The recent years have seen strong working capital performance in the United States. The overall cash conversion cycle (CCC) indicator improved by 4 days in 2021 compared to 2020, for instance, with positive gains across all working capital components that build on a sustained five-year trend.
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This situation happened in a “tailwind” scenario of strong business recovery after 2020’s COVID-led contraction. Having shed the previous year’s restrictions imposed by health authorities faster than in other geographies, US companies’ revenue increased overall.
This can partially explain the working capital improvements, but not entirely: American companies, even in a situation of very low interest rates, have been conscious of the importance of an efficient cash-generating capability, and they were able to prove it across most sectors and working capital components.
The main contributing factors to this overall reduction derive from Accounts Receivable and Accounts Payable management, with a 1.6 Days Sales Outstanding (DSO) decrease and 1.5 Days Payable Outstanding (DPO) increase. On a consolidated basis, a determining factor for this DSO improvement has been an ability from many businesses to impose shorter terms helped by strong demand in many sectors, with customers willing to accept these in order to meet their needs in the face of increased competition. The 1.5 DSO reduction more than offset the 0.7 DSO deterioration experienced in the previous period, when the business slowdown allowed customers to have the upper hand and extend terms or delay payments.
The 1.6 days DPO rise in 2021 adds up to the 4.3-day increase in 2020 and shows an overall willingness from a number of suppliers to extend the lenient terms granted in the peak of the pandemic. In other instances, it can also be a factor of delayed payments linked to delayed deliveries in the context of the shortages that have plagued global supply chains in 2021 (and which are still recurring in 2022). Either reason, at any event, are by nature transitory and, depending on how the supply landscape evolves, these will fade out and a DPO decrease is likely in the cards within many sectors, unless properly addressed with a structural approach to supplier negotiations.
Although overall stock levels have come down in 2021, the decrease in days (0.6) was the smallest of all working capital components and it did not offset the 3-day increase in 2020. Several reasons are behind this performance: on the one hand, the slowdown in business did keep stocks levels high in the previous year, which in some sectors has not picked up fast enough to recover previous levels; on the other hand, supply chain disruptions prevalent during 2021 have led many businesses to increase their safety stocks in order to minimize the risk of stockouts, with the negative impact of lost revenue. The latter reason is prevalent in those sectors with high dependence on semiconductors and, more generally, materials, components and subassemblies supplied through global chains (see Figure 1 for the different pattern of behavior between low and high-inventory sectors). Supply chain problems are still a major concern in 2022, and there is no visible end to this situation, especially with the compounded impact of the war in Ukraine and the sanctions imposed to Russia.
While 2021 was a year of growth and improvement, the outlook for 2022 is not so bright: inflation, which started accelerating in the second half of last year, has reached levels unseen in more than four decades. The Federal Reserve has increased interest rates three times in 2022 (as much as 75 basis points in the last hike), with more certain to come later in the year. This situation will make more expensive the cost of capital and bring to the fore the importance of adequate working capital management as a source of ready cash, rather than a less attractive indebtedness. Businesses need to build on their good performance in the past, in order to maintain (or even improve) their working capital levels.
The article explores the situation by sector, with a number of deep dives in a selection of them. Next, the concluding section sheds light on the impact of interest rates hikes in generating cash to pay back debt commitments and highlights key actions that businesses can take now to prepare for new challenges ahead.
The aforementioned circumstances do not necessarily have the same impact across all sectors, and they are not spread evenly within the same sector. For example, transportation is still experiencing a downturn on the passenger business while increasing exponentially on the cargo side and leading to severe price increases, which contributes to the overall inflationary pressures.
The charts below provide a detailed view by sector, presenting consecutively their working capital performance in 2021 (Figure 2) and how it changed between 2020 and 2021 (Figure 3).
2021 was expected to be a year of recovery for the Aerospace and Defense industry (A&D) after being badly hit by the Covid-led restrictions to travel in 2020, causing many airlines to postpone or outright cancel delivery of new aircraft. Overall revenue in the US A&D industry fell by 7%, but the speed of recovery in 2021 had been slowed down by successive Covid waves along with supply-chain issues, with revenue growth reaching just above 2%, well below pre-pandemic levels
When it comes to working capital, the A&D sector has traditionally one of the longest CCCs, linked to high inventories in the long aircraft assembly process and high receivables days due to complex approval process once invoices are issued. Although DSO could be lower due to customers making regular payments during the manufacturing process, there isn’t always an exact match between these progress invoices and the actual progress made and recorded as revenue. In this case, the cash received is accounted as advanced payments. This is not exclusive of this industry, but large enough to have a significant impact.
