Working capital: Unlocking excess cash Why was 2013 a significant year? India s economic growth rate fell to 5% in FY2013 the lowest figure in a decade. While this slowdown can be partly explained by the weakness in the global economic environment, it can also be attributed to a number of internal factors such as the lack of policy reforms, high inflation, and volatile commodity prices and exchange rates. Top challenges facing CFOs A review of the performance of the leading 500 companies in the country reveals that sales growth has halved, operating margins of the majority of the companies have declined and debt levels continue to rise. ROCE was at a five year low of 11% against average cost of capital of 15%. Some of the key challenges facing the CFOS are: 1. Decline in sales growth and EBITDA margins A review of the sales performance of the leading 500 companies in India during FY2013 reveals that sales growth halved during the year and EBITDA margin declined by 0.8% compared to the previous year. A deep look at the results also indicates that 60% of the companies reported a decline in their operating margins over the period under review. Chart 1: Overall trend of sales and percentage of EBITDA/sales, 2009 2013 Source: EY analysis, based on publicly available annual financial statements 2. Volatile exchange rates and commodity prices For Indian businesses, volatility in the prices of commodities and the weakness of the rupee against major world currencies has adversely affected business planning. The Indian rupee depreciated by 13% (against the US dollar) in the first half of FY2013 and closed at 7% lower on March 2013 than in March 2012. In the first six months of FY2014, the Indian rupee sank further against the US dollar amid growing concerns about the state of India s economy and fears that the US will scale back its stimulus measures.
Chart 2: Change in rupee-dollar exchange rate Source: RBI, exchange rate 3. Expensive and scarce capital availability In March 2013, gross NPAs in the banking system grew by 16.5% to Rs 1.84 trillion and formed 3.42% of the industry s advances. It has been growing progressively every year barring fiscal year 2011. The situation is even bad when we look at the numbers along with restructured assets, the total loans subject to restructuring amounts to Rs 2.41 trillion and total corporate debt restructuring amounts to 1.01 trillion in March 2013. Public sector banks, which account for 76% of total loans of the industry, have major pie of these stressed assets. On the backdrop of tightening of finance ministry and the RBI s directions, Banks are making strict norms with respect to loans offered and collateral requirements to avoid past mistakes.
Chart 3: Gross and percentage share NPA for banks, 2009 2013 Source: RBI publication, Table 7.1: Bank Group-wise classification of Loan Assets of SCBs-2008 to 2013, EY Analysis 4. High debt levels and fall in ROCE The top 500 companies in India have a total debt of INR19 trillion, which went up sharply in 2013 as compared to 2009. Part of this debt was foreign denominated, putting additional strain on the country s balance sheet as the rupee continued to depreciate. All of the above translated into a further fall in the return on capital employed (ROCE) of these businesses to 10.8% in 2013 from a high of 12.5% in 2010 2011. Consequently, Indian companies have been scrutinizing their balance sheets and actively seeking ways to increase their cost efficiency, release cash and optimize their asset structures. Chart 4: Change in total debt, 2009 2013 Chart 5: Change in ROCE percentage, 2009 2013 Source: EY analysis, based on publicly available annual financial statements Source: EY analysis, based on publicly available annual financial statements
Return on Capital Employed (ROCE) emerging as top priority With the currency and commodity markets remaining volatile, regulatory environment being uncertain and the general overall stressed economic environment, managing business has become extremely challenging. The focus of many business is moving away from purely sales (or market share) growth or profitability (PAT, EBIT or EBITDA) on to the more comprehensive returns metrics such as Return on Capital Employed (ROCE) or Return on Equity (ROE). Study of top Indian companies with high return on capital employed (ROCE) shows that many of these companies have operated on negative working capital management. These companies are known to give good returns to their shareholders, both in terms of dividends and capital gains. Ofcourse, some of the sectors like retail and Telecoms have lower capital requirements than other sector such as cement or pharmaceutical. However, our experience shows that a number of operational efficiencies and best practices can be transported and implemented both within and across sector. Chart 6: ROCE driver tree, EY Analysis Negative working capital is one important parameter that no successful investor has ever missed. Cash and working capital management is an especially interesting area it represents the cheapest form of finance and a valuable and largely untapped source of liquidity. Companies that excel in working capital management are more profitable, less dependent on external financing and have more flexibility to take advantage of strategic opportunities.
Why companies should consider extra cash from working capital optimization? To improve returns on capital (by lowering capital employed) To mitigate risks of higher interest rates To strengthen financial flexibility and improve credit ratings To increase cash returns to shareholders To send a strong positive signal to capital market To speed up organic or inorganic growth Focus on improving working capital levels emerging and significant improvement possible Historical changes in WC metrics Cash to cash (C2C) conversion cycle represents how fast the business is able to monetise its investment in the operating cycle of the business. The results for Indian companies WC performance in 2013 show a slight improvement, with cash-to-cash (C2C) dropping by 2% from its level of 2012. Had the oil and gas and metals and mining (O&G and M&M) sectors been excluded, the C2C would have also fallen by 1%. However, this overall level of improvement proved insufficient to reverse the deterioration in performance seen in the previous three years. Between 2009 and 2013, the C2C of Indian companies was still up 21% and 11% excluding the O&G and M&M sectors.
