European companies have more cash on hand than ever before, and are outpacing their American counterparts on working capital management. But their reliance on debt may spell big trouble in the long run.
According to the 2015 REL Europe Working Capital Survey, which reviewed the accounts of the 947 of largest companies in the European Union (EU), cash on hand in 2014 was up 6 percent from 2013 and 62 percent from 2007. However, companies are not actually hoarding cash; cash on hand as a percentage of revenue increased by only 2 percent. CAPEX has increased 21 percent over that time period, though it has slowed down as of late, with only a 1 percent rise in 2014.
The cash conversion cycle (CCC), which represents the amount of time companies convert cash on hand to even more cash on hand, improved by 5.5 percent (2.1 days) in Europe last year. Meanwhile, in the U.S., the CCC remained flat. Furthermore, Europe’s CCC has improved 18.5 percent since 2007.
However, much of EU companies’ cash is coming from debt. Corporate debt has increased 40 percent to €3 trillion; in 2014 alone, borrowing jumped 5 percent. This is unsurprising given historically low interest rates. REL advises companies to be wary of the long-term risks posed by changes in interest rates, debt dependence and pressured cash flow.
REL’s research shows that companies with large debt tend to have worse cash management performance. Fully 65 percent of companies increased their debt over the past seven years, out of which 29 percent saw debt levels increase more than 100 percent. But it is the 35 percent of companies that reduced debt since 2007 that have seen their CCC improve by 27 percent and their cash on hand increase by 225 percent. Companies who increased debt over 100 percent in that timeframe had an average 51 percent decline in their CCC.
“That’s telltale sign that a lot of companies are choosing the easy road,” Derrick Steiner, management consultant with REL, part of The Hackett Group, told AFP. “They’re simply saying, ‘Well, I’m not going to focus my time, energy and efforts to manage cash flow. I’ll just go out and get it in the form of cheap debt.’”
An opportunity for EU corporates
But if companies are willing to refocus their efforts on managing cash flow, they have the potential to reap major benefits. REL estimates that if EU companies can optimize working capital performance, they could gain €1.1 trillion. “We look at each country or region and try to determine who the top performers are per industry—the upper quartile,” Steiner said. “Then we look at individual companies’ performance and compare that to that upper quartile and that gives us that gap opportunity. So that’s where that €1.1 trillion comes from.”
EU companies have about €468 billion in accounts payable (AP), €320 billion in accounts receivable (AR) and €308 billion in inventory, with the amount in AP having the potential to yield the largest benefit opportunity. But that will only happen if companies shed their reliance on debt and focus more on working capital, cash flow and cash management.
“Having not only the topline metrics to understand the end-to-end CCC, but also the sub areas underneath operationally—days payable outstanding (DPO), days sales outstanding (DSO), days inventory outstanding (DIO)—that’s a great start from a management standpoint,” Steiner said. “If you really want to drive improvements, you’ve got to have the metrics underneath those to really understand the ebbs and flows of your cash flow position.”
Some EU companies already understand this. Leoni AG, a German manufacturer of wires, cable and wiring systems, revealed to REL that its CCC has improved for three straight years through a strong focus on working capital. “Strong free cash flow is of key importance to our investors and provides Leoni with the necessary financial scope for both expansion through internal growth and acquisition,” said Dieter Bellé, CFO and CEO of Leoni AG.
Bellé added that working capital is “an essential component” at Leoni and management “has the responsibility to sustainably improve working capital by managing the key improvement levers through the operational processes.”
Once interest rates begin to rise and more countries implement Basel III, debt is going to be a lot less attractive for corporates, therefore, focusing on cash flow needs to begin now. “They’re going to have to adjust and change,” Steiner noted. “That’s why we think, as those rates start to increase, those companies that are doing a better job of managing their cash flow will be in a better position to keep doing what they’ve been doing in recent years.”
Added Steiner: “We’ve seen an increase in capital spending, dividends, share buyback programs and mergers and acquisition activity. That has partially driven the recovery we’ve seen since the financial crisis. But if companies want to continue doing that, they’re going to have to start focusing on their internal generation of cash.”