No Time to Lose: The 2008 Working Capital Scorecard

Tempted to extend payment terms? That's one sign that working capital demands your immediate attention.

Read the complete results of the 2008 working capital survey, or review just those results that appeared in print.

Beware your survival instincts: they may dampen corporate performance more than you might expect. With a recession looming or quite possibly upon us, it can be tempting to ease up on receivables and retain inventory in order to placate cash-strapped customers. But those seemingly small sacrifices actually impose a steep cost, diverting precious cash to working capital. CFOs who want to bolster the case for strict working-capital policies may find plenty of support in the 11th annual CFO/REL Working Capital Scorecard.

The 2008 scorecard ranks working-capital performance at the largest 1,000 public U.S.-headquartered companies. Overall, 61 percent of the 57 industries covered in the scorecard improved their days working capital (DWC) number last year by an average of 8 percent. But there is still much room for improvement.

In a market climate where pennies per share affect shareholder returns, changes in working capital invite scrutiny. Taking note, one securities analyst has called working capital his microscope into the competence of a management team.

Reducing working capital confers benefits for any industry, from high tech to chemicals to manufacturing. “Every dollar we free up from working capital can be deployed back into the business,” says Ken Hannah, CFO of MEMC Electronic Materials Inc., a $1.9 billion silicon-chip maker.

On a weighted working-capital basis, the 10 most improved companies released $1 billion or more each, a 26 percent improvement on their average DWC. Such opportunities beckon to CFOs. Were a median company in the 2008 scorecard (approximately $10 billion in sales) to match companies with the leanest working capital, REL estimates that the company could trim its working capital by $1.4 billion, or 14 percent of sales. That’s a tidy sum for finance executives to invest in growth without tapping credit lines. Savings in interest expense go straight to the pretax bottom line, notes Karlo Bustos, financial analyst at REL, a division of The Hackett Group Inc.

Scorching Pace

As the current working-capital leader in the semiconductor sector, MEMC set a scorching pace last year, trimming its working capital to just 13 days from 36 days in 2006 and 46 days in 2005. The most recent one-year improvement liberated nearly $340 million in cash flow, REL estimates, a sum approaching 18 percent of 2007 sales.

Besides the virtues of leaner operation and ready access to $340 million, another way to calculate the payoff fits the back of an envelope. Had MEMC been forced to borrow $340 million to finance working capital at a modest 5 percent rate, the tab for interest payments (excluding amortization) would drain $17 million a year from cash flow for each year the debt remained outstanding.

Besides bracketing capital expenditures between 10 percent and 15 percent of revenue, CFO Hannah credits MEMC’s success to a “maniacal” focus on cash conservation and trimming costs — twin benefits of better working-capital management.

“It all comes down to asset turns,” Hannah reports. Direct-order contracts transfer ownership of goods to customers once those goods leave MEMC’s shipping docks. The company trimmed inventory levels by adopting more just-in-time manufacturing processes. On the receivables front, MEMC reduced its days sales outstanding (DSO) by leveraging the current high demand for its products through requiring some customers to pay for goods before delivery.

MEMC does not stretch out payments to suppliers, however. “We’re a cash generator,” Hannah explains. “I can take that cash, invest it, and earn, say, 4 percent. Alternatively, I can pay my suppliers 30 days earlier and get, in some cases, a 10 percent discount on their product.”

A determined focus on cash conservation characterizes top working-capital performance in every industry. “We have a very experienced management team that has seen some of the best of times and some of the worst of times in a cyclical industry,” says Dan Greenwell, senior vice president and CFO of Terra Industries Inc., a $2.4 billion manufacturer of nitrogen fertilizers that has pared its DWC to 30 from 51 over the past two years, far below its industry median of 72. Like MEMC, Terra has taken advantage of recent robust demand to negotiate better sales terms. It also has shuttered distribution centers to minimize inventories and prepays supplier invoices in exchange for discounts.

Overall Improvement

Excluding automakers, which skew results disproportionately due to their lending operations, the 2008 results show overall, if marginal, improvement since last year’s scorecard, but not in every corner of working-capital performance. Days inventory outstanding (DIO) shrank, on average, to 29.7 days from 30.7 days. Somewhat surprisingly, despite a looming recession, REL found only a slight uptick in days payables. In fact, says REL’s Bustos, big companies seldom conserved cash in 2007 by making vendors wait. For the group, excluding automakers, days payables outstanding (DPO) edged up only slightly, to 32.5 days from 32.1. DSO also moved in the wrong direction, edging up to 41 days from 39.7 in 2006 and 40.5 in 2005.

Altering key elements of its business model triggered dramatic improvement at Source Interlink Cos., a $2.3 billion magazine publisher and distributor of music CDs, DVDs, and magazines. The company crossed the formidable 10-day threshold for DWC by paring its number to just 9 days. By contrast, a more lumbering Source Interlink held 41 days of working capital as recently as 2005. Much of this improvement came from better receivables management; it cut DSO over the past two years to 20 from 49.

Source Interlink CFO Marc Fierman credits part of the improvement to an initiative that converts many customers from a traditional wholesaler/retailer relationship to a scan-based trading relationship. Under that model, retailers aren’t billed for an item and don’t pay for it until it sells at the retail level. That has the effect of boosting inventories for the wholesaler — in this case, Source Interlink — but from a working-capital perspective those increases are more than off set by a reduction in receivables. “Converting to scan-based trading also results in significant operational savings for both us and the retailer,” Fierman says, “as neither has to continue to perform the processes to hand off inventory at the store level.”

Striking success stories at MEMC, Terra, and Source Interlink were exceptions in 2007, when the largest U.S. companies (excluding automakers) generally recorded only marginal improvement in DWC, down to 38.2 days from 38.4 a year earlier. But that slight improvement outpaced Europe’s largest public companies (also excluding automakers), whose DWC climbed to 47.3 days from 46.8 the prior year.

A prolonged recession may tempt managers to take their eyes off short-term working-capital goals, but managers who stray for long face perilous consequences. Slack working-capital performance may not decide a company’s fate from one quarter to the next, but in the long run it will certainly dull the competitive edge.

Randy Myers is a contributing editor of CFO.

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.

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.

This year’s survey uses the Global Industry Classification Standard to categorize companies.


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