Having said this, 2021 was a year of overall improvement for working capital performance in A&D, with a 4-day decrease in inventories and a bigger one (8 days) in receivables, both linked to the increased activity during last year, which translated into stock reductions as materials got used and invoiced at a faster rate, and invoices paid on more regular deliveries. This positive change has been somewhat reduced by the actual decrease in DPO (3 days), related to the competition to secure supplies in a scenario of widespread shortages and lesser lenience towards extended payment terms (more tolerable in 2020).
The positive performance in 2021 is not certain to be sustained in 2022. Factors such as the inflationary pressure and the security threat caused by the war in Ukraine have a special impact on A&D, translating into reduced air travel and demand for new aircrafts. This can also lead to greater focus on revenue from aftermarket services, which can negatively impact working capital due to increased stockpile to sustain service levels and disputed client invoices concerning what is or is not included in the guaranteed service contracts. All this combined will only reinforce the need of efficient working capital management to ensure business maintain a healthy cash flows.
Overall, the sector experienced an impressive bounce back in 2021 (over 20% revenue growth compared to 2020), almost four times higher than the decrease the sector experienced during the pandemic. Demand from construction and engineering projects, as well as the automotive sector (to a lesser degree, given the supply chain issues with semiconductors), are largely behind this surge for metals, while the demand for batteries is behind the growth for other minerals.
ConfidentialCash conversion cycle for Metals and Minerals is in the higher quartile of all sectors, mostly on account of high inventory levels, which is to be expected on a manufacturing and/or extraction sector. Actions that improve or deteriorate DIO will be the most impacting of all working capital components. This was evident as CCC increased 10 days in 2020 and only improved by 4 days in 2021, following a corresponding 13-day DIO increase in 2020 and a measly 2-day improvement in 2021. This means that, if in a booming year inventories are not decisively reduced, they may become a bigger issue when business slows down, as it may be the case in 2022.
A DPO increase in 2020 was able to partially offset the strong DIO hike, as companies obtained certain leniency from suppliers towards delayed payments, a recipe used across most sectors at the time. Considering the small improvement in inventory performance, it has been positive for the sector that most companies have managed to keep these extended terms in 2021, or even extend them a little further. This has been particularly helpful if we look at the other side of the coin, that is, receivables, where DSO did deteriorate by 3 days in 2020 and has remained at the same level in 2021. Overall DSO level is not very high, but the lack of improvement on this side, keeps the focus on the actions required to reduce inventory levels
Unfortunately, the outlook for the sector in 2022 does not seem very positive. Inflationary pressures may end up delaying or reducing the size of large construction and engineering projects. Actually, they are already impacting on energy-intensive companies (e.g. aluminum), where soaring costs are already translating into more expensive products and may lead to reduced demand. On top of that, the war in Ukraine may also further destabilize this sector. As a consequence of all the factors above, decreasing demand may lead to increased inventories and an overall cash flow generation deterioration. This at a time when interest rates have decisively increased, and may do it again in the coming months, represents a strong risk to the Metals industry.
Revenue in the Construction & Engineering sector was one of the least impacted by the pandemic and showed a swift recovery. Conversely, in 2021 we detected a worsening of the cash conversion cycle by 3 days, up to 147 days, in an industry known for its high CCC.
While DPO has improved by 1 day to 35 days, underlining that payment terms have improved and tensions on the raw/construction material market (iron, lumber, aluminum, and chemicals) have halted and eased temporarily from all-time highs. DSO has improved by 2 days to 48, driven by the strong revenue of caused by both residential and commercial construction. While we see an improvement in these two elements, there has been a marked deterioration of the DIO of 5 days to 133 – prolonging a trend in place since 2016. This DIO hike is largely due to higher stocks being held by companies as a response to the rising commodity prices and longer lead times caused by supply chain shortages; up to now, this was supported by debt financing, but this will no longer be an obvious option.
With a growth of 20% among the observed companies, the outlook shows some headwinds in the short to medium term due to supply chain disruptions, volatility on commodity markets and rising labor shortages and related costs. Moreover, a recent decrease in lumber prices seems to indicate a general slowdown of the industry, which may herald some further deterioration of the working capital position, right at a time when more expensive financing would advise the opposite.
