Business and Digital Trends in the Chemical Industry: Finance
by Bernd Weissenmayer and Jonas Rissler
In this blog, we discuss the challenges that current external disruptions are creating for the chemical and life science industry more than for many other industries. The industry’s reliance on commodities and specialized chemical products that have increased dramatically in price has led to the emergence of new items on the CFO agenda.
The high rate of inflation is forcing companies to optimize their liquidity and streamline working capital management scenarios as they strive to secure their productive capabilities at a time when raw materials and intermediates are both rare and expensive. In this blog, we focus on a number of pertinent areas in which we address challenges from a business perspective as well as from the perspective of the Business Transformation Services group. We demonstrate how working capital and liquidity management solutions from SAP can help counteract recent shocks within the chemicals industry. Topics discussed include:
- Inflation as a top priority, especially with regard to the surge in commodity / raw material prices
- Working capital management to allow your firm to run efficiently and to reduce working capital cost
- Liquidity management as a necessary control element to meet current liabilities
2. BUSINESS TRENDS AND THEIR IMPACT IN FINANCE
2.1 Inflation and Steady Interest Rate Increases and How to Cope with Them
On February 2, 2023, the European Central Bank (ECB) announced another 0.5 percent increase in its interest rate effective as of March. This increase of 50 basis points is already the fifth spike in the interest rate level within just a few months. This is undoubtedly an attempt to counteract an inflation level that remains too high for too long.
This inflation figure is especially critical for the chemical industry, as its dependence on raw material for chemicals and energy for production processes is usually high. Commodity prices for raw materials and intermediates, including energy, have experienced the sharpest price surges, and the war in Ukraine has led to shortages in the supply of gas and as a result significant higher energy cost. The current geopolitical disruptions harm the competitive position primarily in Europe in a way that firms rethink their future investment decisions. This could without a doubt push management’s favored location for production facilities away from Europe to other regions with more stable and cheap supply of gas and energy.
In fact, price surges for relevant commodities have risen to levels that threaten the core production operations of many chemical companies. These companies had previously expected that they would ride out the price increases, but this is no longer the case. They now find that they must adopt to the new inflationary figures and the resulting pressure on their margins. This is especially prominent for chemical companies with product portfolios focusing on high volume commodities with traditionally lower margins compared to firms selling higher margin specialty chemicals.
It’s important for companies to understand the financial impact of these factors so that they can react quickly and predict where the market is heading. These challenges force them to rethink their priorities with regard to the CFO agenda and explore opportunities to gain a competitive cost advantage.
We want to discuss two functions in detail, namely, working capital (especially inventory) and liquidity management.
2.2 Revival of Working Capital Management
In the future, it will be crucial for finance departments to steer their inventory properly so that they can keep their inventory level as low as possible to avoid external financing cost through banks and bonds. At the same time, they need to focus on a demand-oriented production while safeguarding an efficient, continuous production, without jeopardizing the on-time delivery towards the customers.
In finance, time value of money has traditionally been a key factor for financial models. Bound capital within a company bears interest. In recent years, with the interest rates being around the zero-interest rate level in most industrialized countries, borrowing money was cheap and working capital considerations with respect to low inventory levels had lost much of their previous relevance on the CFO agenda. The weighted average cost of capital (WACC) was low, as the risk-free interest rate was only narrowly above zero.
The rise of the interest level, in combination with other external price shocks for raw materials, has now increased the relevance of working capital from two sides. One contributing factor is that there is a higher interest yield for capital that may become even higher in the future, as further interest rate increases as a means to counteract inflation is conceivable. High inventory levels to meet customer demand will threaten the free cash flow situation of many enterprises. The second contributor is that the baseline of the yield interest has increased due to significantly higher raw material commodity prices. The same quantity of an input commodity is currently valued much higher than in previous periods. The second factor becomes even more significant in the context of disrupted supply chains and deferred deliveries. For example, companies in Germany have started to stack more inventory and increase the safety stock levels significantly than was apparent in previous records.
For the chemicals and life sciences industry, it has become important to put working capital, especially in terms of demand-oriented inventory levels, back on the CFO agenda and to optimize working capital and the supply chain. Working capital needs to be steered to enable companies to guarantee meeting their obligations while reducing capital cost. Being at the top of the peer group in comparison to competitors allows companies to generate additional cash flow gained through sophisticated working capital management. They can then reinvest this cash flow to strengthen their position in the market and achieve a competitive advantage over their peer group through, for example, digital transformations, increase of production capacities, or M&A activities. In this way, corporations can lay the foundation for their future success.
Alternatively, they could use the cash flow to directly serve their shareholders on the capital markets and pay out dividends. We believe SAP is your partner of choice to minimize working capital cost while helping ensure efficient production operations, especially in times of highly disruptive supply chains and economic uncertainty.
