Pharma and Working Capital: Where Does the Industry Stand?By
The pharmaceutical industry as a whole historically has had weaker working-capital performance comparative to other industries, but it is a key strategic goal overall for pharma companies and for sourcing and procurement organizations to improve working capital. Since 2016, 11 of 17 industries analyzed in a recent PwC analysis have improved their working-capital performance. Is the pharmaceutical industry one of them?
Working capital: the fundamentals
In a simplified definition, working capital is defined as the value of inventory plus receivables minus payables. It reflects the amount of cash a company has tied up from when it purchases components to produce its products to when it receives payment from customers. Companies want to reduce their working capital as a means of liberating resources to fund other strategic objectives, such as mergers and acquisitions, organic-growth initiatives, and improving shareholder returns. Sourcing and procurement organizations can contribute to improving their companies’ accounts payable position through various approaches, such as better management of suppliers, extending payment terms with suppliers, optimizing sourcing and outsourcing activities, and adopting supply-chain strategies to reduce costs and mitigate risk.
Global working-capital performance
A recent analysis by PwC, Navigating Uncertainty: 2018 Annual Global Working Capital Study, of the largest global companies (14,694 companies analyzed) found that EUR 1.3 trillion ($1.47 trillion) could be released from the balance sheets of globally listed companies if they take steps to address working-capital efficiency. The report estimates that this cash release would be enough for global companies to boost their capital investment by 55% without needing to access additional funding or putting their cash flows under pressure.
Despite working-capital performance improving for the first time since 2014, global companies are facing an increasingly difficult cash environment, according to the PwC study. The report highlights three challenges to financial performance. First, while company revenues are up by 10% on last year, the cash-conversion ratio has declined by 6%, indicating that converting cash is becoming harder. Second, an annual rate of 3.6% in declining capital expenditure is suggesting that companies are committing less cash to investments, which poses a potential threat to their growth in the long term. Thirdly, the tightening of monetary policy and uncertainty around global trade is increasing the cost of cash to companies.
Net working-capital days. The PwC study shows that overall working-capital performance has improved for the first time since 2014, with net working capital (NWC) days falling back slightly from their highest (worst) level in 2016. The modest improvement in NWC days was driven from the asset side of companies’ balance sheets – namely receivables and inventory. The PwC report shows companies’ NWC performance reveal a small improvement this year of 0.4 NWC days. Companies have achieved this by improving on days sales outstanding (DSO) and days inventory on-hand (DIO) performance, both of which saw modest improvements of 0.1 and 0.7 days, respectively, the first improvement in five years. The report notes that the drop in DPO levels by 0.7 days in 2017, possibly signals a recognition among companies that “an existing hard-line approach to suppliers was unsustainable,” following 2016 that showed a high-water mark in terms of supplier pressure. The overall numbers also reflect strong top-line growth in the oil & gas sector. When the working-capital performance of the oil & gas sector is excluded, the outcome actually deteriorated by 0.1 days. In addition, the absolute values of net operating working capital increased by 10.3% in 2017 from the previous year, which represents EUR 300 billion ($339 billion) of additional cash consumed by working capital.
Also, as PwC reported in 2017, days payables outstanding (DPO) is still at a high level, representing a potential risk to supply chains at a time of uncertain trade conditions.
Cash conversion and investment. While modest improvements in working capital have begun to be seen, the levels of cash and investment relative to revenue have declined more dramatically, according to the PwC report, which points to a steady decline in capital expenditures (capex) spend relative to revenue at a compound annual rate of 3.6%. By this measure, the report notes that companies’ relative capital expenditure is now at the lowest level. This year has also seen a drop off of 6.5% from the previous year in operating cash flows relative to revenue. The report points out that although working-capital performance has improved very slightly during the year, companies have not translated this into increased operating cash flows as a proportion of revenue. “Coupled with the broadly flat working capital performance, the ongoing uncertainty in the global trading environment is likely to have contributed to the decline in Capex,” says the report.