Consumer goods experienced a 1-day cash conversion cycle increase from 2020 to 2021, which put a halt to an improvement trend for the previous four years, especially in 2020, when it achieved a 4-day reduction. This deterioration is due to a serious increase of inventory levels, as we will see.
Revenue experienced a strong increase in 2021 (17%), following a minor blip in 2020, indicating renewed demand from consumers but also the start of inflationary pressures being passed through to consumers, as shortages in the supply chain prevented growth in line with that increased demand. This strong demand allowed to keep pressure on customers and brought DSO down by almost 1 day, continuing a trend of DSO reduction in recent years (only paused in 2018), including during the pandemic and even in the face of a contraction of demand.
DPO in 2021 improved as well, by 3 days, building on the impressive 7-day hike in 2020 and sustaining an uninterrupted 5-year trend. This indicates companies have been able to relay onto their suppliers part of the pressure derived from their increased inventories.
Indeed, this working capital component is the blot in the landscape of operating cash flow management as it keeps deteriorating, while the other elements improve, and this is due to a number of reasons. While the decrease in revenue during 2020 led to inventory increases following the reduced demand, in 2021 this sector is suffering as well from tensions in the global supply chain: companies are piling up stocks to meet the bounce back in demand, in a scenario of widespread shortages. The result is a 5-day DIO increase in 2021, which builds upon another 5-day increase the previous year.
This continuous deterioration may become a serious issue for the future. Consumer confidence is rapidly deteriorating, as inflation keeps its upward trend and GDP starts to go down: stagflation cannot be ruled out and the consumer sector is likely to be highly impacted. Companies will have to look carefully into their balance sheet to ensure a reasonable cash flow to navigate this potentially stormy circumstances
As the pandemic continues its impact on peoples’ daily life, the increased needs for healthcare services and medications have led to overall improved cash conversion cycles for both Healthcare and Pharmaceutical sectors
Known for its long cash conversion cycle, the CCC of pharmaceutical industry has improved by 14 days (14%) compared to 2020, which is led by a significant improvement in DIO by 21 days (16%), even if offset by a decreased DPO of 10 days (10%). The revenue for analyzed companies in the sector has increased by 27% in 2021, boosted by the roll-out of COVID-19 vaccines. Just like other sectors, pharmaceutical companies faced a much higher COGS (cost of goods sold), partly due to higher raw materials prices, but also to the increased activity levels. In the meantime, their total accounts payable increased by a lesser extent, which caused the decreased DPO, possibly linked to pressures on the supply side, which have resulted on shorter payment terms and lower tolerance to delayed payments. In terms of inventories, while the industry suffered from raw material shortages and cost increases, their overall inventory levels only increased by 8%. This is likely due to the advanced mass production capability, inventory management system and distribution channel that were built and tested even before the vaccine roll-out. Its DSO remains relatively flat, which indicates the current receivables process has been maintained with the increased customer base.
On the other hand, the healthcare industry has remained in the slowly improving trend of the previous 4 years, which has put its cash conversion cycle at -7 days. Benefiting from low DSO days, typical of “service sectors”, and moderate inventory levels, these companies have managed to extend progressively their terms suppliers, which have allowed them to finance completely their working capital assets. As the pandemic drags on in time, with renewed waves beyond 2020, there will be a limit to future increases on this front. Therefore, managing inventories becomes central to keeping working capital under control: it will be a fine line to tread between ensuring supply (critical with ongoing shortages in numerous fronts) and not letting it increase disproportionately. This was done well during 2021, when DIO increased by less than 1 day, and should remain a priority going forward, as revenue is still projected to grow in 2022.
Industrial manufacturing showed a 3-day CCC improvement, down to 79 days, which is a remarkable result in the face of the difficulties faced by the sector’s supply chains, and breaks a 4-year deteriorating trend
This CCC reduction results from a combined improvement of both DPO and DSO. DPO increased 4 days in 2021, building on a 4-day improvement in 2020. Similarly, DSO improved by 3 days, to 59 days, more than reversing the deterioration experienced in 2020, when customers terms extended by 2 days, driven by a strong revenue growth, which allows businesses to impose more restrictive conditions to their customers.
