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Playing Games

Companies often play games with working capital to boost year-end results.
Jason Karaian, CFO Europe Magazine
December 10, 2007

Opera singers aren't the only ones who like to end on a high note. In a bid to boost the year-end results featured in their annual reports, companies across Europe are going to great lengths to slash working capital in the fourth quarter. However, these improvements often prove unsustainable, resulting in performance data in the subsequent quarter as sour as the previous was sweet.

This trend is highlighted by the 2007 Year-End Gamesmanship Scorecard, a new study produced for CFO Europe by REL, a research and consulting firm. For its analysis, REL studied 145 large Europe-based companies that report quarterly financial results in enough detail to compile meaningful working capital information. From the third to the fourth quarter of 2006, gross working capital at these companies shrank by 4.4 days, an aggregate swing of €35.5 billion. But then, from the fourth quarter of 2006 to the first quarter of 2007, working capital increased by 4.1 days, or €27.6 billion. And this is not the first year in which this pattern has emerged. (See "Dash for Cash" at the end of this article.)

To understand how it happens, look no further than receivables and inventory. According to the research, companies extend discounts and rebates, step up collections, and push back inventory on suppliers in a dash for cash as the year-end approaches. Days sales outstanding (DSO) fell 8.9% in the fourth quarter of 2006, then rose 10.3% in the first quarter of 2007. Days inventory outstanding (DIO) fell 7.5% in the fourth quarter before rising a whopping 19.9% in the first quarter.

Payables, however, followed a different path. Companies in REL's sample cut days payables outstanding (DPO) by 10.5% in the fourth quarter, thereby worsening working capital, before allowing it to rise by 24.3% in the first quarter. This could be seen as a tactic to defend margins, explains REL analyst Karlo Bustos, as companies that take advantage of early-payment discounts boost operating margins to counterbalance lower sales resulting from the heavy discounts that pull sales forward.

Of course, not all companies resort to such gamesmanship, and some seasonal businesses expect fourth-quarter surges. Still, 101 of the 145 firms in REL's study experienced fourth-quarter improvements in 2006. Of those, 87% saw working capital deteriorate in the first quarter of 2007. This "addictive and expensive" behaviour distracts employees from the normal course of business, dents margins and alienates suppliers, REL claims.

The mere insinuation of gamesmanship puts CFOs on the defensive, with few willing to speak about it on the record. As one UK-based finance chief notes, boards may be "happy to tolerate it" if it means that employees at least have working capital on their agenda, and understand its importance. "If the awareness is higher than it once was," he notes, directors probably feel they "can live with those spikes."

For its part, REL declines requests to help companies cut working capital to meet a looming year-end target, Bustos says. However, "if we're struggling for cash, then you never know," he jokes.

Read the complete scorecard, showing DSO, DIO, DPO and weighted working capital trends for the past three year-ends.





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