Working Capital: Fourth and Goal

To buff up their fourth-quarter numbers, companies often play games with working capital. Unfortunately, the shine doesn't last, according to REL's Year-End Gamesmanship Scorecard.

Read the complete results of the 2007 Year-End Gamesmanship Scorecard, or review just those results that appeared in print in CFO magazine.

Let the games begin.

The working capital games, that is. Right now, companies all over America, in every industry, are beginning a dash for cash. If past is prologue, many companies will go to great lengths to slash their working capital in the fourth quarter. The goal: to paint a beautiful picture of their cash flows by December 31 — one suitable for framing in the annual report.

To that end, companies will grant extremely favorable terms to customers, and make liberal use of discounts and rebates. They will step up their collection efforts, even as they hold back on paying their vendors. They will push inventory orders back on suppliers. They will do everything they can, in short, to free up cash from receivables, payables, and inventory, the components of working capital.

But after the dash for cash is over, working capital will return, and with a vengeance. The first quarter of 2008 will find many companies contemplating a dismal set of metrics — and the need to begin shrinking working capital all over again. To switch metaphors, companies are like crash dieters: they lose working capital rapidly, but just as rapidly gain it back.

That tendency is brought to light in the 2007 Year-End Gamesmanship Scorecard, a new study conducted for CFO by REL, an Atlanta-based global research and consulting firm. REL’s analysis of the largest 1,000 U.S.-headquartered public companies (excluding the financial sector) reveals large year-end swings in working capital. From the third quarter to the fourth quarter of 2006, gross working capital at those 1,000 companies shrank 7.9 days, resulting in an aggregate swing of $100.5 billion. But then, from Q4 2006 to Q1 2007, working capital increased 9.3 days, or $122.3 billion.

What’s more, this year-end seesaw is evidently an annual occurrence (see “The Working Capital Seesaw” at the end of this article). Three key metrics add detail to the picture of year-end working capital swings:

Days inventory on-hand (DIO) fell 8.6 percent in Q4 2006, or $71.8 billion, to its lowest level for the year, then rose 7.1 percent in Q4 2007, or $51.3 billion. With sales volume at the annual peak, inventory is rapidly consumed but slowly replenished, notes Karlo Bustos, a financial analyst at REL.

Days payables outstanding (DPO) fell 11.8 percent, or $104.1 billion, then rose 15 percent, or $111.5 billion. The main reasons for the swing were the pushing back of inventory on suppliers and the taking of early payment discounts, says Bustos.

Days sales outstanding (DSO) decreased by 2.8 percent, or $28.8 billion, then increased by 6.9 percent, or $67.3 billion.

At least gross margins improved in the first quarter of 2007, notes Bustos. Indeed, he adds, they had nowhere to go but up, since margins were at their worst in the fourth quarter, as companies heavily discounted product to pull sales forward. Typically, the fourth quarter is the best quarter for sales and the worst for margins, says REL. That goes in reverse for the first quarter of the following year: sales are weak but margins improve.

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