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Too Much of a Good Thing

Working capital is piling up at America's largest companies.
Russ Banham, CFO Magazine
August 1, 2012

The 2012 CFO/REL Working Capital Scorecard
It's one of the most important metrics for gauging a company's efficiency and financial health. So when a new survey of 1,000 of the largest public companies in the United States indicates that their working capital continues to be much larger than is considered prudent, that's cause for concern.

The annual survey, conducted by REL Consulting, reveals an overall lack of sustained working capital improvement among U.S. companies. After a predictable decrease in working capital during the Great Recession, when companies focused more on the balance sheet, working capital performance has leveled off.

Days working capital (DWC) — the number of days it takes to convert working capital into revenue — did decrease marginally in 2011, from 37.7 days to 37 days. But REL downplays the improvement, attributing it in part to the companies' 13% average revenue growth. "To have a 1.9% decrease is a positive, but not by a lot," says Prathima Iddamsetty, senior manager of operations, research, and marketing at REL, a working capital consultancy.

Cash on hand across the group of surveyed companies, dubbed the REL U.S. 1,000, increased by $60.3 billion in 2011, helped in part by companies taking advantage of low interest rates to issue more debt, up by a record $233 billion year-over-year. Those companies now have a staggering $910 billion in excess working capital, including $425 billion in inventory, according to REL. "Way too much cash is being left on the table and not being put toward growth objectives," says Iddamsetty.

There is a wide gulf between top-performing companies in the upper quartile of the survey and median performers. On average, top performers have 49% less working capital tied up in operations, collect from customers more than two weeks faster, pay suppliers about 10 days slower, and hold less than half the inventory than median companies. (The 2012 CFO/REL Working Capital Scorecard shows the best and worst companies in terms of working capital performance in 20 industries.)

The research indicates little sustainability in working capital improvement. Fewer than 8% of companies managed to reduce days working capital over the past three years, and no company surveyed improved all elements of DWC — inventory, receivables, and payables — over the period.

Image links to Global Business Outlook Survey charts

CFOs should care about these results, not just because working capital is a reliable index of efficiency, but because the world is getting more competitive. "When global investors think about where to put their money, they look for where they're going to get the best return for a given amount of risk," says Kevin Kaiser, professor of management practice at INSEAD, the international business school. "Having capital tied up is an inefficient use of their investments. In a world where people have choices about where to send their cash, they're not going to invest it in companies with inefficient working capital practices."

Gains Not Sustained
REL also attributes the modest improvement in DWC to companies doing several things (in addition to the revenue growth already mentioned): collecting faster from customers, getting rid of excess inventory built up during the recession, and tightening production. Although days inventory outstanding fell, the survey indicates that companies turned inventory over slower in 2011 than in the prior year.

"We are more or less back to where we were well before the recession," says Iddamsetty. "The long-term trends indicate virtually no ability to make sustained working capital improvements."

Many companies that improved working capital during the recession haven't continued to do so, says Ashley Sparks, an REL associate. "They made it a priority to get working capital in order, but now they have so much cash they've shifted their focus from the balance sheet to the P&L statement," emphasizing new products and revenue growth, she says.

Overall, corporate efficiency declined in 2011: operating expenses increased by 13%, gross margins decreased by 2.3%, and profitability fell by 0.4%, according to REL. Sparks notes that operating expenses are increasing in tandem with revenue growth — $1.2 trillion and $1.1 trillion, respectively, according to the survey. "Companies are failing to realize the importance of a sustainable, significant, and reinforcing cash flow," she says. "Revenues are increasing, but so are operating expenses. There is a missed opportunity to limit the amount of working capital it takes to generate revenue."

Kaiser notes that poor working capital performance and inferior products may go together. "A company with a poor product will provide better payment terms to customers than its competition — 45 days instead of 30," he says. "It will keep more inventory to provide that product on the spot to a buyer. It will pay suppliers faster to make sure the inventory is full. In effect, its working capital deficiency drives its revenue growth, not the quality of its goods or services. If this keeps up, it will eventually be overtaken."


Hoarding Cash
Why aren't companies putting more energy into their working capital management? "For the most part, they have strong balance sheets, record cash on hand, and record cash flow from operations over the last five years, so they're thinking they'll just sustain things as they are," says REL associate principal Dan Ginsberg. "This is a common, but shortsighted, attitude."

