Working capital crisis: economic consequences and possible ways out

Working capital has long been the subject of heavy research in the field of finance, specifically its relationship with profitability and liquidity. An efficient working capital management mechanism is often equated as a sign of a 'well run' company, although the true meaning of 'efficiency' in this regard is a debatable subtopic -- with different managers, academicians and investors putting forward their own opinions on what constitutes ideal working capital management. In reality, however, like many other concepts, it is never straightforward and is always a product of numerous factors, many of which are not in control of the company itself.

What we probably already know - A brief background

In general, many industries and companies are heavily reliant on working capital to not only keep themselves afloat but use it as leverage to take risk, grow business volume and create further wealth which goes back into the business/industry. It has been likened to the bloodstream of a human body (maybe a little too dramatic), and barring any unorthodox circumstances, indeed a lot of businesses and industries would likely be forced to shut down or sell if working capital is unavailable. This is also a major reason why some investors avoid certain working capital-intensive industries and/or companies operating on a business model which is over-reliant on continual injections of working capital.   

Keeping aside the varied factors that affect working capital management strategies for a company, the minimum level of current assets that a business needs to continue operating gives way to a corresponding minimum level of working capital (let's call this minimum required working capital or MRWC). MRWC would usually be expected to grow in tandem with the growth of the business; it can also be implied that a growth in inventory and certain components of the working capital can signal that the company foresees higher than usual volume of business. Similarly, a level of reduction in these components could point to a general sentiment of pessimism in the economy itself. Broadly, there is reason to suppose that changes in the level of certain elements of the working capital are a leading indicator for their respective industries or even the economy as a whole, to some extent. Alongside MRWC, which is quite semi-permanent, extra working capital (let's call this EWC) can be viewed as much more fluctuating, and more elastic to the dynamic business environment. EWC comes to the rescue in events of abrupt changes in operating cycles, although it often sits as a soft cushion on the balance sheets otherwise. During elongated periods of smooth business and economic cycles, not only is there a fall in investment in EWC, but businesses also tend to sometimes deploy EWC elsewhere, in order to maximize venues of investment return. 

EWC unpreparedness

As well run as companies can be, a much broader look gives an idea of how much working capital really is key to the economy as a whole. An extreme economic scenario, such as dramatic supply chain disruptions in major industries, provides a distinct perspective on working capital management and pushes it into limelight, since a lot of smaller businesses in an economy make crucial fight-or-flight decisions with regards to their overall working capital needs in such severe situations. EWC becomes as crucial as it can ever be. For companies who find themselves without adequate EWC scurry to arrange for funds to be able to continue their operations and not lose customers. For any business, predictability is perhaps the most important for an effective working capital management; however, this predictability is gravely affected. Cash inflows and outflows become extremely hard to predict, and fixed costs start eating up major chunks of revenue.

Small and medium companies usually look for affordable versions of bridge financing during these periods of uncertainty and lack of EWC. Bridge financing, which usually covers the most urgent needs of the business, can be difficult to obtain for businesses since private lenders offering such financing rely on hefty collateral. Businesses with highly hypothecated balance sheets would find this to be a difficult option to pursue. In the long run, taking on a ton of short term financing or even bridge financing (which could gravitate into a need for a larger long term borrowing) could not only disturb the debt/equity structure of a business but also create much more serious solvency issues if the repayment layout is not carried out properly (a result of poorly planned borrowing).   

In a lot of cases the business can not arrange for sufficient bridge financing in time. This happens when management prefers not taking up debt, or is faced with harsh borrowing environment characterized by an uncomfortable degree of lack of control and thoroughly unfavorable credit terms. In such a situation, the managers could end up trying to increase sales by creating artificial working capital, offering discounts to customers and overstretching the existing working capital cycle. This involves them renegotiating and sacrificing major debt assets to settle with debtors by recognizing bad debt and foregoing interest on the rest. This could also involve renegotiation of existing creditor agreements where the business ends up agreeing for much higher interest rates in return for an extension of repayment cycle. These types of drastic changes to the working capital cycle could make it extremely difficult for smaller businesses to come out of liquidity traps and return to normalcy, even when the supply chains are operational.

