The concept of effective working capital is relatively straightforward – a business needs enough cash to fund day to day operations such as paying suppliers and funding inventory, while awaiting income from customers.
However, in reality it is a delicate balancing act, and achieving effective work capital is nothing short of a challenge. Too much may be an unnecessary expense, while not having enough can expose a business to serious financial distress.
To make things even more complex there is no right formula or methodology for obtaining the right level of working capital. Sure, many business leaders will have their views, however ultimately it is dependent on a number of competing factors – and there is none so great than working capital expectations within your supply chain, which can vary across sectors, borders and market capitalisation segments.
Make your capital work
For this reason, working capital needs to become a top agenda item for businesses of all sizes across the globe. And given the current capital constrained climate, it has never been more important to get it right.
To shed some light on key working capital trends, the Annual Ernst & Young working capital report examines the working capital performance of the ASX 200 over the previous two years, highlighting opportunities and threats for Australian businesses.
And for the first time, as more Australian businesses look to Asia for growth, we have extended our study to consider the relative and historical performance of other indices across Asia Pacific. This has highlighted just how vastly different working capital expectations and norms can be across regions and how this can impact your operations, transactions and overall profitability going forward.
Our key findings from the report reveal:
- The majority of Asian companies are working capital heavy carrying A$318bn more than their Australian counterparts
Australian companies need to be mindful of differing working capital conditions in almost each country across the Asia Pacific region. Of the 1,000 companies listed on the Asia Pacific indices that were surveyed in this report (including Australia), only the Hong Kong index had a better working capital performance than Australia.
In fact, in 2011 the average working capital requirement across Asia Pacific (excluding Australia) was 48 days compared to 28 days in Australia. In particular, Japan and Korea have considerably longer working capital cycles than Australia with an average of 67 and 62 days respectively in 2011.
Of course there are historically complex reasons why there are generally longer payment cycles in Asia, and this will not change overnight. Notwithstanding this, if companies in the Asia Pacific region were operating at similar performance levels to those of their Australian counterparts, then an estimated A$318bn of working capital could be released.
In 2011 the drivers behind the performance difference were around debtor days; the average across Asia Pacific was 51 days compared to 32 days in Australia. Similarly, in the same year the inventory days was 38 days compared to 30 in Australia.
It’s therefore critical for Australian companies operating or looking to conduct business in Asia to account for the likely expectations around longer trading terms or supply chains, and build such measures into their working capital strategies.
Ultimately, these large discrepancies in working capital practices could impact the viability and profitability of investing in Asia, and in worst case scenario, the success or failure of an operation.
- Australia’s resources sector continues to outperform...
even in working capital
Thanks to our resources boom, Australia’s resource sector continues to outperform other industries in Australia as well as their counterparts in Asia Pacific, and this dominance has flowed through to their working capital performance.
Australian businesses within the Metals & Mining sector improved their working capital cycles by moving from 52 days in 2010 to 35 days in 2011 – a stark contrast with Asia Pacific businesses which held their performance steady at 57 days over the same period.
Two of the world’s largest mining companies have contributed substantially to the gains in this sector through their respective increases in performance. Both these organisations combined comprise of 56% of the trade working capital of the ASX 200 Metals & Mining sector. Therefore, any movement by these two companies has a significant effect on the working capital index.
- Act big. Smaller companies can learn valuable lessons from their larger peers and potentially realise A$2bn in working capital
This year the majority of working capital improvements noted have been made by larger companies who can execute more influence around where working capital is held in the supply chain.
In fact all ASX 200 companies with over A$10b in revenue have improved their working capital cycles by an average of 7 days from 2010 to 2011.
In contrast, those organisations with less than A$1b in revenue have only improved their working capital cycles by an average of four days from 2010 to 2011.
If smaller companies were as effective as their larger peers at managing their working capital they could potentially release an estimated $2bn of working capital.
The need to become more agile and robust
Effective working capital management allows businesses to not only improve cashflow and service, while reducing costs, but also to be more agile against a backdrop of changing economic and financial conditions.
It is important to consider the following 5 key steps towards effective working capital management:
- Effectively manage and negotiate payment terms for customers and suppliers (with terms and conditions appropriate to the current environment).
- Improve speed and accuracy of billing and cash collections and deal with disputes effectively.
- Build greater linkage and closer collaboration among the various participants of the working capital value chain internally and externally, focused around sharing of demand signals and planned response down the chain.
- Identify the key drivers of working capital consumption and focus on improving them (forecast error, lead-times, minimum lot sizes, supply variability, capacity constraints, speed and accuracy of billing, customer segmentation and appropriate collection strategies).
- Identify, understand and quantify the trade-offs that need to be made (e.g., order fill rates or inventory levels, early payment discounts or longer payment for payables optimisation, larger batch sizes or inventory levels).