Indeed, cash is still king for the REL U.S. 1,000. This is clearly evidenced by the $60 billion increase in cash on hand and the $233 billion increase in debt in 2011. Over a three-year period, cash on hand was $277 billion and accumulated debt $268 billion.

But using debt instead of efficient working capital management to get more cash into the bank account "comes with a long-term cost: eventually they will have to pay [the debt] down," points out Ginsberg. "They'll also have to generate a return on their existing assets that exceeds the interest rate, which is not what we're seeing."

It's better to tap working capital as a funding source for long-term growth strategies, says Ginsberg. REL Consulting cites top performers in a broad range of industries, leveraging working capital to open up new businesses in emerging markets with growing consumer demand, for instance.

"Top performers have very tight manufacturing timetables and inventory management practices, in addition to strict collections and payment systems that are standardized across all locations," says Michael K. Rellihan, an associate principal at REL. "The cash they generate from this high level of working capital efficiency is then applied to the growth agenda. Long-term, the result is a powerful benefit to the bottom line."

"Only process improvements will provide sustainable cash flow benefits," adds REL's Sparks. "This requires working more closely with customers, getting better information to suppliers, and improving demand forecasting. You need to have an underlying process in place to manage working capital on a day-to-day basis; if not, it will be difficult to sustain."

Kaiser has a similar view: "Building a business with a sustainable competitive advantage insists on working capital efficiency," he says. "They go hand in hand."

Russ Banham is a contributing editor at CFO.


Capital Companies
At these companies, working capital is working well.

Six companies top the REL U.S. 1,000 list in terms of sustained working capital performance: Colgate-Palmolive, Cubic, Cytec Industries, Deluxe, PH Glatfelter, and Watts Water Technologies. These companies either improved working capital performance (days working capital and its three major elements) or sustained it (performance did not deteriorate by more than 5%) each year for three successive years.

Working capital performance is "a critical element of how we define success here," says Bill McCartney, CFO of Watts Water Technologies, a $1.5 billion (in 2011 revenues) global manufacturer of safety and control packages for residential and commercial applications. "Half our growth here has come from acquisitions — 36 in the last 11 years — and we've been able to finance a lot of it through internal cash flows. We've been able to achieve free cash flow in excess of net income the last 4 years, thanks to effectively managing working capital."

Working capital also is a key part of the cash flow metrics at Cytec Industries, where it is linked to employees' annual incentive compensation. The firm established a target to reduce net working capital in 2009 and challenged the workforce to achieve it. "We linked 20% of everyone's bonus to achieving the metric," says CFO Dave Drillock. "They've done it now three years in a row."

The $3 billion specialty materials and chemicals manufacturer did it by segmenting inventory to better track slow- and fast-moving products, hunting down late payers, and extending terms with vendors. "We did things like hiring more collectors and urging them to make proactive phone calls to improve receivables," Drillock says. "That took our days past due from an average of 12 to 15 days to 5. We then extended terms with vendors from 45 days to 60 days, but promised we'd always pay on time. And we decided if a product moves slowly, it should be made when needed, whereas we could build inventory for products with a fast turnover."

"Constantly Chipping Away"
Deluxe, a $1.42 billion provider of marketing tools and web services for small businesses and financial institutions, also has what CFO Terry Peterson calls a "diligent" accounts-receivable process. "After a certain number of days past due, we send a letter and follow up with phone calls to collect the balance," Peterson explains. "We also push customers to receive electronic invoices, which shaves several days off the payment terms. We're also more careful in extending credit to small businesses, we reduced the number of our SKUs, and we enhanced forecasting with a new SAP tool to get our inventory in line."

He adds, "We're constantly chipping away to get another inch of progress."

Like the other top-performing companies, $1.2 billion Cubic keeps close watch on its key working capital metric: days sales outstanding plus days inventory outstanding minus days payable outstanding. "We're a systems integrator for government and transportation, so we don't have products, but when you're in the services business it's all about performance," says John D. Thomas, Cubic's vice president of finance. "You make deliveries on time, you get paid on time."


Cubic also links working capital to senior employee compensation. "Our management's incentive pay has been very good of late because of our high return on net assets," Thomas says. "People are focused when they negotiate contracts, building in terms they can meet and getting advance payments where they can, minimizing the amount of capital used per transaction."

The CFOs were not surprised their companies topped the REL U.S. 1,000. But they can't offer any simple solutions for their poorer-performing peers. Says Drillock, "There's no magic to improving working capital management. The key is not to take your eye off the ball." — R.B.


Working capital best practices


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