14 Sep 2016 02:14pm

Why firms need to release locked-up working capital

Recent analysis by PWC suggests that there is a €1.1trn opportunity for companies across the world to release cash from one of the cheapest sources available, working capital

Caption: Alex Dell on why freeing up capital is essential for creating efficiency

In the UK, PWC's research data in relation to 450 businesses studied over 10 years suggests that there is a working capital opportunity of £28bn for those businesses alone. Post-Brexit concerns may result in the tightening up of working capital by holding minimal levels of inventory and businesses demanding prompt payment of receivables. That said, market data suggests that levels of cash trapped in working capital is rising.

The failure to efficiently release this cash means that businesses are less willing and able to invest and grow. If UK business is going to take advantage of the post-Brexit environment it must improve working capital efficiency.

Asset-based lending (including receivables financing) can materially assist businesses by creating more effective working capital management. Asset-based lenders are focused on the performance of the underlying collateral against which they structure their finance. To an asset-based lender, collateral covenants are more useful measurements than financial covenants.

Large companies are holding more cash than at any time in recent history

In relation to receivables, the type of collateral covenants commonly adopted include measuring debt turn, dilutions and the concentration of the receivables pool. In relation to inventory, the rate at which raw materials become finished goods, the mix of inventory type and the return rate of dissatisfied customers are all critical measurements.

Selling receivables to an asset-based lender should have a marked improvement on working capital management. If a business can access, say, 90% of the value of its receivables without waiting 120 days for its money (with the balancing 10% less funding costs being made available on performance of the receivables), this is clearly going to have a substantial impact on that business and its ability to invest and grow. It is unlocking the working capital trapped in its unpaid receivables.

The collateral covenants may be perceived as intrusive but that is missing the point and looking through the telescope from one end only. If corporate treasurers take time to flip the telescope around they will come to realise that these collateral covenants create rigour and efficiency within their businesses that should be a management objective in any event, and will have a lasting impact on the health of that business.

Furthermore, the funding cost of asset-based lending is a fraction of the funding cost of other working capital options such as leveraged finance or unitranche. This is because the FCA recognises that asset-based lenders both understand the collateral base they are funding and regularly monitor its fluctuating performance.

Basel III rewards such scrutiny by allowing banks to allocate far less of their own capital to such transactions as they are required to allocate to a leveraged finance transaction, for example. It is this regulatory treatment that creates a low-cost working capital product.

It is self-evident that the efficient use of a bank's capital creates efficiencies for its customers' own working capital management. Furthermore, the flexibility of asset-based lending means that it works well in a number of sectors including manufacturing, distribution, recruitment, pharmaceuticals, telecommunications, retail and oil & gas.

Efficient working capital management applies equally to payables as it does receivables. Large companies are holding more cash than at any time in recent history. However, there is a price to pay for cash surpluses in an ultra-low interest rate environment. Holding on to cash creates a cost for businesses and is potentially a missed opportunity for them to make a return on that cash.

By finding ways of deploying cash early to payables can both increase EBITDA and also create an additional benefit of strengthening the supply chain. However, there are few methods of achieving this objective outside formal supply chain programmes. These programmes can and do work well, but inevitably they take time to establish with a relevant bank and carry a cost to the business.

The spirit of post-recession innovation is alive and well however and fintech newcomers to the UK market are specifically re-thinking working capital issues by focusing on creating efficient markets facilitated through online platforms.

Efficient markets are good for business and releasing locked-up working capital is an essential component to creating efficiency.

Alex Dell, partner at Mayer Brown


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