European cash conversion cycle

Shawn Townsend and István Bodó at The Hackett Group argue that the deterioration in the European cash conversion cycle by 4% signals more challenges ahead 

 

The volatile economic landscape continues to present challenges and underscore the importance of sound working capital management. The Hackett Group’s 2024 Working Capital Survey revealed some concerning trends in the financial performance of Europe’s largest non-financial companies – headlined by a 4% increase in the cash conversion cycle (CCC), which now stands at 44 days.

 

The 1,000 public companies studied produced small improvements in days sales outstanding (DSO) and days payables outstanding (DPO) during the 2023 fiscal year, reflecting their diligence in managing receivables and payables. But the significant increase in days inventory outstanding (DIO), now at 66 days, drove overall CCC deterioration.

 

Industries reliant on fossil fuels have faced particularly formidable challenges, prompting a strategic shift towards pre-emptive inventory buildup to secure energy supplies against a backdrop of geopolitical uncertainties. This move, while intended to mitigate cost increases, contributed to the troubling rise in DIO.

 

Aggregate revenue also dropped 5% across all industries studied, as increasing consumer prices for many products and services took their toll on demand. On the other hand, EBITDA margin increased slightly to 17%, demonstrating companies’ efforts to maintain profitability despite declining sales.

 

The survey also revealed a significant motivation to be proactive in strengthening all facets of working capital management. The 1,000 companies studied have a startling €1.3 trillion tied up in excess working capital – equal to 14% of aggregate revenue. These are funds that can be deployed more effectively to enhance financial resilience and the ability to navigate through continued uncertainty.

 

The sharp divide between leaders and laggards

Railways and trucking stood out among the best-performing sectors, driven by sustained DSO improvements. Internet and catalogue retail companies also saw impressive gains, with 16% improvements in both DSO and DIO, despite broader declines in inventory performance. Additionally, the hospitality sector—including hotels and restaurants—continued to benefit from the post-pandemic economic recovery, exhibiting double-digit revenue growth and ongoing DSO improvements.

 

In stark contrast, the beverages industry saw a steep 414% deterioration in CCC due to a significant drop in DPO. This situation has been heightened by political turmoil that led to supply chain issues. Marine shipping (69% CCC increase) experienced a downturn, with a 35% revenue decline and deteriorating DSO stemming from reduced shipping volumes and freight rates – potentially signalling continued weakness in European trade and exports. Meanwhile, the airline sector (18% CCC increase), once a strong performer, now contends with increased liabilities from unused flight documents and volatile fuel prices.

 

Disparity isn’t just an industry phenomenon. Our comparison of companies in the top quartile of working capital performance to those at the median found that top performers are converting cash more than five times faster than median peers.

 

These contrasts underscore both the challenges and opportunities within the current economic landscape. Recent economic forecasts published by the European Commission estimate a moderate return to growth in 2024 following economic stagnation, but the challenges plaguing many companies – including geopolitical tensions and tight monetary policy to control inflation, making credit less available and affordable – aren’t going away.

 

Where should you focus?

More than one-third (35%) of the €1.3 trillion in excess working capital is in payables, historically the “low-hanging fruit” for optimisation. However, declining performance since 2021 signals a need for renewed focus in this area. Receivables represent another 34% of the total. This, combined with the sharp 5% revenue decline in 2023, increases the urgency around optimising the receivables processes to prevent bad debts and maintain healthy cash flow.

 

Optimising working capital in a complex business environment calls for discipline in employing proven principles and best practices. It also requires continuous effort to strengthen collaboration, both internally among business partners and externally with suppliers. These are some areas of focus from which many companies can benefit:

 

1. Accounts payable

Maintaining a stable supply of critical raw materials and parts remains a significant challenge for many industries. It is vital to prioritise supply assurance to meet the fluctuating demands of customers. Continuing to balance just-in-time strategies with just-in-case approaches builds the flexibility needed to respond to unexpected shifts in demand.

 

Exploring near-shore sourcing options can help mitigate risks associated with supply chain disruptions. Furthermore, establishing strategic partnerships and diversifying sourcing channels can help ensure a steady flow of materials while improving working capital management.

 

2. Accounts receivable

Payment behaviours will evolve, so it is important to proactively review credit and collections processes to minimise bad debt exposure. Understanding changing payment behaviours enables your organisation to adjust pricing, payment terms, and contractual milestones effectively.

 

To manage receivables effectively, it is essential to integrate these practices within broader commercial and contracting processes. By fostering a culture that prioritises timely collections and clear communication with customers, you can enhance cash flow and reduce the risk of late payments.

 

3. Inventory management

Inventory challenges are likely to persist. A thorough review of your end-to-end supply processes can identify improvements that enable quick recognition of and response to changing demand signals. This agility is key to maintaining optimal inventory levels and avoiding excess stock or stockouts.

 

Additionally, revisiting product and portfolio rationalisation programmes regularly helps you remain focused on high-demand products, while implementing a disciplined product life cycle management strategy ensures that inventory remains aligned with market needs.

 

The common denominator is Gen AI

Using proven practices proactively is essential for optimising working capital and positioning your organisation for success in a changing marketplace.

 

But there is one way to boost the effectiveness of actions across all three elements of working capital: Gen AI. More and more, we see companies exploring Gen AI use cases to optimise revenue and payment cycles, anticipating customer demand and inventory requirements better, finetuning just-in-time sourcing strategies, and forecasting cash flow with greater accuracy.

 

How could your organisation leverage Gen AI to release excess working capital? The sooner you assess readiness to adopt Gen AI and identify deployment opportunities, the sooner you can begin to see the potential.

 

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Shawn Townsend and István Bodó are Directors at The Hackett Group

 

Main image courtesy of iStockPhoto.com and MicroStockHub