Efficient cash flow cycles help local employers withstand shocks

As the economic fallout of COVID-19 gathers steam, the study's lead author, Deakin Business School senior lecturer Dr Sagarika Mishra, said the findings can also help smaller non-listed local companies currently cash-strapped and struggling to stay afloat.

Noting a slew of high profile businesses in both regional and metropolitan centres have been closing down since 2019, Dr Mishra said it is imperative those weathering economic storms who need to pay staff wages before the government's JobKeeper payments begin in May, examine their day-to-day efficiencies.

The findings from 'Efficient working capital management, financial constraints and firm value: A text-based analysis' were recently published in the Pacific-Basin Finance Journal and could offer an important opportunity for Australia's struggling retail sector in particular. By the end of January, well-known brands with shopfronts in regional and city areas including Bardot, EB Games and Harris Scarfe announced the shuttering of scores of stores that provided local jobs, while Jeanswest entered voluntary administration.

"Our research shows sub-optimal management of cash flow and other working capital could be one of the important factors contributing to the retail slowdown and spate of store closures pre-COVID 19, which is arguably even more relevant now and could be for some time," Dr Mishra said.

"Effective management of a firm's day-to-day cash and liquid finances can help drive sales and keep staff in jobs even during financially constrained times, so it's critical that retail firms large and small, in regions or big cities, public or private, give due focus to this short-term liquidity."

"Our study showed that the shorter a company's cash conversion cycle, the lower the likelihood of future financial constraint for that firm. It's difficult to say why these firms weren't converting their stock to cash quicker, but we can see they don't get any benefit from storing their goods. Like some companies, it's possible their current processes and arrangements restrict them from solving this problem, they could simply be unaware of how much of a difference it can make, or they might not see it as a problem big enough to worry about."

Dr Mishra suggested Australian businesses focus on shortening their cash conversion cycle right now, because it can have an immediate positive benefit and in almost all cases it is totally in their control.

"This is not about outside opportunity, outside pressures or outside investment. If any business wants to manage their working capital better, they can do it. For most business, this means a far bigger focus on how much credit you're giving to people, how much inventory you hold and how quickly you can convert that to cash to meet your obligations, which may mean re-evaluating credit and working capital policies."

Dr Mishra said there was often a focus on long-term capital when assessing a company's strength and value, but her study showed working capital was a vastly under-utilised way companies could ensure their security.

"Our data also shows that investors reward effective management of working capital, by investing more. This is not just important for heading off future issues, but in turning the ship around for companies in difficulty," Dr Mishra said.

"Specifically, investors appear to recognise that effective working capital management helps firms overcome the effects of financial constraints, and these insights can help Australian businesses now as they navigate the weeks, months and years ahead when investment will be crucial. In further positive news, we found that financially-constrained firms with effective working capital management have higher one-year ahead share prices and analyst target prices, than firms with ineffective working capital management."

The study is the first in Australia to use an innovative method of identifying a company's likelihood of facing future financial constraints. The method looks beyond the numbers to evaluate the language used in company financial reports, identifying 184 words that show firms are under pressure.

"These are words like committed, bound, confined, depend, forbid, impose, limit, obligate, pledge, require, restrict and dictate," Dr Mishra said.

"The idea is that the language can give us a far better indication of a company facing financial constraints than quantitative measures, which are usually numbers, and the literature built up using this method in the United States confirms that is the case."

Dr Mishra said her study followed on from a PricewaterhouseCoopers (PwC) report in 2017, which calculated listed companies in Australia and New Zealand could unlock $90.6 billion by improving their working capital management practices. The report contended these companies would then have enough cash to more than double their capital investment without the need to access additional funding or put pressure on cash flows.

Dr Mishra said there were many smaller Australian enterprises who could similarly benefit.

"Our study shows that not only is there an enormous amount of value that can be released into Australian business for immediate continuity and investment, but those who better manage this short-term liquidity are also securing their longer term future," she said.

"This allows more immediate funds to be invested back into the business for things like new product development or talent recruitment; and simply keeping the business running by paying staff and suppliers during tougher times.

"Our data shows working capital management seems to be a big problem for local companies."