Scrubbing the Numbers

Cleaning up the balance sheet boosts year-end cash flow, but it can leave some messy problems.

Annual Pay

Indeed, given the scrutiny of financial results each quarter, it may at first seem curious that it would be worth fiddling with fiscal year-end results. What, after all, is so special about the fourth quarter? New regulations now require faster financial reporting year-round. And investors and analysts have long been skeptical of annual reports that are as much gloss as glossy.

But there are important differences between 10-Q quarterly Securities and Exchange Commission filings and the annual 10-K. Most significant, quarterly results are not audited. And since the focus of quarterly results tends to be on earnings, there are subtle differences in the amount of detail provided on the balance sheet. Indeed, the quarterly financial announcements made directly to the public sometimes do not provide a balance sheet at all.

Greater balance-sheet detail also makes year-end results the numbers of choice for all kinds of marketwide studies of corporate performance—including CFO magazine’s own annual working- capital survey. For example, Johnson & Johnson, a first-quartile working-capital performer in a survey CFO published last September, reduced its 2002 working capital by 3 percent over 2001—a modest improvement. But a quarter-by-quarter look at the company shows that the firm reduced its days working capital in the last quarter of 2002 by 20 percent—only to jump back up by 19 percent during the first quarter of 2003.

The most significant driver of year-end bumps, however, is compensation. “You get the behavior that you reward,” notes Beebe. Before Corn Products instituted a working-capital management program in 2002, she says, “managers’ bonus payments were focused on the income statement and delivery of operating income.” Unfortunately, she says, that meant managers didn’t have to worry about the cost to the company of holding an overdue receivable. “In some cases, your financing costs could be higher than your profit margin.”

Corn Products fixed that by tying 20 percent of each manager’s bonus to working-capital targets and providing education and training. “It’s not some corporate geek at headquarters dictating the decision,” says Beebe. “If it is a more-appropriate decision for a manager to make the sale and carry the receivable or carry inventory, they can make that decision, but they will be rewarded for their operating income and penalized for their working capital.”

More important, however, is that Corn Products’s bonuses are based on a 12-month average of total working-capital days. That helps ensure that working- capital decisions aren’t swayed by the year-end reckoning. Notes Beebe: “We weren’t looking for window dressing; we were looking for long-term continuous gains.”

“Economic value is infinitely more important than year-end optics,” echoes Owens-Illinois controller Ed White, who began a working-capital improvement program in late 2000 by revamping the accounts-receivable department. “This is not a fad,” declares Channell, who runs the working-capital initiative for White. “We are looking for continuous improvement.” Like Corn Products, Owens-Illinois tracks working-capital metrics on a monthly basis and ties them to incentive compensation.

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