Growing Problems: The 2007 Working Capital Survey

Focused on growth and more reliant on overseas suppliers, companies have let inventories swell.

Read the complete results of the 2007 working capital survey, or review just those results that appeared in print.

Maybe it’s globalization. As U.S. companies source more goods from the far corners of the world, it makes sense that they would stock more inventory as a guard against potential breakdowns in their supply chains. Or maybe it’s economic priorities. With corporate coffers bulging like overloaded transpacific freighters, finance executives could be taking their eye off second-tier metrics like inventory, payables, and receivables. Whatever the explanation, 2006 marked the first time in five years that the 1,000 largest publicly traded companies in the United States (excluding automakers) failed to decrease the amount of cash they had tied up in working capital relative to sales. In fact, by year-end 2006, working-capital days were actually up a smidgen: 38.8 days versus 38.7 at year-end 2005.

Blame inventories, says REL, the research and consulting firm that compiles the data for this annual scorecard. According to its figures, the nation’s biggest firms allowed their days inventory outstanding (DIO) to rise to 31.2 last year, up 2.1 percent from 2005. That performance overshadowed slight improvements on the payables and receivables fronts, the other two key components of working capital. Days sales outstanding (DSO, a measure of how efficiently companies convert receivables to cash) shrank to 39.5 from 39.9, an improvement of 1.2 percent, while days payables outstanding (DPO, a measure of how long companies hold onto their own cash before paying vendors) rose to 31.9 from 31.8, an improvement of 0.3 percent.

The paltry gains in DSO and DPO suggest that many CFOs are worrying less about working capital these days and more about taking advantage of a strong economy to drive sales. “We’re in a very high growth stage right now,” concedes a senior finance executive at one specialty retailer, who asked to remain anonymous. “Squeezing that last dime out of the payables account isn’t the biggest focus of our attention at the moment.”

That’s understandable, perhaps, but also unfortunate. As cash-flow connoisseurs seldom tire of pointing out, money tied up in working capital is money that’s not available to invest in the business, fund an acquisition, pay a dividend, or finance a stock-buyback program. And according to REL, the opportunity foregone by companies that haven’t whittled down their working capital to best-practice levels is enormous: $764 billion excluding automakers, $877 billion if you include them. That’s the amount of cash that would be freed up if companies in the bottom three quartiles of working-capital performance simply brought themselves in line with first-quartile performers.

Inside the Rise in Inventories

To be fair, finance executives and supply-chain managers were fighting at least three head winds last year as they sought to keep inventory levels to an optimal minimum. First, sales were growing in 2006 but not at the same pace as they were in 2005; the gain was up 10.6 percent in 2006 versus 14 percent the year before. As the growth rate slowed, says REL president Stephen Payne, some companies may not have been able to pare their inventories fast enough to keep pace.

Meanwhile, with companies searching ever farther afield for cheap goods and labor, some probably found it prudent to carry more inventory as a guard against potential supply-chain disruptions. And even if they didn’t physically hold more inventory, notes REL analyst Karlo Bustos, they might have found themselves posting higher inventory values on their books anyway — particularly where their supplier contracts required them to take ownership of goods during the long transit from Asia, Eastern Europe, or South America.

“We’re producing merchandise in places many people have never heard of, even places where there’s a pretty significant element of instability,” says the specialty retailing executive cited earlier. “Any time you start producing in places like that, you end up allowing for longer lead times and ordering and carrying more inventory. We carry a lot of items that remain popular year after year, but for a retailer that depends on having the most-updated trends in its stores at all times, that can be a challenge.”

Payne agrees. The increased lead times associated with shipping product from low-cost and faraway countries, he says, force companies to house more inventory and reduce the speed with which they can respond to changes in customer demand. Not only can that increase overall inventory levels, he warns, but, more ominously, it also can inflate the amount of “slow and obsolete,” or SLOB, inventory on corporate balance sheets. “Companies have to find the right balance between taking advantage of cheaper product and creating flexibility in their supply chains,” he says.

Pockets of Improvement

Not all companies suffered setbacks in working-capital performance this year. Of the 1,000 tracked by REL, nearly half, or 472, were able to reduce their DWC (days working capital) by an average 11 percent. By industry group, the top performers were hotels, restaurants, and leisure companies; independent power producers and energy traders; construction and engineering companies; and multiline retailers. The worst performers were gas utilities; oil, gas, and consumable-fuels companies; diversified consumer services companies; and food producers.

In some cases, dramatic changes in the way a few key players were managing their balance sheets helped entire sectors to look good. Multiline retailers were a top-performing industry group, for example, in part because some big companies in that group decided to sell their credit-card operations and the receivables associated with them, dramatically paring their days sales outstanding. When $27 billion Federated Department Stores sold its credit-card accounts and related receivables to Citibank between October 2005 and July 2006, for example, it drove its DSO figure to 0 from 33. Similarly, $15.5 billion Kohl’s Corp.’s sale of its private-label credit-card accounts and outstanding receivables to JPMorgan Chase in April 2006 helped the retailer pare its DSO figure to 0 from 45.

