Cleaner (Balance) Sheets: The 2009 Working Capital Scorecard

Hard times have inspired companies to wring lots of cash out of working capital. How much better can they get?

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Plato called necessity the mother of invention. It may also be the mother of collection.

Squeezed by a slowing economy and nearly frozen credit markets, U.S. companies showed themselves surprisingly adept last year at freeing cash from the one remaining source at hand: their balance sheets. Ramping up collection efforts and paring down inventories, the 1,000 largest companies slashed days working capital (DWC) in 2008 by 6.4% — the best improvement on that front in at least five years, reports consulting firm REL, the Hackett Group division that compiled this 12th annual edition of the CFO/REL Working Capital Scorecard. The result: a total of $62.7 billion liberated from working capital.

To be sure, the improvement may have been exaggerated by the unusual arc of the year’s economic activity, especially on the collections front, where 80% of companies were able to reduce their days sales outstanding (DSO). While business conditions in the fourth quarter were a nightmare, the first three quarters were sufficiently strong that full-year revenue for the 1,000 companies in the REL universe actually rose 10.3%. When business activity cratered in the fourth quarter, it likely drove year-end receivables (the numerator in the DSO calculation) sharply lower, even as the divisor (average daily revenue for the year) remained high.

Still, it’s easy to find companies that were able to reduce DSO even as revenues remained strong. Church & Dwight Co., the $2.4 billion maker of Arm & Hammer Baking Soda and other household products, cut DSO by 22% and DWC by 30%, even as its revenues grew from quarter to quarter. Cliffs Natural Resources, a $3.6 billion producer of iron ore and coal, cut DSO by 49% — and chopped DWC by 42% — while posting a year-over-year fourth-quarter revenue gain.

“We started focusing on the difficult economic environment very early in the fall,” says Cliffs executive vice president and CFO Laurie Brlas. “Everybody in the company turned their attention to it, and made cash their front-and-center focus.”

In fact, the improvements in working capital were broad and deep; 603 companies reduced DWC, as did more than three-quarters of the industry groups tracked by REL. The top-performing sectors: air freight and logistics, auto components, computers and peripherals, and metals and mining.

“It’s good news that so many companies, caught in the cash crisis and credit crunch, finally recognized that they can secure a substantial amount of cash from working capital,” observes Mark Tennant, president, Americas, for REL. “But this is just one year, and it will be interesting to see how it plays out in 2009.”

A Mark of Quality

Certainly there remains room for improvement. REL calculates that if the companies in the bottom three quartiles of working-capital performance matched those in the top quartile, they could extract another $776 billion in cash from their balance sheets.

If that isn’t sufficient argument for upgrading working-capital management, here’s another: it improves not just cash flow, but also business in general. “Working-capital performance is a good indicator of discipline and process rigor within a company,” says Matthew Farrell, executive vice president and CFO at Church & Dwight. “If you find it, chances are you’ll also find quality processes in lots of other places, too — marketing, analytics, sales, planning, plant operations.”

Indeed, the same systems and capabilities that enable strong working-capital performance also tend to foster strong performance in other areas: better forecasting of customer demand, a better ability to deliver goods and services on a timely basis, and better relationships with vendors. They can also drive cost savings in surprising corners of the enterprise. As it reduced the number of SKUs (stock-keeping units) it offers over the past two years, for example, Church & Dwight not only lowered inventory and warehousing costs but also saved on the cost of designing new packages and conducting legal reviews each time it created or changed a product label.

Tennant suspects that over the near term, larger and more-powerful companies with greater leverage over their supply chains will continue to improve their working-capital performance, perhaps by pushing more working capital onto the balance sheets of their smaller suppliers and, in some cases, their customers. But, he warns, such brute-force measures have limits; smaller companies typically have less ability to tap external sources of capital and can absorb only so much punishment. Longer term, he says, this opens the door for supply-chain financing to play a bigger role in driving working-capital performance. The idea is that financially strong buyers can leverage their superior credit ratings to help suppliers secure quick payment of invoices from intermediaries such as banks and other financial institutions.

