European Companies Have Leverage to Spare

After three years of caution, as companies sought to ride out the global financial and economic crises, business confidence and growth aspirations are returning. While this is welcome news, steering the right course through this stage of the cycle can be as difficult, if not more so, than managing a business through a downturn.

The comparable period in the mid-1990s saw a huge surge in business growth, acquisition, and profitability within some companies. Business failures also escalated, however, as companies took more risks and some overreached. Now the ability of finance and treasury teams to provide proactive financial management and sharp strategic insights will be critical in letting companies plot the most effective business course and ensure they have the financing model to realize their objectives.

This time around, many European businesses are targeting the rapidly expanding markets of Asia, Latin America, and the Middle East. This shift in focus will have a profound impact on the way companies fund their businesses and manage their finances. Realizing this, the most effective finance and treasury teams are developing the forward-looking analysis and insight needed to strike the right balance between curbing finance costs, ensuring effective risk management, and maintaining the flexibility to capitalize on opportunities.

In our recent report—Forward Thinking Finance: The Growth Challenge, developed in partnership with PwC—we examined how midmarket businesses (€2 billion or less in revenue) are adapting to the particular demands they face. We revealed that companies have an estimated €120 billion they could release for investment without even making improvements in their working capital ratios. (Freeing up working capital could more than double the funds available for investment.) This pot of wealth could add 1.4 percent to economic growth in leading EU economies over the next few years.

But how do businesses release this cash in reality?

The priorities for companies looking to optimize their financing model will focus on making the most of the funding options available to them. PwC's analysis of midmarket companies in the U.K., France, Germany, Italy, and Spain reveals that:

Many midmarket European companies are holding surplus cash accumulated to help sustain them through the downturn. The cash-to-equity ratios in these leading economies was 8.2 percent in 2010, compared with 6.8 percent in 2007. Taking the ratio back to 2007 levels would release around €60 billion in cash.

Gearing (or leverage) has now begun to decline, falling to 24.9 percent in 2010. Taking gearing back to prudent, precrisis levels (an increase of 1.7 percentage points) would generate a further €60 billion in debt funding. Companies should carefully weigh any increase in debt for its affordability, taking into account potentially higher interest rates in the future. Given that more than half of the midsize companies in the EU's five leading economies have gearing levels of less than 10 percent, most of the potential debt increase could be realized by taking levels at those companies up 5 percentage points.

Locked-up working capital is considerable. In fact, the lowest-performing 50 percent of businesses in our analysis could release some €125 billion in cash for self-funding by improving management of working capital.

Through this analysis we've calculated that midmarket companies in Europe's five largest economies could generate an extra €245 billion for investment without unduly stretching their balance sheets.

There is no magic approach, however, especially as each business has different characteristics and demands. What is clear is that finance teams can no longer rely on tried and trusted financing models and ways of working to see them through. The marketplace has changed. Boards and executive managers are going to be relying on finance departments to judge where to direct investment and ensure the risks are understood and controlled.

We believe that success will come down to how well chief financial officers and treasurers address four pressing demands:

Objectively reviewing financing strategy's alignment to the corporate strategy.

Assessing existing funding arrangements against the ability to meet the operational, financial, and business development priorities in such areas as acquisitions and new-market entry.

Putting in place the processes, information, and support needed to be able to provide the most effective insight, control, and efficiency.

Underpinning this with regular, periodic, finance-function effectiveness evaluation to drive continuous improvement.

Above all, a huge amount of funding, internally and externally, is available. Smart companies will use this to capitalize on opportunities and drive profitability, leaving their competitors trailing in their wake.

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