The Chemicals industry effectively passes rising prices to their customers. Their working capital levels have actually continued to fall ( a sign of improvement efficiency).
Between 2005 and 2007 the median days of working capital (DWC) in the European Chemical sector has fallen from 84.3% to 73.7% a 12.6% improvement. Looking at best performing companies in the sector the improvement is even greater. The top quartile companies have improved their performance over the same period by 22.7%, illustrating that the best keep getting better.
If companies improved their days of debtors (DSO), stocks (DIO) and creditors (DPO) to the same level as the top quartile, these companies could liberate €22billion of cash from working capital.
This released cash from working capital efficency can enable funding of capital expenditure as well as reduce debt, (shareholders). All of these uses would have a substantial positive impact on valuation.
Levers for releasing cash are: improving the stock days and debtor days.
1. Days of inventory outstanding i.e., the days of sales that the company is holding as inventory and
The improvements in inventory are most likely being driven by continual investment in the manufacturing process to improve yields, remove bottlenecks and accelerate production.
Furthermore shifting greater responsibility for raw material inventory onto suppliers in the form of consignment stock drives down the inventory on the balance sheet.
2. Days of sales outstanding i.e., the number of days of sales the company has tied up in debtors
3. Days payable outstanding i.e., the number of days of sales sitting in trade creditors
4. Nearly 50% more cash can be generated by negotiating longer payment terms with suppliers.
- Thus it is critical to focus on the total cost of ownership during negotiations with suppliers and weigh up the benefits of longer terms against potential discounts or shifting ownership of raw material inventory from your balance sheet.
- But over-pushing the suppliers to a position of dis-advantage (in paymnet and supply terms) would make the suppliers un-viable and thus squeeze the supply chain elements (in an event of higher buyer power).
- A way out is to improve your forecasting efficiency and tell the supplier accurately about the supply schedules. This will enable shortening the working capital cycles / improving efficiency.
- Inventory is the buffer between supply - demand thus accurate forecasting of demand and matching suppply to it will enable optimization of inventory.
- Reducing inventory is the second largest cash generator. A better supplier management will enable to reduce inventory.
- Reducing overdue debtors is an effective way of releasing locked up cash.
- Segmenting the customer base to develop strategies that yield the highest return with limited resource. In an ideal world every customer would be called prior to invoice due date to ensure they received the invoice and identify if any problems exist. In reality companies do not have the resource to accomplish this, requiring careful identification of how to manage different types of customers. This should also then be fed through into payment terms, payment methods and credit limits.
- While introducing a new product the intended impact of 'working capital' must be calculated.
- In the current economic environment those companies with financial strength should fair best. The continuous focus on product innovation and high commodity prices is likely to drive business complexity in the chemicals industry and squeeze margins.
