The 2021 instalment of J.P. Morgan's Working Capital Index has found that there remains significant amount of liquidity tied up in supply chains across the S&P 1500 companies observed in the DSO, DIO and DPO metrics, as well as the cash levels within industries. Assuming every organisation improved its working capital and moved into the next performance quartile in their respective industries across the DSO, the DPO and the DIO metrics, the report states that an estimated US$507bn in working capital could have been released as of year- end 2020. This is up from US$497bn in 2019.

Overall, in 2020, the Working Capital Index rose to its highest level in 10 years. Widespread lockdowns impacted supply chains as a result of the pandemic crisis, combined with a stalling of demand for products and services across multiple industries as the global economy went into recession, left corporates with high levels of excess inventories. The situation was exacerbated as companies stocked up on inventories to mitigate further supply chain disruptions.

As business sentiment recovered towards the end of the year, sales in some industries improved and receivables levels subsequently rose, further contributing to the increase in working capital levels. With the global economy expected to recover this year, working capital levels in 2021 will likely trend lower as consumer confidence rebounds and demand for goods and services returns.

Cash index rose significantly on fortified liquidity buffers

The Cash Index segment of the report also rose in 2020 to levels not seen in seven years as corporates turned to fund-raising initiatives and cash preservation measures to shore up their liquidity buffers amid the pandemic. Cash preservation initiatives employed included putting a pause on share repurchases, cutting back capital expenditure and reducing external spending. 

The record low interest rate environment coupled with the massive stimulus from the US government further made it easier for companies to boost their cash holdings. With a recovery taking shape in 2021, the report authors expect corporates to start deploying the excess cash through capital investments, share buybacks, dividends payout, debt repayments or M&As, reducing their cash holdings.

The pandemic crisis also posed unique challenges in the ability to procure funding, resulting in a widening gap in cash levels between small and big companies. Small companies generally maintain higher cash levels than their larger counterparts, as bigger companies tend to have more efficient cash management practices and better access to external capital. During the pandemic, the propensity for lenders to provide capital to small companies relative to big companies reduced, prompting smaller companies to beef up their cash buffers. For this reason, 2020 saw an increase of 4.7% in cash levels for small companies vis-a-vis a 4.0% rise for their bigger counterparts.

Cash conversion cycle lengthened the most in nine years

The cash conversion cycle (CCC) of the S&P 1500 companies lengthened by 6.3 days in 2020, representing the biggest increase in nine years, largely due to a rise in inventory levels. Weakened demand and supply chain disruptions resulted in the inventory buildup, prompting the days inventory outstanding (DIO) to reach a new high where companies were carrying inventories for 6.1 more days on average.

The days payable outstanding (DPO) and days sales outstanding (DSO) also showed sharp increases last year as some companies extended payment terms with their suppliers, customers and leveraged solutions like supply chain finance to manage working capital challenges.

In terms of the CCC performance across sectors, 15 of the 19 industries saw deterioration, or longer CCCs, due to accumulated inventories. Among the industries, the CCC of the oil & gas upstream lengthened the most as inventory piled up as a result of reduced demand for oil. The CCC of the aerospace & defense sector also increased significantly amid cancellations of aircraft orders and a drop in demand for aviation parts.

On the other hand, the semiconductor industry experienced the biggest improvement in their CCC due to leaner inventories as a result of strong demand for data storage firms and personal computer manufacturers with the majority of the global workforce pivoting to remote work arrangements.

"COVID-19 has further exposed the vulnerabilities of global supply chains, which were already under pressure in recent years as a result of the geopolitical trade tensions," said Gourang Shah, global head of Treasury and Working Capital Optimisation for Wholesale Payments at J.P. Morgan and one of the authors of the report. "A key focus for finance practitioners will be to continue building supply chain resiliency in their operations, in order to withstand future shocks as well as to mitigate the negative impact on working capital."

Different treasury approaches as businesses recover

The pandemic has put unprecedented financial pressures on businesses, compelling CFOs and corporate treasurers to re-evaluate their cash and liquidity management to ensure business and operational continuity. Treasurers will continue to play an important role as businesses recover from the pandemic. 

The report highlights four different approaches treasurers can take to navigate the crisis this year, depending on the speed of recovery and the strength of their balance sheets:

Expansionary

Companies with strong balance sheets that are expecting a fast recovery would likely invest aggressively either through organic or inorganic means for growth in 2021. Cheap cost of funding and high cash levels can provide the necessary firepower for these companies to execute their plans. The key priority for treasury in these companies will be to ensure that necessary cash is available at the right place, at right time and in right currency to fund high value transactions.

Cautious aggression

Companies that are expecting quick recovery but have high leverage ratios may have challenges accessing external capital due to limitations to further stretch their balance sheet. Treasurers will need to balance funding growth while ensuring the company does not face liquidity challenges.

Waiting game

Companies with slow expected recovery but with strong balance sheets will likely wait a little longer to invest in the growth. Focus for treasurers in these companies will likely be to continue with cash preservation activities like reduction in capex, M&A activities and discretionary expenses to create reserves for funding growth when the opportunities arise.

On the defensive

Companies with slow expected recovery and weak balance sheets will be the most at risk of further impacts from the crisis. Conserving liquidity will be the key priority as treasurers look to ensure the company has enough cash until the crisis blows over.

While there are varied paths treasurers will have to take during recovery in 2021, the authors of the report expect working capital optimisation to continue to remain a key priority for treasurers. With approximately US$507bn currently trapped in working capital that can potentially be released, it can provide a cheap source of funding to either support the growth for companies experiencing strong recovery or provide the liquidity cushion for businesses waiting to ride out the crisis.