Going forward, opportunities for such dramatic gains in that industry group will diminish. Already, of the 16 companies in the group, only 7 show a DSO figure above 0, led by $59.5 billion Target Corp., which has a DSO of 38, and $8.6 billion Nordstrom Inc., with a DSO of 26; both still operate their own credit-card programs. While they do sell their associated receivables through a securitization program, REL’s methodology factors securitized receivables into the DSO calculation.

As it happens, few industries have been affected by global sourcing more than the retail industry; just think about how long it’s been since you picked up a piece of clothing with “Made in the USA” on the label or bought an electronic device that didn’t come from Asia. That this is not a new development in the retail sector may help to explain why the multiline retail industry was among the 13 industry groups, out of 56 total, that managed to improve DIO last year, with a median reduction of 7 percent. Among the top performers, Federated reduced its DIO by 18 percent, $6.4 billion Family Dollar Stores reduced its DIO by 13 percent, and $4 billion Dollar Tree Stores reduced its DIO by 10 percent.

Specialty retailers weren’t as successful on the inventory front; the median DIO in that group rose 3 percent last year. However, with a median DIO of 57 days, they are working from a lower base than their multiline counterparts, where the median was 63 days. And the specialty retailers aren’t content with their inventory performance either. Clothier Abercrombie & Fitch is spending money on information-technology systems intended, it says, to help it become more scalable, efficient, and accurate in the production and delivery of product to its stores. Last year, the $3.3 billion company’s DIO declined a modest 1 percent, to 47 days, but that was after ballooning to 48 days in 2005 from 38 in 2004. Similarly, $2.8 billion clothier American Eagle Outfitters has invested in systems designed to help it mark down prices on aging inventory more strategically, and thereby better manage inventory levels. With days inventory outstanding of 34, it’s already among the best in its industry group on that score. And $5.3 billion video-game retailer GameStop Corp. has developed a proprietary inventory-management system that it pairs with point-of-sale technology to allow it to see its daily sales and in-store stock by title, by store. That lets each GameStop location carry merchandise tailored to its own sales mix and rate of sales. Last year, the company shaved its DIO figure to 46 from 71 en route to posting the best DWC figure in its industry group, –2 days.

While performances like that are encouraging, Payne expresses surprise that more companies haven’t been aggressive in searching out ways to liberate some of the cash they have tied up in working capital. “Running a successful business is all about cash flow,” concurs REL’s Bustos. “You can do well on the top line and well on the bottom line, but if you’re not generating true cash, you’re not running the business to its full potential.”

In an age when private-equity investors are all too eager to help underachievers extract cash from their businesses, that’s a mistake few firms will want to make.

Randy Myers is a contributing editor of CFO.

United States vs. Europe

Despite making no headway in improving their working-capital performance as a group last year, big U.S. companies remain ahead of their European counterparts in doing more with less — though the gap is narrowing. Excluding automakers, the biggest companies in Europe had 45.2 days of working capital on their books at year-end 2006, versus just 38.8 for the biggest companies in the United States. However, the average European company reduced its days working capital by 6.6 percent last year, while the average U.S. company saw its DWC increase 0.1 percent.

REL analysts attribute Europe’s better performance last year in part to currency and outsourcing trends. Many European firms have been quicker than their U.S. counterparts to source low-cost goods from Eastern Europe and Asia, says REL analyst Karlo Bustos. That has driven down the value of inventories on their books (thanks in part to faster transit times than U.S. firms experience). So has the strength of the euro against the U.S. dollar, since goods sourced in Asia are typically priced and sold in dollars. All that helps to explain why last year, the largest 1,000 companies in Europe, excluding automakers, reduced their days inventory outstanding by 4.6 percent, versus a 2.1 percent increase for their U.S. counterparts. — R.M.

How Working Capital Works

Days Sales Outstanding: AR/(total revenue/365)

Year-end trade receivables net of allowance for doubtful accounts, plus financial receivables, divided by one day of average revenue.

A decrease in DSO represents an improvement, an increase a deterioration. In the accompanying charts, companies marked with an asterisk have securitized receivables, which improve DSO through financing alternatives without improving the underlying customer-to-cash processes such as credit-risk assessment, billing, collections, and dispute management. The scorecard eliminates this distortion by adding securitized receivables back on the balance sheet before calculating DSO.

Days Inventory Outstanding: Inventory/(total revenue/365)

Year-end inventory divided by one day of average revenue.

A decrease is an improvement, an increase a deterioration.

Days Payables Outstanding: AP/(total revenue/365)

Year-end trade payables divided by one day of average revenue.

An increase in DPO is an improvement, a decrease a deterioration. For purposes of the survey, payables exclude accrued expenses.

Days Working Capital: (AR + inventory – AP)/(total revenue/365)

Year-end net working capital (trade receivables plus inventory, minus AP) divided by one day of average revenue.

The lower the number of days, the better. The percentage change is marked N/M (not meaningful) if DWC moved from a positive to a negative number or vice versa. Also, when a company has a negative DWC, an improvement will show up in our chart as a positive percentage change from 2005 to 2006.

*Note: Many companies use cost of goods sold instead of net sales when calculating DPO and DIO. Our methodology, however, uses net sales across the four working-capital categories to allow a balanced comparison. Reported sales have been adjusted for acquisitions and disposals during the year.

This year’s survey uses the Global Industry Classification Standard (GICS) to categorize companies. Results from past years have been recalculated for consistency.

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