In a recent article in the Daily Telegraph, under the heading UK firms’ excess working capital levels “worrying”, Lloyds bank research indicated British companies have around £498 billion tied up in excess working capital. Chris Williamson, an economist with IHS Markit, said “it is worrying that firms are under such high pressure to increase working capital….. when other economic indicators suggest the economy is starting to slow”.
There are two points in this piece to be considered:
1. A company’s ability to respond to demand indicators. As businesses gear up to respond to increased demand, they inevitably struggle to meet customer service levels and match capacity required. As purchasing and production increase activity to respond, businesses increase capacity and start meeting customer service levels again. Indicators delay response across sales and operations planning, meaning production increases get started after demand has picked up – catch up mode. This is fine when the demand is going up and businesses gear up the output to match. But, just like a super tanker, when demand reduces – it takes time to turn it down and the result is excess tied up, unproductive working capital.
Another point to consider with the lead and lag on demand is that as demand increases it can consume existing inventories – if the right stocks are held (another point for another day). It is very hard to consume excess stock when demand is going down. Stock turns slow and increase the risk of slow moving and obsolete stock.
Having the right metrics and responsive processes in place enables businesses to match capability with demand – key areas of working capital development. As ever, you have to be able to measure key elements of your business to manage them.
2. Are companies responding to pressure rather than managing their working capital poorly? The assumption that firms are under pressure – external pressure? – to drive up working capital use.
In our experience, working capital is often the poor relation when it comes to effective management reporting, visibility, measurement and control. Companies will carry on using excess working capital as the approach and visibility to challenge it is not available or a priority. With extended cycle times businesses not only increase the levels of working capital, they increase the cost of the process and reduce cash flow as extended cycle times fill up with it.
Working capital is an end to end process and metrics and incentives that measure and reward individual part of the process often act to increase working capital levels. The buyer who is incentivised on price alone is unlikely to negotiate longer payment terms and lower order quantities – both factors in optimising working capital. Production incentives that are not linked to stock cover will help drive excessive inventory levels – to make sure production and output is cushioned.
The link between excess working capital and external factors is an issue – but there are many more direct and manageable factors that will lower working capital, even as demand goes up or comes down.