Working Capital in the ‘New Normal’

If anything positive has come out of the Covid-19 pandemic, it may be companies’ new focus on working capital management at every level of the organizational structure.

The Hackett Group recently released its analysis of 2020 trends in the corporate cash conversion cycle. The results are not surprising given last year’s business climate. Among the 1,000 largest publicly traded U.S. companies, excluding the financial services sector, days sales outstanding (DSO), days payables outstanding (DPO), and days inventory on hand (DIO) all increased—by 1.5 days, 4.4 days, and 4 days, respectively.

Payments are taking longer to arrive and inventory is spending more time on shelves, but those are not the only interesting results of the study, according to The Hackett Group’s associate principal Craig Bailey and director Istvan Bodo. Treasury & Risk sat down with both thought leaders to discuss how companies managed working capital through Covid and what they should be doing as we emerge from the pandemic economy.

Treasury & Risk:  Your “2021 U.S. Working Capital Survey” indicates significant growth in all three core working capital metrics. How does this jibe with what you’re seeing in the real world?

Craig Bailey:  Yes, accounts receivable deteriorated, inventory deteriorated, and accounts payable improved. Organizations that felt negative effects of Covid, that experienced loss of revenue or operational impacts, were naturally slower to pay invoices. In some cases, they took a structured approach and tried to push out payment terms. In other cases, they just withheld or delayed certain invoices. That was especially evident in retail, but it happened in most industry sectors. Organizations’ payables increased, and their suppliers’ receivables grew commensurately.

T&R:  What length of extension were most companies granting their customers?

CB:  It depended on the company and industry, but we often saw terms extended by 30 days or so. What was more important than the length of the extension was making sure to clearly define the criteria around how long the extension would last and under what requirements or time frame payments would revert to the original terms.

At the same time, it’s worth noting that some customer companies took the opposite approach. Different industries were impacted very differently by the pandemic. Grocery retailers and food manufacturers, for example, saw revenues go up. Some of these companies evaluated the health of their supplier base and temporarily reduced their own payment terms, paying invoices faster than required, for the suppliers that needed their support. So we did see it go both ways, but the majority of customers were looking to push their terms out.

T&R:  Do you see that as a best practice in a situation like the Covid economy—to carefully evaluate suppliers’ financial health and use the cash conversion cycle to relieve pressure on those that need relief?

CB:  Most definitely. Covid was impacting everybody, so it was important to collaborate across the end-to-end supply chain. Our recommendation is always to evaluate the health of your supplier base. Where you’re hurting, see whether you can push out terms and share that burden. But also recognize that sometimes your suppliers may need to be supported, and it’s in nobody’s interest to put those suppliers in a bad position.

T&R:  And how did suppliers react to customers that were paying late?

CB:  Many companies saw overdue accounts receivable building up because customers were just unable to pay. A lot of them reacted by reorganizing their accounts receivable teams to very quickly identify and ring-fence those customers that were having difficulty paying. This enabled them, first, to prioritize efforts to collect invoices on companies that didn’t fall into that Covid category, in order to collect as many available dollars on time as possible. And second, it enabled them to identify what to do with the customers that were slow paying: They created payment plans and negotiated with those companies, trying to bring in some payments rather than none at all.

Of course, the opposite was happening in days payables outstanding. That’s the one metric that was improving. This didn’t start with Covid: For the past five or six years, payables has been one of the first areas companies tackled when they started looking at working capital optimization. Their level of success in pushing out DPO depended on how much leverage they had with their suppliers, but it was a strategy, and it continued last year when organizations were looking for ways to preserve liquidity and cash.

T&R:  What have you seen as 2021 has progressed and the global economy has begun to recover?

CB:  At this moment, we’re not seeing a great change. We re-ran the figures for Q1/2021, and there was actually another slight improvement to DPO as payments continued to be late going out the door. That fits with what we find when we speak with CFOs. They’re feeling a lot of uncertainty at the moment, so organizations are still holding onto cash.

What we are seeing change, though, is much more of a renewed focus on working capital. In the past few years, organizations would sometimes struggle to build internal enthusiasm for working capital optimization—particularly inventory. While the finance function is looking at cash flows and costs, the commercial team is looking to maximize inventory in order to maximize the products they have available to sell. These competing interests are why companies historically have focused first on payables and receivables.

T&R:  Does that explain why inventory increased substantially over the past 18 months?

CB:  Well, the increase in inventory was also expected because of the massive disruption in consumer demand, which was like nothing we had ever seen before, not to mention the factory closures and international shipping blockades. In an ideal world, companies would have had good visibility so that they could plan for their supply chains to adapt, but everything was happening so rapidly that companies weren’t always able to react in time. They ended up with excess inventories that they needed to reduce.

So we saw organizations looking at consolidating their ranges and their product portfolios. Before Covid, the push to give consumers more choice, more products in more targeted markets, was unrelenting. But last year, we saw a reversal of that: Some organizations were saying, ‘Let’s concentrate on the key drivers of demand and focus on the products that meet those needs.’ The textile and apparel sectors even started consolidating seasons.

What we’re seeing this year is organizations revisiting inventory—having those conversations that have always been pretty difficult—in order to become more agile. Executives are saying, ‘The demand picture is very uncertain going forward. We’re seeing some false starts as different parts of the world open up and then turn back. We’ve also seen a major shift of consumer demand onto e-commerce platforms, and we’re not sure how much of that demand will shift back to traditional bricks and mortar. We need to keep a much closer eye on demand, inventory, and receivables performance.’ These working capital considerations have moved to the forefront of C-suite thinking.

T&R:  How do you expect this to affect corporate management and strategic planning in the near future?

CB:  We still don’t know what the ‘new normal’ is going to look like. Some of the accepted behaviors from the past might not work as well in the future. Now, when companies are looking at their accounts receivable, they need to regularly reassess customers’ credit risk, keeping a close eye on payment behaviors. The old, traditional methods may not be adequate to enable the company to react quickly if there’s a slippage that could indicate a larger problem.

On the payables side, CFOs are not just pushing for longer payment terms. They’re also starting to reassess their supplier base, recognizing that they’re facing increased competition for some resources. When evaluating payables strategy, in addition to cash and cost, they’re figuring out how to factor risk into the equation. In some cases, that means diversifying their supplier base and possibly even bringing some offshore suppliers back to near shore.

And then the whole organization needs to be focused in on demand signals to ensure inventory management is optimized. We often find pockets of inventory knowledge within an organization, particularly in the customer-facing parts of the business, but that information may not make its way back to operations. In the future, everybody really needs to be aware of the working capital levers so that the company overall can react very, very quickly.

Istvan Bodo:  The next few years are going to be a really interesting time from a working capital perspective. The shift in demand will create some opportunities, but also some challenges, for organizations and for the corporate functions responsible for managing working capital.

T&R:  There’s one more statistic in the “2021 U.S. Working Capital Survey” that I wanted to ask about. As the cash conversion cycle expanded, debt also increased substantially.

CB:  Yes, debt increased by 10 percent year-on-year, and it’s up 100 percent over the past decade. Meanwhile, cash on hand was up 40 percent in 2020. We’re encouraging our clients to keep a close eye on debt levels. Companies have become accustomed to cheap debt, low interest rates, and the availability of credit. Obviously, we’re not sure what will happen in the future, but building visibility and leveraging working capital strategy to improve corporate agility will prepare businesses for whatever the future may bring.