Managing Working Capital in a Lowering Rate Environment

In a lowering rate environment, a drop in interest rates on loans or a decline in interest earned on funds in savings and money market accounts should jumpstart a conversation among business owners and their partners about their working capital strategies.

“When we talk with our clients, we discuss everything from deposits to receivables to payables to fraud, and we ask them what is impacting their business,” said Lisa Bollinger, head of City National Bank's Working Capital Advisory team. “Our team works with treasurers and chief financial officers to improve their working capital in any environment.”

Internal business changes and external market changes, including a lowering interest rate environment, can impact many categories of working capital, including cash, accounts receivable, inventory and accounts payable.

“That’s why it’s so important to establish a plan to pivot,” Bollinger said. “We don’t know how quickly things will change or whether a business will need to adjust its working capital strategies in a short period of time.”

 

How a Lowering Rate Environment Can Change Your Working Capital Strategy

Lower interest rates make borrowing money cheaper, which in turn encourages consumer and business spending as well as investments, and can boost stock prices.

“When the Federal Reserve changes interest rates, it has a ripple effect throughout the broader economy, affecting both stock and bond markets in different ways,” Bollinger said. “Changes in interest rates tend to impact the stock market quickly but may have a lagging effect in other areas.”

Just as businesses had to adapt their cash flow management as interest rates rose, they will need to adjust their working capital strategies as interest rates drop. City National's team, which has expertise across a variety of industries and businesses that range from $5 million in assets to more than $250 million, can help business owners develop effective working capital management strategies.

“If a company is a net borrower, their costs are going to be lower and they’ll have more cash to spend,” Bollinger said. “If they’re getting interest on their cash, which is likely to be diminished as rates fall, they’ll need to make adjustments and invest in other things or cut costs.”

 

Key Performance Indicators of Working Capital Management

A short cash conversion cycle indicates that a company is managing their working capital cycle in an efficient manner, and cash is being converted quickly from raw materials to sales receipts, Bollinger said.

“To make working capital improvements, finance and treasury teams must be firmly aligned with the people managing the various components of the cycle while also having a firm grasp of the performance metrics and KPI’s,” she said. “Without access to, and an understanding of, the metrics that govern your working capital cycle it will be impossible to initiate positive changes.”

Any improvement proposal or strategy must be backed up by facts.

“By gaining an understanding of the metrics that influence working capital within an organization, you will be in a better position to positively influence the overall process,” Bollinger said. “Start with the simplest metrics first and focus on the largest sections of your business or the areas that experience the most volatility.”

Some of those key metrics include:

• Days Sales Outstanding (DSO), a calculation about how long it takes your firm to collect payments from customers. Faster sales collections have a positive working capital impact.
• Days Payable Outstanding (DPO), a measurement of how long it takes your company to pay its suppliers. Longer payment durations have a positive impact on working capital.
• Days Inventory Outstanding (DIO), a metric that shows how quickly inventory is sold. Selling items faster has a positive impact on working capital, since cash is not tied up in unsold goods.
• Cash Conversion Cycle (CCC), which uses the above metrics to demonstrate how effectively a company manages its short-term assets and liabilities. This is a key indicator of management efficiency.

 

Working Cash Flows Strategies to Consider

Optimizing your working cash management must be done on an individualized basis and depends in part on how cash rich your business is, Bollinger said.

“All companies should review their risk management in the context of a lowering interest rate scenario,” she said. “This is a good time to implement new risk tolerance levels and make sure portfolios are properly diversified.”

If your borrowing costs are lower due to an interest rate adjustment, this may be the time to invest in your business, possibly in automation or in developing a new line of business.

“You may want to consider investing and implementing upgrades in existing technology that allows for greater connectivity and data aggregation functionalities,” Bollinger said. “Another option is accelerating digital transformation to enhance back office manual processes and improve digital customer experience.”

As interest rates change, businesses should also re-evaluate their investment policies and their liquidity management, she said.

The goal with all working capital strategies is to manage the balance between assets and liabilities in order to maximize capital efficiency.

“It’s important for treasurers and CFOs to reach out to their banking relationship management teams to adjust their liquidity planning and to understand how lower interest rates could impact their working capital management,” Bollinger said.

In addition, business owners, CFOs and treasurers should consider the following steps to adapt to a new economic environment.

Forecasting Cash Flows

Ensuring the company can meet its obligations remains the treasurer’s core role, Bollinger said, which is achieved by identifying, measuring and managing risk to protect company assets.

Developing a plan includes:

• Careful liquidity planning
• Incorporating process disciplines in working capital
• Establishing a plan to pivot and knowing when to switch direction
• Continuous evolution of treasury for working capital support

An essential component of planning is forecasting cash flow in the context of lower rates.

“Treasurers and CFOs need to re-evaluate purchases that were put on hold and identify and implement new strategies to boost sales,” Bollinger said. “As interest rates lower, businesses can borrow funds or access funds to invest in expansion, such as purchasing new equipment, updating plants or hiring more workers.”

Revisit Procurement Strategy

Lower interest rates may open up more capital sources, which could make it easier for companies to secure financing.

“Businesses may want to aggressively invest in more inventory as cash flow improves,” Bollinger said. “On the other hand, if they’re losing interest income as rates change, they may want to reduce inventory levels to reduce carrying costs and balance supply with customer demand.”

Automate Accounts Payable

As interest rates change, this is a good time to consult your working capital team about your accounts payable process.

“We can analyze accounts receivable and accounts payable with our clients to optimize cash flow,” Bollinger said. “We can discuss better efficiency on accounts payable which could take advantage of early payment discounts or reduce costs in other ways.”

This may also be an optimal time to negotiate new terms with suppliers.

Cash Conversion Efficiency

In a lowering interest rate environment, businesses may want to take advantage of changing economic conditions and convert inventory and investments into cash flow.

“If interest earnings are declining and demand increases, it may make sense to shift investment strategies and aggressively focus on reducing excess inventory,” Bollinger said.

Improve Debt Management

Businesses that are net borrowers should consider refinancing into lower rate options or consolidating debt to improve cash flow with reduced payments and to save capital on interest payments.

 

Tailoring Working Capital to the Business’s Needs

While every business requires a unique working capital strategy, there's also a universal need to adapt to change.

“We work with companies of all sizes and in most industries, so we can offer insight into what others are doing to manage capital flow, what’s worked for them in the past and what hasn’t,” Bollinger said.

In any rate environment or changing macroeconomic circumstances, Bollinger recommends the following optimal working capital practices for treasurers and CFOs:

• Review your working capital strategy to ensure it aligns with current trends in the economy.
• Work with banks, consultants and specialists to identify opportunities that promote liquidity generation and new processes that can augment sustainable financial performance.
• Be strategic about borrowing decisions.
• Secure access to liquidity and closely monitor needs.
• Strategically manage payables and receivables through implementation automation technology.
• Implement and measure metrics across the organization to incentivize change and assess business performance.
• Monitor strategically important trade partnerships.
• Actively manage risk and employ strong fraud prevention.
• Improve visibility: Look for opportunities to improve visibility over cash flows, positions and risk exposures.
• Communicate with the business: The financial acumen that treasury brings can help the business make more informed decisions.
• Think strategically about how to implement and support change.

To learn more, get in touch with our treasury management team today and discover what options might be best for your company.