for the study alone could free up a total of between 270 and 441 billion euros if they improved their working capital ratio. The picture is even more dramatic when looking at the 7,368 largest companies worldwide. Only 9 percent of them have significantly improved their working capital ratio in recent years. According to PwC’s calculations, this means that up to 1.4 trillion euros remain unused around the globe—money that is not being channeled into investments. These investments are urgently needed. To achieve moderate growth of one percent, companies worldwide must invest around 300 billion euros over the next three years, according to PwC. “Companies in Europe, in particular, can further reduce their working capital ratio,” says Englert.
Europe Is Lagging Behind
“Despite all the progress made in this area, Europe lags behind other regions of the world,” Dobringer also emphasizes. With an average of about 41 days, European companies have a lower working capital turnover rate than those in Asia and the U.S., which stand at 37 days. Among
European companies, those in Germany, Austria, and Switzerland, as well as in Scandinavian countries, have the highest levels of working capital.
Success Through Professional Optimization
Financing professionals can help. “Experience shows that through targeted working capital optimization, we can achieve an improvement in the ratio of five to ten percent for our clients,” says Dobringer. It is not possible in every company to optimize both accounts receivable and inventory. However, improvements of between 10 and 80 percent can be achieved through individual measures. Success is most evident when a company succeeds in optimally combining the various measures.