Economic outlook and working capital. The PwC report points out that the economic outlook suggests that the impact of holding excess working capital could be amplified by increased interest rates in the future. For the 2018-19 period, PwC projects that the US economy will grow at an average rate of about 2.5% per annum, partly fueled by corporate and household tax cuts as well as strong growth in business and household spending. In the Eurozone, it expects growth at an average rate of about 1.5% per annum assuming trade relations between the US and the European Union do not deteriorate. Interest rates will be a key factor in influencing overall economic growth and working-capital performance. The interest rate outlook heavily influences businesses’ cost of capital, which in turn amplifies the impact of excess working capital. Key influencing factors are the potential tightening of monetary policy in the US and the uncertainty of the impact of the UK’s withdrawal from the European Union (i.e., Brexit).
In analyzing the working-capital performance of 17 industries, the PwC report shows that 11 out of 17 sectors have improved their working capital performance since 2016 and achieved an improvement in 2017. Of the companies that showed an improvement over this period, those in the energy & utilities sector saw the biggest reduction in net working-capital days (NWCD), which was was coupled with a strong increase in revenues over the same period. The healthcare sector also experienced a decline in NWCD due to strong revenue growth of approximately 6.0% that the sector delivered in 2017. In contrast, as revenues have risen in the entertainment & media, hospitality & leisure, and technology sectors, working-capital performance has declined.
So which industries have shown improvement in working-capital performance? Eleven sectors showed a reduction in working-capital days in the period of 2013 to 2017. Ranking from best performance were: energy & utilities; industrial manufacturing; retail; transportation and logistics, forest, paper and packaging; healthcare; chemicals; engineering & construction; metals & mining; aerospace and defense; and consumer.
So where does the pharmaceutical industry stand? The pharmaceutical and life sciences industry was one of six industries that showed a decline in working-capital performance with an increase in net working-capital days of 0.3 days. Other industries showing a decline in working-capital performance during this period were: automotive (+0.3 days); technology (+1.0 days); communication (+2.5 days); hospitality & leisure (+2.8 days); and entertainment & media (+3.8 days). To put these numbers in context, those industries with the strongest improvement in working-capital performance, energy & utilities and industrial manufacturing, showed a reduction in working capital days of 2.1 days.
In looking at how particular industries fared, three key metrics were evaluated: days sales outstanding (DSO), days inventory outstanding (DIO), and days payable outstanding (DPO). DSO is a metric to measure accounts receivables (i.e., the time it takes for a company to receive payment for its goods/services); the lower the DSO, the better it is for reducing working capital. DIO reflects the amount of inventory from raw materials to finished products; the lower the DIO, the better it is for reducing working capital. DPO is the amount of time companies take to pay suppliers; the higher the DPO, the more advantageous it is for companies in reducing their working capital. Sourcing and procurement organizations can effectuate an improvement in DPO by extending payment terms with suppliers and other strategies to increase DPO.
In benchmarking performance within the pharmaceutical and life-science industries, top performers had DSO of 109 days, the median was 78 days, and bottom-level performers had DSO of 54 days. For DIO, top performers had DIO of 193 days, the median was 134, and bottom-level performers had DIO of 84 days. For DPO, top performers had DPO of 111 days, the median was 71, and bottom-level performers had DPO of 46 days.
Working capital and company size
When it comes to working capital performance, company size is an important factor. The gap between the largest and smallest companies in the PwC study has widened from a difference in NWCD of 39.6 days in 2013 to 46.8 days in 2017. “The widely-held assumption is that large companies achieve this performance by using their spending-power and market muscle to squeeze their smaller suppliers,” explains the PwC report. “While this undoubtedly has some truth in it, the numbers actually show that small and medium-sized companies have much longer payables cycles than larger companies.”
The other main driver for the size gap, notes the PwC report is inventory performance, with a difference of 27.8 days between the DIO of large and small companies in 2017. However, this gap is narrowing steadily, having declined from 30.0 days in 2013 – a trend that suggests smaller companies are taking greater interest in managing their inventory.
Large companies also generate a higher level of return on capital employed (ROCE, at 9.3%) than small and medium-sized enterprises, whose ROCE stands at 7.8% and 7.0% respectively. This can be explained partly by larger companies’ slightly higher profitability and partly by their better working-capital performance, with large companies leading at 42 days, medium-sized businesses second at 67 days, and small enterprises last at 88 days.