Chart 7: Change in C2C days, 2009 2013 Source: EY analysis, based on publicly available annual financial statements Our analysis also reveals that Indian businesses are starting to realise the benefits on improving WC management as they seek to raise cash and improve their operational efficiency, driven by the need to grow their returns and repair their balance sheets, which have been stretched by their aggressive spending of capital and acquisition strategies. Compared with their peers in the US, Europe, Japan and other main Asian countries, Indian companies remain at the bottom of WC performance. Chart 8: Current WC metrics by sector across regions and countries C2C India US Europe Japan Asia* Auto parts 54 36 57 60 60 Building materials 42 56 51 84 65 Chemicals & fertilizers 83 64 67 87 53 Electric utilities 49 35 32 22 36 Food producers 66 47 32 53 57 Oil and gas 23 29 29 53 12 Pharmaceuticals 108 88 88 123 N.A. Steel 68 67 78 87 71 Telecommunications -25 10-3 46-50 * excluding India and Japan Source: EY analysis, based on latest publicly available annual financial statement
Our research also reveals a considerable disparity in the WC performance of Indian companies within the same sector, which clearly indicates that there is potential for significant improvement. A high-level comparative analysis conducted by EY reveals that Indian companies have up to INR5.3tn (US$96bn) of cash unnecessarily tied up in their WC processes. This is equivalent to 12% of their aggregate sales. At a time when Banks are struggling with high NPAs and their ability to fund is limited, working capital optimisation offers a source of largely untapped liquidity. With the prevalent high interest rates this could have a significant impact on the bottom line of companies. Overview of challenges to drive operational efficiency Most businesses find it difficult to balance profitable growth with optimum levels of working capital levels. While variation in working capital performance can be partly explained by variations in business models and geographic footprint, it also points to fundamental differences in the degree of management s focus on cash and in the effectiveness of WC management processes against the backdrop of rapidly changing business, financial, commodity and currency markets. Not treating working capital as an operational issue, poor system data management, lack of awareness of global best practices, verticalised structure with poor organisational ownership and insufficient focus on continuously adapting business policies and processes to a rapidly changing environment appear to be the primary reason for the divergence in WC trends between India and the US and Europe. Typical reasons for excess deployment of working capital levels Treating working capital as a finance issue and not an operational issue Poor system data management such as payment terms and dates in system, inaccurate inventory levels, and unallocated customer cash Lack of organisational awareness of global best practices especially at the mid level management Vertical structure that does not enable organisational ownership of cross functional issues such as raw material and spare parts levels Insufficient focus on continuously adapting business policies and processes to a rapidly changing environment Road to improvement - The CFO s Guide The CFO s role has so far been stereotyped in the past as a person who closely looks into accounts. But with the changing times, CFOs have shown greater ability to execute on a number of areas, beyond the traditional functional areas such as mergers and acquisitions and financing. In this highly challenging global and domestic economic and financial environment, it is essential for firms to initiate comprehensive initiatives with a view to improve ROCE of more specifically working capital deployed in the business. Program should focus on capturing immediate savings and cash flow opportunities by reducing operating costs and net working capital.
In our experience, most successful programmes have been led by CFO, but they ve included a crossfunctional team comprised of people from finance, sales, operations, procurement and IT. Improving demand forecasting and inventory planning processes to lower inventory requirements, tracking accounts payable performance by commodity and extending terms to industry benchmarks, and eliminating errors in the order to delivery process to reduce disputes and improve accounts receivable performance are just a few of the operational improvements that can dramatically reduce working capital requirements. Other essential enablers include application of lean manufacturing and supply chain initiatives, effective management of payment terms with customers and suppliers, closer collaboration with each of their partners in the "extended enterprise," globalization of procurement, and taking an approach that balances cash, cost and service levels. All key operational levers need to be targeted and a robust supporting infrastructure set in place, including focused metrics, aligned incentives and strong risk management policies. A tried and tested structured approach focuses to: 1. Rapidly identify ambitious improvement potential by challenging current practices and business norms Quick wins that underpin immediate improvement and help in gathering organisational buy in Process- and compliance-related improvement areas for operational improvement Structural changes to make business operations asset and expense light 2. Focus on areas with highest impact and ease of implementation by defining and empowering clear business owners 3. Design and pilot test improvement solutions leveraging existing global best practices 4. Dedicate resources and top management implementation focus for full benefits delivery 5. Ensure sustainability of results by improve organisational awareness and controls by establishing right infrastructure including relevant metrics, incentives, SOPs, system and tools support The secret of success is not to manage working capital or some of the cost elements but to change the business and the organisation mind set for long terms benefits.
Wrapping it up: The concluding thought The current business environment requires a strong focus on cost, and risk but even more important on cash management. ROCE is a key metrics for most businesses and their investors. High debt and related interest costs could eat into the bottom line and could force businesses to lose financial strength. Business that manage profitable growth with optimum capital levels are the ones that appear as leaders. Working capital is an area of value creation for most businesses. There is a natural tendency among many companies to blame tough business environment for poor performance as banks make lending tougher, customers struggle to pay on time, supply chains fail to keep pace with falling demand, and suppliers seek to get early payments. Our experience shows that there still are a number of areas within management s own influence that can be dramatically improved upon such as timely billing, credit blocks and proactive collection, establishing responsive supply chain to adjust inventory in real time with demand, and improved supplier and spend category management. This can lead to a substantial and sustainable cash release in a relatively short period of time. Indian companies need to take initiatives challenging the status quo in order to stay the course in the tough economic environment. Till the economic situation changes, CFOs have to take the initiative to keep costs low and investing in processes and upskilling resources to take on the good times when they return. Ankur Bhandari, Partner, Working Capital Advisory Services, EY has authored this article. This was published in IMA s CFO Connect magazine. Article is based on EY s working capital management report (All Tied Up 2014) containing working capital performance of the top 500 cpompanies in India. Article contains information in summary form and is therefore, intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. You can get in touch with Ankur Bhandari on ankur.bhandari@in.ey.com