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The practice of manipulating working capital in the fourth quarter appears to be alive and well.
Karen M. Kroll, CFO Magazine
May 1, 2008
Last year, when we first took a look at the corporate propensity to prop up fourth-quarter results at the potential expense of the following quarter's performance (see "Fourth and Goal," November 2007), recession loomed on the horizon. Today everyone from Warren Buffett to a bevy of economists to, in fact, CFOs say that the recession isn't just looming, it's here — and it's not leaving anytime soon.
Given that, one might expect companies to direct their attention to activities that offer sustainable financial-performance advantages. Guess again. A subsequent look at 55 companies indicates that fourth-quarter gamesmanship remains a popular corporate pastime.
The analysis, conducted by Atlanta-based research and consulting firm REL, suggests that many companies contort themselves in December in order to improve their working-capital numbers and thus post more-favorable year-end results. For instance, they discount prices to move products, put off vendor payments, or aggressively step up their collection efforts.
Working capital improves in the fourth quarter, only to deteriorate the next quarter, sometimes with a vengeance. Altogether, the 20 companies tracked in this updated REL study — none of which has a seasonal business — improved their working capital by $7.1 billion, or 6.6 percent. However, many of these same firms (which were chosen based on the availability of year-end data at press time) are likely to slide back within the first three months of 2008, in many cases more than erasing their gains. "The underlying processes and culture truly drive quarter-to-quarter habits that offer no true benefits in sustainability," says Karlo Bustos, financial analyst with REL.
One might argue, so what? Isn't a final year-end push standard practice, and perhaps even healthy in providing a rally-the-troops focus? Some go further and point to the realities of the calendar: Praxair says the December holidays may slow sales in the final days of the fourth quarter, depressing accounts receivable, while capital spending rises as projects budgeted for the year are completed, increasing accounts payable. Dow Chemical argues that seasonality influences many apparently nonseasonal businesses, and that hedging strategies, M&A, and other factors all influence working-capital metrics.
REL says its analysis reveals there is often more at work as companies pull out the stops to end on a high note, in the process skewing demand forecasting and antagonizing suppliers and customers.
Fourth-quarter games may also diminish the importance of working capital by treating it as an easily pulled lever rather than as a critical facet of the business. When Minerals Technologies Inc., a $1 billion technology-based minerals-processing company, hired CEO Joseph C. Muscari last year, he made it clear that how the company managed its working capital mattered a great deal. "He recognized that people weren't focused on improving the balance sheet, but were income statement–focused," says senior vice president and CFO John Sorel.
While the company had shown small, consistent quarterly improvements in working capital for the past few years — and without backsliding at the beginning of each subsequent year — it improved by $29 million between the third and fourth quarters of 2007. One reason is that variable compensation for the heads of the company's three business units is now tied to working capital, says Sorel. For instance, the businesses, rather than treasury, are now responsible for following up on delinquent accounts.
For companies interested in breaking out of the year-end quest for a happy ending in favor of consistent gains in working capital, there are a number of steps worth exploring. (For a quick checklist, see "No More Games" at the end of this article.)
Inventory and demand forecasting is a good place to start. For example, measure and report on raw materials, work-in-process, and finished goods monthly or even weekly. Settling for top-level numbers at the end of the quarter leads to overly rosy assumptions, Bustos says. Total inventory may be down, which is generally a positive, as you don't want to hold more than you need, but not if the drop stems from putting off regular purchases until the next year.
It's also helpful to clearly define which products are "make-to-order" and which are "make-to-stock." This helps operations avoid producing goods destined to sit in inventory because demand for a make-to-stock item showed an artificial jump after a price cut. Companies can also review ERP parameters more frequently, including minimum and maximum inventory levels, lead time from suppliers, and the time required to manufacture different items. Salespeople need to know what is and isn't available so they don't make promises the company can't keep. Manufacturing needs an accurate count of products on hand and product lead times so workers know which products should get priority on the manufacturing floor.
REL also recommends having sales and operations folks discuss demand and production capacity at least monthly. "It will change the culture when teams start working together," says Bustos. Many companies wait until a problem crops up with a customer's order, and then the two sides blame each other. If they can talk through expected orders and the company's ability to meet them, customer complaints should be minimized.
While Bustos says that a commitment to improve the processes that drive working-capital levels demands executive leadership, Sorel of Minerals Technologies says success also hinges on "fundamental grunt work." The company's procurement, operations, finance, and treasury teams jointly analyzed its supply chain, assessing everything from what to buy to how and when to pay for it. They also sought to improve quarter-to-quarter consistency by more effectively using their global manufacturing capacity. For instance, confronted with a declining U.S. dollar, Minerals Technologies has been manufacturing more products stateside and shipping them to Europe.
"Today we say that capital is our last line of defense," Sorel says. "We look at our system and see how we can best deploy it."
Karen M. Kroll is a freelance writer based in Minnetonka, Minnesota.
Room for Improvement
Even companies cited by REL for strong year-over-year improvements in working-capital performance seem to mount a fourth-quarter push. Click here to see a listing.
No More Games
To improve working capital year-round, focus on 10 key steps.
• Report operational and management metrics at least monthly for all categories.
• Clearly define classifications for "make-to-order" and "make-to-stock" items.
• Establish a continuous daily process for reviewing ERP inventory-management parameters for factors such as manufacturing/purchasing lead times and safety stocks.
• Use cross-function sales and operations planning process to reconcile demand forecasts with production capacity.
• Align purchasing requirements companywide.
• Manage and monitor suppliers via a strategic procurement framework.
• Negotiate suppliers discounts based on prompt payment terms.
Days Sales Outstanding
• Get credit department involved in negotiations with major customers.
• Segment treatment of customers based on size, strategic value, risk class, and so on.
• Develop an enterprisewide process to address and eradicate disputes.