A commentary on the current tarrif challenges and the impact on export-driven companies
In our paper published in December last year, Capital Efficiency Outlook 2024, we highlighted the elevated levels of working capital since the Covid-19 pandemic. We talked about some of the challenges and uncertainties companies had faced, ranging from broken supply chains, double digit inflation, rising interest rates, increased geopolitical tensions and weakening consumer demand. We made a case that companies focusing on working capital improvements, not only enjoyed better cash flow, but also seemed to have improved EBIT-margins during the period. We emphasized the importance of getting working capital optimization higher up on the strategic agenda and ensuring that both tactical and operational decisions are aligned to support strategic initiatives. A couple of months later, this same conclusion couldn’t have been more relevant.
On April 2nd, Donald Trump revealed a series of reciprocal tariffs, thereby changing the global trade order as we know it. In the following days, different decisions were announced leaving much of the world in a confused state. The coming weeks and months to come, are likely to be characterized by high uncertainty and unpredictability.
For companies with a high dependency on exports and global supply chains, quickly developing different scenarios to mitigate the worst effects will become a top priority. Revenues are likely to decrease, while costs are likely to increase putting downward pressure on EBIT margins. For companies carrying significant amounts of debt, shrinking EBIT margins could quickly escalate into more serious financial challenges, including the risk of covenant breaches. For companies with strained liquidity, the environment may prove especially difficult, making effective cash flow management critical to ensuring long-term sustainable operations and financial performance.
The effects of -5% revenues, +5% operating costs and different levels of working capital reduction on net debt/EBITDA1
1) To illustrate our point, we've simulated various scenarios for a fictitious industrial company with revenues of 100 bSEK, operating costs of 80 bSEK, and a healthy EBITDA margin of 20%. The company has relatively high net operating working capital to sales at 30% and a reasonable net debt to EBITDA ratio of 2. In all scenarios, revenues drop by 5%, and operating costs rise by 5%. The key difference between scenarios is how much net operating working capital is reduced, with the freed-up cash used to pay down debt.
- Scenario 1: Revenue and cost strains without operational adjustments - No improvement in net operating working capital or debt. As revenue decline, NOWC/Sales increases to 32%. The main impact is a rise in Net debt/EBITDA to 3.6, which is well above typical thresholds and may breach debt covenants, putting significant pressure on the company
- Scenario 2: Working capital optimization with moderate debt relief - A 20% reduction in net operating working capital frees up 6 bSEK in this example, used to amortize debt. This improves NOWC/Sales to 25%, while Net debt/EBITDA would increase to 3.1 compared to the base case – for a company otherwise solvent these levels are manageable over a limited time-period
- Scenario 3: Aggressive working capital release with acceptable leverage - A more aggressive 30% reduction in working capital frees up 9 bSEK in this example, used to debt amortization. NOWC/Sales improves to 22% and Net debt/EBITDA increases to 2.8 compared to the base case – a debt level broadly considered acceptable for most companies, through not ideal for the long term
Reducing working capital by 30% may seem ambitious—especially in the short term—and it would undoubtedly require significant effort. However, some of the effects may occur naturally in a context of declining sales and rising costs, such as lower receivables and higher payables. Inventory, on the other hand, should be monitored closely, as it tends to be the most challenging component to manage during periods of change.
By reducing receivables (through lower volumes, better terms, and improved collections), increasing payables (from higher costs and negotiated terms), and improving inventory turnover (from smaller orders, phasing out slow movers, better planning), a 30% reduction in net operating working capital could be realistically achieved within 6 to 9 months.
Shifting focus to the balance sheet amid revenue and cost pressures
In addition to managing working capital, efforts should focus on offsetting declining revenues and rising costs. This can include exploring new markets, adjusting pricing, negotiating with or switching out suppliers, or reducing headcount. However, focusing solely on these without managing working capital may lead to missed opportunities and leaving cash on the table.
Many companies have unrealized potential in their balance sheets. While structural changes take time, reviewing the current setup in light of recent developments is essential. Short-term improvements can unlock substantial cash flow and foster a cash-conscious culture, driving further positive effects.
For most companies, a detailed assessment of the current situation is necessary, followed by categorizing improvements into short-, medium-, and long-term actions. While interest rates may fall in many regions of the world, ensuring a healthy cash flow remains vital for companies wanting to stay in business.