Macroeconomic lookout

  

This is important to understand since such small and medium sized companies form a core of the national economy and there does exist a possibility that a remarkably large portion of such businesses are unprepared to an extent where the economic growth rate not only goes down dramatically, but other implications can be far worse. In a recent article on The Indian Express, the Chief Economist at JP Morgan Sajjid Chinoy wrote, "If economically-viable but illiquid small and medium enterprises go under, the implications both for unemployment and India's underlying production capacity could be severe." This is both contextual in the idea of how an economy can recover, and also on how a country itself can avoid much deeper sociocultural problems at the grassroots level from re-emerging.

Even on a much larger scale, the emerging markets and developing economies (EMDEs) face these problems on a much regular scale. In the latest report on the global economic outlook (which incorporates the study, analysis and forecasts for the global pandemic as well), the World Bank talked about how the pandemic takes an especially heavy humanitarian and economic toll on EMDEs, who exhibit a high degree of informality. This informality contributes to financing constraints and eventual collapse among SMEs, which rely on internal funds and moneylenders for working capital. More broadly, SMEs across EMDEs face significant financing constraints as higher information asymmetries caused by their lack of established track records and publicly available information discourages bank lending.

 

Source: World Bank

EAP = East Asia and Pacific, ECA = Europe and Central Asia, LAC = Latin America and the

Caribbean, MNA = Middle East and North Africa, SAR = South Asia, SSA = Sub-Saharan Africa.

Aggregates calculated using U.S. dollar GDP weights at 2010 prices and market exchange rates.

Regaining balance

Government support and policy reform is key in such situations. Policy reform could help eliminate major legal roadblocks in raising funds and repayment, and perhaps more importantly, resuscitate short term financing. Temporarily incentivizing all forms of lenders from banks to private institutions to new-age digital lenders can be a part of this. For instance, very recently, the Reserve Bank of India (RBI) proposed a comprehensive framework of sale of loan exposures to help create a dynamic secondary market for stressed assets for these lenders. The lenders can resort to strategic loan sales to re-balance their exposures. At first glance this might not look related to the large SME financing issue at hand, but it solves the supply side of the problem by clearing the lender balance sheets of stressed/bad debts and helping them redeploy the newly gained corpus (from such loan sales) to further finance the struggling businesses in the economy.     

Another thing that the government could consider is to make sure the lenders themselves do not go out of business due to excessive market imbalance. The huge sums invested by lenders in the public market automatically become risky in highly unstable market situations as such, and could lead to heavy losses ultimately translating into solvency issues. 

Similarly, apart from the small and medium enterprises in any industry, the larger, more sturdier companies help maintain the business flow by supporting the smaller B2B firms (suppliers) of many other industries, who rely almost exclusively on contracts and order flow from such industry giants to keep their businesses afloat. If such large companies take a major hit, they scale back their operations heavily and could terminate their contracts with smaller suppliers and render them out of business. Thus another approach the government could consider is to temporarily inject equity into certain larger, productive companies in key industries who fit the above description, and ensure they don't retreat from the market.  

Among the many more policy reforms that the government can further consider, a few more ideas that can solve key issues follow. (1) Reducing information asymmetry by creating credit information systems. (2) Reforms in collateral laws which can make hypothecation easier and enhance use of movable assets as collateral, thereby reducing risks to lenders. (3) Redirecting credit towards SMEs by enabling public credit guarantee schemes (temporarily, can be introduced with sunset clauses).        

Finally, along with or apart from government policy support, the businesses themselves can be better prepared for a crisis. Notwithstanding the fact that such situations are more often than not highly unexpected for every sect of the economy, a well-built working capital strategy can help businesses navigate the rough tides with much lesser damage. As talked about in the beginning, the MRWC acts as sort of an internal machine which churns cash for running the operations of the business smoothly. This machine can be maintained and supported well in order for it to grow along with the revenue, and vice-versa. An ideal balance of profitability and liquidity needs to be struck in the long run whilst avoiding over- or under-trading in order to avoid insolvency stress in extreme economic scenarios.

Sources:

1. The Indian Express: 'Public sector assets must be monetised to fund physical, social infrastructure' - Sajjid Z. Chinoy - May 19 2020

2. The World Bank : 'Global Economic Prospects' - June 2020.

3. Write Kraft on Medium.com: ' Working Capital Management: A Case Study of Air India Ltd'