Inventories, on the other hand, is the working capital component dragging down CCC performance, as it has been for the past 5 years. Indeed, we see a continuous trend of increased inventories, leading to a DIO of 82 days (+4%), exacerbated by supply chain shortages caused by disturbed logistics for parts (especially those coming from China), and this after a full 5-day increase in 2020, when demand in this sector shrank by more than 7%
Industrial manufacturing in the US is set for further growth but will require more efforts towards building reliable supply chains to weather potential headwinds from China’s zero-covid policy, long backlog in ports and potential increased trade tensions with the US. This is of paramount importance as this industry has not managed to improve inventory management even in the years of bonanza. With the increased costs of financing companies are already facing, there are limits to what they will be able to pass along to suppliers and customers.
Retail is a sector with sustained revenue growth in the past 5 years, but while this averaged 7%-8% in the period 2017-2020, in 2021 it grew at almost double that rate (15%), showing the resilience of this sector and the spendthrift mood from consumers coming out of lockdowns and pandemic-related restrictions in 2020.
Concerning working capital performance, however, this strong growth in 2021 has not transformed into an improvement in cash conversion cycle, but rather the contrary: interrupting a 4-year improvement trend which had brought CCC down from 23 to just 6 days in 2020, last year we could see a 3-day CCC deterioration, which happened across all working capital components, the only one of the sectors analyzed with such behavior.
ConfidentialBy the nature of this business, inventories are the main working capital element, so it has to be properly financed, traditionally with a mix of stock management, supplier long terms and customer short ones. And the trend in recent years has largely gone in the right direction, with progressive small decreases in DIO, coupled with small increases in DPO, and a DSO hovering around 12-14 days. Until 2020, when following the Covid-induced disruptions to business, DPO experienced a 9-day increase, a general phenomenon across most sectors, as suppliers displayed widespread lenience towards cash-strained businesses. However, this was not the case for most companies in Retail, nor was it a sustainable move in the long term.
Therefore, in 2021, despite the strong expansion of the sector, all working capital indicators have deteriorated, namely DPO, which has decreased by almost 3 days and may have more room to go down, if the gains achieved during the pandemic cannot be consolidated. Along with this deterioration, DIO and DSO contributed to a growing CCC with marginal increases, of less than 1 day in both cases. This may be a natural correction from the previous year decrease, but it comes at a time of escalating interest rates and dwindling consumer confidence, which may spell trouble in the near future.
Although in 2022 consumers have continued to spend, inflation is moderating volume growth, and, in some categories, it is even masking a reduction. This coupled with lower brand fidelity as consumers look for better deals, may quickly turn into excess inventories for many businesses, which were stocking up to face widespread supply issues but based on earlier rosier forecasts. If this ends up being compounded with suppliers less tolerant about longer terms and customers short of cash and paying late, the forecast trend will be one of continued CCC deterioration, at a time when financing it will become dearer.
Since 2019, there has been a considerable increase in the combined short- and long-term debt of the analysed companies (+31%). Meanwhile, revenues increased by 15% (after a decrease in 2020) compared to 2019, as shown in Figure 4
Source: Efficio analysis based on financial reports from 1,695 US companies with revenues over $500m.
These loans were key to fund increased operational costs and working capital requirements and were enabled by very low interest rates and quantitative easing programs put in place by the Federal Reserve. Figure 5 below shows how the total % of interest costs over total debt has decreased by 18% during this same period.
Source: Efficio analysis based on financial reports from 1,695 US companies with revenues over $500m.
However, the inflationary pressure in the market has forced the Federal Reserve to increase interest rates in 2022 from 0.25% to 2.5%, and they are expected to go up again. Subsequently, the interest costs incurred by companies are going up and putting pressure on margins and liquidity. In this context, we recommend that business managers start acting now on measures to generate cash to pay back the debt or at least cover the increased interest costs.
Above all, strong cross-functional coordination and improvements in internal processes are key to ensure that working capital can be sustained in the longer term
The economic growth that occurred in the US during 2021 is not expected to continue in 2022 and 2023.
Growth forecasts have been revised downwards: increased material prices, labour shortages, supply chain disruptions, higher interest rates, and geopolitical tensions are among the key challenges that business sectors will face in the foreseeable future. More agile supply chains will be required to face these challenges without suffering from bloated inventories as a buffer between uncertainty and strong customer demand, which risk becoming obsolete and increase the burden of debt.
Companies should not wait to focus on addressing their weaknesses in working capital management and should attempt to face these uncertain times with a healthy balance sheet and a strong cash generation capability.
If you would like to discuss any of the themes in this paper, or need support in driving your business’s working capital performance, please visit our Managing Working Capital service page or contact one of our experts.Managing working capital
Ernesto Muñiz-Grijalvo, Manager
Johannes Bartl, Senior Consultant