Extreme cost increases lead to more than just margin pressure

04/10/22

Grip on liquidity is essential

‘Due to a sharp increase in production and other costs, we are seeing more volatility in average working capital trends in 2022,’ says Danny Siemes, working capital expert at PwC. ‘We expect several developments to weaken the liquidity position of businesses. However, current economic developments are demanding additional caution with liquidity in order to be prepared for a possible recession and further setbacks. Rising working capital levels are also leading to debates during business acquisition processes.’ This article examines the different facets of these trends and possible problem-solving approaches for businesses.

Extreme cost increases for businesses

Almost all business have been facing sharp increases in production and other costs since mid-2020. Mainly as a result of the COVID-19 pandemic and the conflict in Ukraine, prices for commodities, energy and transport have risen massively and uncertainty remains about what is to come. The scarcity of available products often drives up prices even further. In addition, labour market shortages and inflation compensation lead to wage increases, further raising production costs.

Impact on business operations goes beyond margin pressure

Businesses are focusing on the impact of cost increases on revenues, but passing on cost increases to customers fully and in a timely manner is not always possible. This exerts pressure on margins, either temporarily or permanently. Moreover, margin pressure is not the only concern for many businesses.

Siemes: ‘We expect many businesses to have to finance a structurally higher working capital requirement in the period ahead. Stock levels will rise in many cases as price levels for procurement and processing are far higher. Moreover, as a result of uncertainty, scarcity and supply chain times, greater safety stocks are often stockpiled, if possible. Accounts receivable are also fluctuating in line with price increases, in so far as businesses can implement them. Depending on payment terms, businesses may have to pre-finance more. On the other hand, supplier bills will also rise, which can absorb some of the higher accounts receivable and stock levels.’

The lower margin and increased working capital requirement translate into lower operating cash flows, at a time when interest rates on external financing are rising and approximately 280,000 Dutch businesses have to start repaying EUR 20 billion in deferred taxes. Many businesses are also facing additional financing costs due to rising interest rates and any additional financing they have used to survive the COVID-19 period. Pressure on the financial position of businesses is increasing from various quarters, warns Koos Beke, restructuring expert at PwC. ‘To what extent do they have sufficient buffers to absorb these pressures in the short or longer term? Is there still scope for investments? And can they maintain their earning capacity in the future?’

Cost cutting, pricing initiatives and balance sheet measures

Businesses would be advised to gain and maintain control of the situation. That starts with updating the business plan to better understand the expected impact on revenues, working capital and cash flows, and to what extent the business can still meet its debts. It is also important to develop and implement models and scenario analyses to calculate, analyse and predict the impact of price increases on liquidity.

‘Besides cost-cutting and pricing initiatives, businesses need to take balance sheet measures,’ Siemes argues. ‘Examples include stabilising and improving the working capital. One way to do this is by optimising the stock position and supply chain and strengthening the accounts receivable management. Exploring opportunities to extend creditor payment terms and shorten debtor payment terms – possibly with the help of credit insurers and/or financiers – can also contribute. As well as adjusting standard contracts to cushion and/or accommodate future price increases.’

Raising additional capital (debt or equity) can enable businesses to get through the difficult period and introduce more long-term measures. ‘Should the situation become more urgent, a restructuring of the debt, to a level appropriate to the new earning capacity of the business, may possibly offer a solution,’ Beke says.

Balance sheet measures prevent value erosion in the case of business sale

Current economic developments mean that parties are experiencing greater uncertainty. Together with the increased interest rate levels, this generally leads to pressure on prices paid for businesses. Berco van Echtelt, transaction expert at PwC: ‘A structural and proactive approach to cost increases to minimise the negative impact on earnings and working capital (substantiated by data, track record) gives potential buyers and financiers confidence in the business, its business model and management – therefore increasing the likelihood of a transaction and a better price.’

‘Specifically regarding working capital, we now see more debate between transaction parties about the working capital level appropriate for the business in question,’ Van Echtelt continues. ‘Parties often use an historical average, for example based on the figures of the most recent 12 months. We increasingly see buyers proposing alternative scenarios to increase that average, because the full effect of, for example, higher stocks or price increases has not yet been factored into the historical average. This is a valid argument if working capital is in fact rising and we can expect further increases. However, this does result in a lower net acquisition price when the business is sold. Having a good plan for mitigating the effects on working capital with substantiated structural improvements in place ensures that this argument has no solid foundation and that the seller obtains the best possible result.’