James Fraser, global head of structured solutions at J.P. Morgan, outlines how corporate working capital strategies are evolving amid an ever-more challenging global economic and financial landscape.
The business disruptions caused by the large-scale shut down of the economy as a result of the pandemic forced many treasurers in 2020 to shore up their liquidity, with cash preservation being the key focus. Since then, there have been violent swings in working capital with an initial economic rebound tempered by renewed upheaval due to the reversal of quantitative easing, volatile commodity prices, increased production costs, continued logistical hindrances and supply chain bottlenecks. To chart a path through this turbulent environment, proactive working capital strategies are required – but what those look like are changing.
The macro view
Working capital pressure has been building for some time. The populist shift of the last decade away from multilateralism catalysed nearshoring and ‘friend-shoring’ activity, while the US-China trade war forced US companies to invest in new suppliers to alleviate over-reliance on Asian exporters, particularly as the cost advantage reduced. Heading into early 2020, the rolling economic shutdowns that began in Asia initially exposed concentration issues for just about every major manufacturing industry, given reliance on China for critical materials and components. Against a backdrop of just-in time delivery models, employed to maximise operating margins, the sudden shock of a closed China led to supply shortages and an urgency to build excess inventory. This risk was quickly overwhelmed due to a sharp decline in demand and consequently sales activity. However, with record levels of monetary and fiscal stimulus corporates were able to bolster liquidity to absorb the highest levels of working capital in 10 years.
Now, there are yet more threats for businesses. As countries in the developed world began to reopen their economies, the combination of elevated consumer saving levels (US households accumulated US$2.5tn in excess savings in the two years from 2020) plus accommodative monetary and fiscal policies unleased a level of demand supply chains were ill-prepared to handle. From raw materials to semiconductors, corporates were challenged with meeting end-market demand as they struggled to source key inputs on a timely basis. As such, companies were forced to react to supply constraints by building excess inventory which has triggered major corporations (and governments) to review inventory management in order to boost supply chain resilience.
The resulting supply/demand imbalance has created inflationary pressure, which most notably has worsened in the commodity markets as a result of the war in Ukraine, altering global patterns of trade, production, and consumption. Structural mismatches between productive capacity and running demand in energy and other commodities are going to make near-term inflation very sticky, with impacts downstream beginning to build rapidly (developed economy producer price indices have been growing at double digits for H1 2022). This in combination with the supply shocks still emanating from China is exacerbating demand and underlying inflationary pressure on prices. Equally, as real incomes start to come under pressure, consumer demand will start to fall, dragging sales figures downwards.
A short-lived recovery in 2021…
In contrast to the travails of 2020, last year saw the cash conversion cycle performance improve across a majority of industries. Supported by fiscal and monetary stimulus, an uplift in economic activity drove higher-than-expected demand which meant corporates generated more sales, holding onto inventory for less time and reducing days inventory outstanding (DIO). Inventory reductions were also driven by supply-side disruptions such as raw material shortages and logistic bottlenecks.
Notable performances revealed by J.P. Morgan’s research include the pharmaceutical sector, which benefited significantly from the pandemic due to elevated demand for Covid-related drugs and vaccines. High demand – leading to an increase in sales of 27% in 2021 – accompanied by limited supplies sharply reduced the average number of DIO and collection time during the year.
The retail sector also did well, as robust consumer demand and a boost in online commerce pushed days sales outstanding (DSO) below pre-pandemic levels. Both the auto and auto parts, and oil and gas industries experienced strong sales momentum, with DIO declining by eight and 14 days respectively.
… while 2022 brings additional challenges
However, 2021 presented a series of challenging circumstances for working capital management that continue to reverberate into 2022. Inflation is running at 40-year highs, while liquidity is beginning to recede given tighter fiscal and monetary conditions.
To tackle persistent inflation, the US Federal Reserve is looking at a dual shock with a reduction in its balance sheet and yet another 75-basis point increase. As tighter monetary policy is reducing governments’ capacity to inject liquidity into the market and a constrained financial environment is challenging corporates’ ability to tap the debt and capital markets, efficient liquidity and working capital management strategies that can free up cash are fast becoming the key focus areas for treasurers.
Even large energy and tech sector firms, long accustomed to building excess liquidity with limited stress, are now turning to working capital discipline as a means to recognise revenue and increase cash balances. This is creating an appeal for liquidity sources derived through the sale of assets such as receivables.
The surge in payables finance brought about by the environment of supply chain co-operation and support during the pandemic is now beginning to taper off, as the balance of power between buyers and suppliers shifts. Rather than stretching payables to harvest working capital, supply chain finance can be used to provide additional liquidity in the market to suppliers, enhancing supplier relationships and creating a sustainable supply chain.
Now, with buyers facing challenges in sourcing critical goods and inputs to ensure they can meet end demand, inventory finance has become the latest working capital lever to pull in order to mitigate balance sheet impact.
Opening the working capital toolbox
The latest J.P. Morgan Working Capital Index, which enables companies to benchmark their working capital performance against industry peers, finds that there is as much as US$523bn of liquidity trapped across the supply chains of the S&P 1500 companies as of year-end 2021, up from US$507bn in the previous year.
The focus of working capital has shifted once again as the repair and rebuild of inventory levels must now be balanced against slowing economic activity and slowing demand. Evidently, it’s vital to leverage every tool available to convert sales into cash as swiftly as possible, and by developing a sustainable action plan, corporates can ensure they can survive – and thrive – in the face of future shocks.
 J.P. Morgan Working Capital Index 2020
 Brookings: Bolstered balance sheets: Assessing household finances since 2019
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