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.

True, not all companies play working capital games at year-end. Some businesses are seasonal; the fourth quarter is naturally the strongest for retailers and makers of holiday gifts. Others simply eschew such games. And not all companies in the REL study saw their working capital performance improve in the fourth quarter of 2006.

Still, 609 companies did realize fourth-quarter improvements last year, many of them dramatic. Of those companies, however, 80 percent subsequently saw their working capital deteriorate in the first quarter of 2007. Overall, 64 percent of the companies in the scorecard saw working capital performance decline from Q4 2006 to Q1 2007.

In 2006–2007, the nonseasonal industries with the largest average working capital swings (in weighted dollars) were construction materials, auto components, paper and forest products, food and staples retailing, food products, and pharmaceuticals. Of the latter industry, the biggest swingers (in descending order) were Merck, Pfizer, Barr Pharmaceuticals, Eli Lilly, and Wyeth. Merck’s working capital decreased $540 million in the fourth quarter of 2006, but increased a whopping $934 million in the first quarter of 2007.

A Dangerous Addiction

Stephen Payne, president of REL, says his firm receives (and turns down) requests in October from companies that simply want help in reducing their working capital before year-end, without having to make sustainable improvements in working capital management. “We won’t help them put lipstick on the pig,” he says.

Over time, playing fourth-quarter games becomes addictive and can exact a stiff toll on a company. “It’s a very destructive behavior,” Payne says. Sales, accounting, collection, and operations staff work overtime to meet goals, and mistakes happen. Discounts and rebates erode margins and produce a distorted view of demand, making forecasting more difficult. Companies are left in a weaker negotiating position with customers that come to expect fourth-quarter bargains. Stepping up collections annoys customers; delaying payment strains vendor relationships; pushing back inventory irks suppliers.

But playing fourth-quarter games is a hard habit to break. The obvious reasons are because companies want to meet analysts’ expectations and show investors the best possible result in the 10-K. “They are painting a false picture to the investor community,” comments Payne. Compensation is another big motivator, he notes. If managers’ pay is tied to year-end goals for cash flow or working capital, they will be tempted to play year-end games.

For those who care about effective supply-chain processes, healthy customer and supplier relationships, fatter margins, and just plain old integrity, renouncing yearend gamesmanship is required, says Payne. To that end he recommends:

  • Base compensation tied to working capital and cash flow on a rolling 12-month period. This will reduce the emphasis on fourth-quarter and period-end results.
  • Stop pulling orders forward. Eventually, sales will be better distributed throughout the year and margins will improve.
  • Collaborate with suppliers instead of alienating them by delaying payments.
  • Redesign processes so that working capital is reduced every month, not just at period-end.

The Scorecard

The Year-End Gamesmanship Scorecard that appeared in print is culled from REL’s survey of the 1,000 largest (by sales) U.S.-headquartered public companies. The data source is Capital IQ. Results are shown for 20 of the 57 industries covered.

The scorecard shows days working capital (DWC), a metric that provides a clear picture of net working capital on a quarterly basis. The complete scorecard for all 57 industries, which also shows DIO, DSO, DPO, and weighted working capital for the past three year-ends, can be found here.

Edward Teach is articles editor of CFO.

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