Managing Working Capital Through the Crisis

As companies attempted to shore up liquidity amid the pandemic, the cash conversion cycle lengthened 13 percent. Here’s how to look at payables and receivables going forward.

The Hackett Group’s “Q2/2020 U.S. Working Capital Survey” found what many corporate treasurers know instinctively—that companies did everything they could to ensure they continued to have access to adequate liquidity as revenues shrunk in the early stages of the Covid-19 crisis.

In the study, The Hackett Group calculated working capital performance metrics for 849 large U.S.-based public companies that are outside the financial services sector. They found that revenue fell 14 percent, on average, from Q2/2019 to Q2/2020. Over the same period, gross margin fell 1.5 percent, earnings before interest and taxes (EBIT) margin fell 23 percent, and net income fell 61 percent. Companies responded to these changes by taking on more debt and pushing out their payables.

To explore the research and its implications for companies going forward, Treasury & Risk sat down with Gerhard Urbasch, a senior director in The Hackett Group’s North American Working Capital practice who played a leading role in the Q2/2020 survey. (He also discussed the survey results in a recent Treasury & Risk webcast, which is now available on-demand.)

Treasury & Risk:  Welcome, Gerhard. It’s not a big secret that corporate revenues deteriorated significantly in the first half of this year. I’m wondering, though, if you could talk about how this affected companies’ cash on hand.

Gerhard Urbasch:  Well, cash on hand increased 47 percent from the second quarter of 2019 to the second quarter of 2020, while debt increased 13 percent. What’s even more interesting than the percentages is the change in absolute terms. Debt increased by a total of $792 billion among the 849 companies in our research, and cash reserves increased by $414 billion. This suggests that companies were borrowing to ensure they had adequate cash to weather the storm.

They were drawing down their credit facilities to increase their cash balances. At the same time, their working capital—as measured by the cash conversion cycle, which is DSO [days sales outstanding] plus DIO [days inventory on hand] minus DPO [days payables outstanding]—deteriorated by 13 percent.

T&R:  So, companies started paying later to preserve liquidity?

GU:  We did see some companies extending payables. Given the uncertainty earlier this year, many were worried about their cash reserves. Companies’ DPO increased as they paid late or extended terms with their vendors—which is typically one of the first levers businesses pull when liquidity concerns arise.

That, in turn, increased suppliers’ DSO. In our study, DPO grew 10 percent and DSO grew 7 percent from Q2/2019 to Q2/2020. We saw overdue receivables rise in certain industries, as well.

T&R:  Is there also an element of larger companies pushing their cash management issues onto smaller suppliers?

GU:  Yes, in some cases. I’ve worked a lot with the automotive industry, where big OEMs [original equipment manufacturers] often source from medium-sized suppliers, and the suppliers all complain about the pressure they’re getting on payment terms. When a crisis like Covid happens, payment terms become a matter of survival of the fittest, to some extent. Those that have more negotiating power tend to use that power because cash is tight.

That said, we’ve also seen the opposite trend recently, where some companies are looking for suppliers that might be at risk of insolvency. For those that are critical to the supply chain, the customer organization might proactively start paying earlier, using A/P [accounts payable] to protect those suppliers a little bit. For example, if only one supplier makes a critical part, and without that one component a large OEM cannot sell its finished product, then it’s absolutely critical to help that company stay in business. The customer may willingly shorten its own payment cycle to provide a cash infusion.

T&R:  What other factors are affecting companies’ working capital management practices right now?

GU:  Well, in some areas, companies have gone out of business, which obviously has an impact on their trading partners’ DSO and DIO. Sectors like airlines, hotels, restaurants, recreation, and motor vehicles suffered significantly from both a revenue and a DSO point of view. But these are the same industries that saw the biggest DPO improvement.

In addition to these external factors, part of the change in working capital metrics reflects a volume effect. When the equation’s denominator shrinks more rapidly than the numerator, the overall KPI [key performance indicator] increases. So, when companies’ revenue was falling much faster than their A/R [accounts receivable] balances, DSO expanded. When cost of goods sold fell faster than the volume of inventory, DIO increased. And the drop in cost of goods sold actually led to an improvement in DPO.

So, as business activity starts to increase again, if we now see revenues and cost of goods going up, we should see an improvement in the cash conversion cycle moving forward.

T&R:  What are the longer-term implications of the increase in debt that companies took on to increase cash on hand?

GU:  The nearly $800 billion increase in the debt balance is something we need to monitor. Even as the cash conversion cycle improves with overall business activity, debt may no longer be as readily available in the future because of the increased risk. We’ve seen a lot of prominent companies go out of business recently. This means banks needed to increase their risk provisions, and they may become more stringent with regard to lending.

That would obviously increase the attention on internal sources of funding. From a risk management and working capital point of view, for companies that haven’t yet fixed their integrated business planning or sales and operations processes, now is really the time to do it.

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T&R:  How should companies be planning today to meet their cash needs of the future?

GU:  Companies really need to think in terms of scenarios. What would different types of economic recovery—a V-shaped recovery or an L—mean for both the business overall and for individual product families? This scenario planning needs to be tightly integrated into the corporate cash-flow forecasting process, and needs to be inclusive of all the elements of working capital.

Some companies already include inventories in their cash-flow and integrated business planning processes, but most don’t include A/R or A/P. Accounts receivable and credit risk management are critical right now, as we’re likely to see more insolvencies in the future. A/R and A/P projections need to be part of companies’ scenario planning within an integrated business planning process.

Business planning typically starts with looking at revenue expectations over the next 18 or 24 months, by product family and by type of customer. You look at variable costs, gross margin, and contribution margin. Then you look at your fixed costs. From these inputs, you look at your cost structure, and whether you have any planned strategic initiatives that impact your fixed-cost base. What are your staffing plans and your expected product mix? How does production capacity need to change to satisfy demand? And then, how do you expect A/R and A/P to link with those projected changes in operations?

It’s also important to look toward the future and forecast risks. Not just credit risks, but also supply chain risks. A lot of companies experienced disruptions this year in their overseas supply chains. In some cases, that resulted in increased lead times. In other cases, they simply couldn’t get the raw materials or product components from their previous suppliers.

So, now companies need to include in their planning processes a view on what risks they face if cross-border trade restrictions come up. Also, how might delays in delivery or travel restrictions with China or other countries impact production? There was even a period where we thought the novel coronavirus stuck on surfaces, and products might have to spend time in quarantine.

Obviously, for all of these reasons, alternative sources of supply are important. Companies should also keep in mind how their actions might influence the ability of suppliers to stay in business. As I described before, large businesses that see a smaller supplier at risk of insolvency might be smart to pay earlier, just to keep that line of supply open.

T&R:  What about supply chain financing? Is that something companies are pursuing?

GU:  It is. It’s a growing trend and a pretty big issue for some of these companies. Supply chain finance has been growing in parallel with the overall increase in companies’ debt balance.

For investment-grade companies, there are a lot of opportunities right now to pull DPO, DSO, and DIO levers to improve working capital. Our 2020 annual working capital survey revealed that the value of the total working capital opportunity for the 1,000 largest publicly listed non-financial companies in the United States is $1.3 trillion. That is huge, and it is something companies should be looking at as access to credit begins to tighten.

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