2.3 Working Capital Management: Freeing Up Capital in Your Supply Chain
SAP has a long history of supporting companies to become their best version. Improving operational efficiency while guaranteeing full operational capacity is what working capital and liquidity management solutions from SAP are all about.
SAP’s landscape for working capital and liquidity management
Solutions from SAP and Taulia, recently acquired by SAP, combine a comprehensive supply chain and working capital strategy across the direct, indirect, and services spend range for buyers and suppliers alike. This allows stakeholders from procurement, finance, and treasury departments to reap the combined and independent benefits from working capital optimization. Suppliers can benefit from streamlining their own cash flow, helping the overall supply chain to become more resilient and sustainable.
Generally, companies want to pay late and receive cash early and keep storage and lead times as low as possible. The cash conversion cycle is a metric to determine how long it takes a company to convert its investments of input materials, manufacturing, and other resources into generating cash flows through sales.
Concept of the cash conversion cycle
Management needs to optimize the cash conversion cycle while keeping in mind that this cycle does not exist in isolation but depends on relations with the company’s business partners. A later payment from a buyer results in an adverse effect for the supplier.
SAP and Taulia solutions can help companies in the chemical and life science industry to achieve improvements in several areas, including those measured by the following three parameters: days sales outstanding (DSO), days payable outstanding (DPO), and days inventory outstanding (DIO). This is particularly true in relation to DIO, as companies have often struggled to improve and to achieve the necessary results with regard to this parameter. In simple terms, DIO states the average numbers of days that it takes for a company to sell off its inventory. One way to improve DIO is to accurately plan and forecast incoming sales. The more precise a company’s sales prediction, the closer is the match between its level of planned input raw materials and actual demand. Accurate forecasting enables companies to keep inventory in storage without the need for a large safety stock, thereby saving capital expense.
Another way in which Taulia solutions can improve your working capital position is its supply chain financing module, where suppliers and buyers can act based on dedicated finance contracts between both parties and external banks to reduce financing cost and to guarantee a higher degree of flexibility.
It’s vital for companies in the chemical and life science industry to focus on demand-oriented production. Taulia planning solutions and those of SAP S/4HANA provide tools to combine input from sales functions together with AI-enabled forecasts. With the help of these tools, companies can gain a clear outlook into the future and manage inventory properly. Furthermore, having a transparent view of demand allows inbound logistics to follow a just-in-time method for many raw materials, drastically reducing the bound capital in inventory.
Of course, the just-in-time approach might not be feasible for all materials – for example, if materials are production critical and bottlenecked or if high discounts can be granted for high volumes. Nonetheless, it is usually applicable, especially for high-value items that bear a lot of capital cost.
Taulia is innovating in the area of inventory ownership. To further support the safeguarding of production and economies of scale, the Taulia software’s inventory ownership service offers a supply chain assurance, supporting your firm against supply chain disruptions such as long lead times and stock outages. In this scenario Taulia is innovating on a model where Taulia’s entity can own consigned inventory and where the buyer acts as Taulia’s agent for goods receipt, inventory care and control, invoicing, and collections. This service owns inventory in transit and warehouses close to your location for “always available” just-in-time deliveries while preserving your balance sheet. Naturally, it’s possible to use analytical capabilities and to track purchase orders, statuses, warehouse volumes, and more.
2.4 Liquidity Management: Safeguarding FX and Raw Material Exposure
Besides the inventory management, another relevant topic on the CFO agenda is liquidity management. The current year presents challenges for many companies with respect to their FX and raw material exposure including energy inputs such as energy and gas. Using the SAP Treasury and Risk Management application, companies gain a centralized, nearly real-time view of their cash position and forecast. Combined with SAP Analytics Cloud as a reporting solution, the application makes it easier for companies to monitor and predict cash-in and cash-out and manage overall cash flow.
Liquidity management is vital because financial leaders know that in the current market, financial distress can also be caused by missing payments from a customer or through foreign exchange (FX) exposure. The Hedge Management Cockpit in SAP’s Treasury and Risk Management allows customers to obtain an overview of their FX exposure and corresponding hedging instruments. As an example, for a firm doing business in a currency that has been under pressure for several months, such as the euro, a major risk is presented by loans or accounts payable that are in dollar terms.
Technology is an important element in liquidity management because it is a key to the survival of firms and is always looking to the future. Our tools provide the insights needed to counteract the dangers relating to volatility from FX exposure and the raw material market.
3. Conclusion and Outlook
In this blog, we discussed the shocks currently impacting the chemicals and life sciences industry and how SAP solutions can create value for your corporation in troubling times. We explained how they can do this by helping you overcome challenges in relation to inflation, working capital, and liquidity. Technology can bring transparency to vital issues along the supply chain, thereby enabling executives to act quickly and decisively. In the long term, our set of tools allows for cost reductions in the field of working capital while helping assure smooth production in your company’s facilities and a solid cash position.