“We see people are finally getting the message” about working capital, says Tennant. “Now we want to make sure they continue to seize the opportunities that are out there.” The CFO/REL Working Capital Scorecard recognizes the three companies in each of 20 industries that made the most of their opportunities in 2008. Here are the stories of two such companies: Church & Dwight and Atlas Air Worldwide Holdings.

Church & Dwight Shines the Light

“Sunshine,” says Matthew Farrell, paraphrasing the late U.S. Supreme Court Justice Louis Brandeis, “is the great disinfectant. Shed light on something and good things happen.”

Church & Dwight CFO Farrell has been shining a light on the company’s working-capital management practices since his arrival in late 2006. With the endorsement of chairman and CEO Jim Craigie, free-cash-flow metrics, which include working capital as a critical component, now account for 25% of the formula that sets incentive compensation for Church & Dwight executives.

And good things are happening. Over the past two years, the company has lowered days working capital from 51 days to 34 days thanks to big reductions in days sales outstanding and days inventory outstanding. There’s been no magic to it, Farrell says — no throwing extra manpower at the problem, no slick software deployed. To collect receivables internationally, for example, company executives simply began hosting monthly phone calls with general managers and finance executives stationed overseas to discuss their working-capital performance and highlight areas ripe for improvement. “It was purely a matter of making more of an effort,” says Farrell.

On the inventory front, Church & Dwight benefited from a reduction in the amount of safety stock that was being held, but also challenged managers to cut back on the number of SKUs the company was carrying and published monthly reports on the results. The company also began producing monthly reports on slow-moving and remnant inventory, by business unit, showing managers where they stood against their peers. Not surprisingly, the old stuff started to disappear. “Nobody wants to be at the bottom of the list,” Farrell observes. Especially when there’s a spotlight on the offenders.

A Model Improvement at Atlas Air

Dunning late-paying customers and making across-the-board inventory cuts can quickly reduce working capital, but the benefits aren’t always sustainable. Poor working-capital performance tends to be rooted in any number of operational inefficiencies that aren’t always amenable to superficial fixes — such as faulty goods or erroneous invoices that give customers reason to pay late, or forecasting miscalculations that lead to overstocked distribution centers, or processing glitches that cause bills to be paid before they’re due.

In short, sometimes it takes a complete overhaul of your business model to set things right.

Last year, Atlas Air Worldwide, a $1.6 billion air-freight company, began making changes to its business model that would simultaneously improve its working-capital performance and leave it less vulnerable to the ups and downs of the business cycle. Historically a lessor of freight aircraft through its Atlas Air subsidiary, the company in 2001 acquired Polar Air Cargo, which primarily operated as a scheduled-service carrier.

Polar Air was more susceptible to downturns in the business cycle, and last fall Atlas Air Worldwide shifted its focus to leasing, too. Under that business model, customers pay in advance for their use of the company’s planes and crews, which drives down the carrier’s outstanding receivables, and also pay for the jet fuel they use.

By minimizing the day-to-day risk of filling its planes or getting hammered by volatile fuel prices, says Atlas Air Worldwide senior vice president and CFO Jason Grant, the company has gained better visibility into its earnings and freed substantial amounts of cash from working capital. It is also attracting a generally more creditworthy clientele with the leasing model, which cuts credit risk and minimizes past-due accounts. The payoff? Last year, Atlas Air Worldwide reduced its days sales outstanding by 51%, driving a 46% reduction in days working capital.

Meanwhile, on the payables front, in 2007 Atlas installed new payment-processing software that allows its vendors to forgo paper invoices and file for payment electronically. The system routes the pertinent data directly to the people who need to see it, giving the company greater ability to take advantage of negotiated discounts for early payments. “Previously, we could have committed to paying sooner to a vendor, but it would have been tough for us to do it,” Grant says. “Anytime you’re taking in paper invoices and passing them around from desk to desk, it gets hard to accelerate the process. Now we know exactly where an invoice sits at any time and can act on it as quickly as we wish.”

In addition to making it easier to prepay, Grant says, the new system has allowed Atlas to reduce the number of people devoted to accounts payable by more than a third. So, while prepaying invoices isn’t conserving cash, earning prepayment discounts and reducing payroll certainly are. Taken together, the structural changes Atlas Air Worldwide has made to its business model hold the promise of lasting improvement in its working-capital performance.

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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