British businesses are taking a double-whammy hit on their working capital because of the unusual combination of a positive economic environment coupled with uncertainty as to the future outlook, according to new research from Lloyds Bank Commercial Banking.
The bank’s newly-launched Working Capital Index shows that this combination of factors is putting above-average pressure on companies, leaving them with £498bn tied up in excess working capital. That figure works out at more than £12m for a typical UK company, or almost £35m for a larger company with more than 250 employees, the research says.
“That’s excess working capital compared to either industry best practice or simply historic levels, depending on the size of the company,” says Adrian Walker, managing director and head of global transaction banking at Lloyds Banking Group. “This represents cash that could be used for capital investment, growing your business, reducing debt levels or be returned to shareholders.”
The Working Capital Index currently stands at 104.1, not far off the historic high of 105.0 recorded in October 2016. The index has been back-calculated to January 2000 using data from the IHS Markit Purchasing Managers’ Index and the baseline is 100. The record low of 88.5 was scored just after the onset of the global financial crisis in 2008, when businesses were focused on cash and liquidity above all else. The report also put questions to 650 businesses about their outlook for the future.
The report notes that, while the UK economy has been surprisingly resilient since the Brexit vote in June 2016, financial conditions – as measured by Markit’s Financial Conditions Index – have deteriorated to the greatest extent since 2013. This seems likely to lead to a renewed focus on releasing working capital.
Comments by British businesses
“We need to control working capital better in light of exchange rate swings as well as the potential of declining business levels”
“We stockpiled goods at the beginning of 2016 to avoid the expected price rises. We’ll have used these up by the end of next year”
“We are seeing increased sales volumes and customers requiring longer credit terms”
“We intend to expand our business which will require higher stocks. We expect bigger customers to continue to take longer to pay”
Working capital components
The components of the index reveal that the biggest pressure on working capital comes from the rising level of receivables. In part this reflects growth in revenue arising from the positive economic environment. More importantly, however, it is being driven by lengthening payment terms. The number of businesses reporting longer payment terms from customers was three times the number that reported an improvement. Pressure on payment terms was particularly felt in the construction sector with more than a quarter of businesses reporting that it is taking longer to get paid.
The pressure on receivables is not wholly being passed on to payables, probably because of EU late payment legislation and growing consumer expectations for prompt payment of SME suppliers.
Inventories have been building up somewhat over the last three years, seemingly reflecting the buoyancy of the economy.
Smaller companies are under great working capital pressure with their index reading of 107.9 comparing unfavourably with the larger companies index of 101.4.
Scotland and London were the only two parts of the UK to record a working capital index below 100 (99.5 and 99.3 respectively). In Scotland’s case, the figure was a notable decline from the June 2016 reading of 104.5, probably related to the slowdown in the oil industry, reducing pressure on inventory levels.
All other regions apart from London scored working capital index readings almost 2.5 points higher than before. The North of England scored 1.5.9, the South and East of England 107.1 while Wales and the Midlands had the highest score, 108.0, driven by strong industrial output.
The weaker pound
Sterling’s weakness is an issue that has been raised by one-in-five of the businesses included in the Working Capital Index survey. For manufacturers it is now a more commonly-reported issue than payment terms. The WCI shows a close correlation with the effective sterling exchange rate, meaning that a weaker pound encourages businesses to reduce their working capital.
The data since the Brexit vote has diverged from that trend, probably because of a build-up in inventories in anticipation of yet higher import purchasing costs as well as an expected increase in export sales volumes – both driven by a weaker pound.
It also seems likely that smaller firms, lacking treasury expertise, have not been able to hedge their position in the way that larger businesses can.
Start with a plan
There is no doubt from the data in this report that there is significant pressure to increase working capital with Britain facing new challenges and opportunities following the EU Referendum.
For companies concentrating on growth, it can be easy to overlook the benefits of an intense focus on the operational controls that drive earlier collections, lower inventory levels and well timed payments.
The rewards of such a focus are clear. If even a small percentage of the £498bn excess currently sitting in the working capital cycles in Britain were freed up to be redeployed as a driver of growth, the effects on the British economy as a whole could be dramatic.
Businesses need to do three things to implement a plan for growth, the report concludes.
· Make it a business priority: working capital is a cross-functional issue.
· Start with data: simply monitoring DPO, DSO and DIO can reveal opportunities to generate cash. New technology can help
· Understand all your levers: know what’s driving working capital and understand the financial tools available, such as trade finance instruments, discounting invoices, asset financing, purchasing cards and supplier finance programmes.