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Capital Ideas: The 2005 Working Capital Survey

Despite cheap credit and surplus cash, companies still find plenty of reasons to improve operational efficiency.
Tim Reason, CFO Magazine
September 1, 2005

What's dumber than a box of hammers? For home-improvement retailer Lowe's Cos., it's the same box sitting on "high steel," the storage shelves that tower over every aisle, out of reach of customers. "If stock is on high steel, in a back room, or in a distribution center, then it's not in sellable position," says Robert Hull, CFO of the Mooresville, North Carolina–based company.

Sellable position is an obsession for Hull, who measures inventory turnover on a weekly basis. For Lowe's, as with most retailers, inventory is the most critical element of working capital. At first glance, then, it seems surprising that CFO's annual working capital survey, conducted by Purchase, New York–based REL Consultancy Group, showed Lowe's with a 10 percent increase in days inventory outstanding (DIO). That caused the retailer's overall days working capital (DWC) to soar 24 percent, to 60 days, and dropped Lowe's — one of the top performers in its sector in our previous survey — out of the first quartile of specialty retailers.

But as it turns out, Lowe's numbers are a good sign. Inventory spiked in 2004 because the company maintained historical levels of "safety stock" in its stores even as it increased the amount of products at its regional distribution centers. Lowe's did that because it didn't want any customers going away empty-handed during an initiative to increase reliance on that network of distribution centers. The initiative's goal: less backup inventory in stores, and replenishment from distribution centers in three-and-a-half days instead of seven. Ultimately, Lowe's R3 (for "rapid response replenishment") initiative will mean less inventory overall, and more of the remaining stock where customers can see it. "We manage the business for the long term," remarks Hull. "We'll take a short-term blip in a metric."

"[We] have taken a conservative approach," explained Lowe's 2004 annual report, "by adding inventory to our distribution network without lowering inventory levels in our stores." Most of that safety stock has been removed from stores since, says Hull, and inventory levels have already dropped in the first quarter of this year.

"For retailers, inventory turnover and customer service are obviously conflicting objectives," observes Stephen Payne, CEO of REL. Lowe's move, he says, "makes perfect business sense. Lowe's is using inventory as a strategic lever. It knows its initiative will drive out that excess inventory — and more — once it's up and running."

Why Working Capital Matters
Lowe's is not alone. The 2004 annual reports of many U.S. companies, including Gillette, KLA-Tencor, McGraw-Hill, and Wal-Mart, as well as European firms such as France Telecom, Saint-Gobain, and Sainsbury's, mention initiatives aimed squarely at reducing specific elements of working capital. At health-sciences firm Perkin-Elmer Inc., some 10,000 employees have received training in "compressing the cash cycle," says director of global processing Frank Giammarco.

One might ask why working capital matters when debt is cheap and companies are awash in cash. Companies these days are urged to deploy cash, not squeeze more of it out of daily operations. But even as our survey shows hints of growing capital expenditures, working capital remains top of mind for many CFOs. Indeed, continued working capital improvement — or even a controlled, temporary deterioration — can ultimately drive growth.

Zebra Technologies Corp., a manufacturer of bar-code-label printers, for example, keeps a tight grip on working capital even though it holds almost a year's worth of revenues ($663 million last year) in cash. "Working capital is important because it is the funding mechanism for future growth," explains vice president and controller Todd Naughton. "We think of ourselves as an acquirer. Managing working capital gives us the currency to do that." The company, which has no debt, has completed three cash acquisitions in the past three years and, with $500 million in revenues in 2000, bought back $100 million in stock.

Zebra does much of its business through resellers. That makes receivables the crucial working capital element. The company keeps resellers, often privately owned and thinly capitalized, on tight credit limits and terms. "We want top-line growth and we don't want write-offs," explains Naughton. "If we give a reseller a $300,000 credit limit and it pays us every 30 days, it can do $3.6 million a year [in sales]. If it pays us in 60 days, it does half that. By keeping the reseller to terms, it turns its account more frequently and we do more total business."

Likewise, he says, "when people start missing terms, accounts go bad quickly." By considering days sales outstanding (DSO) an early warning sign, he says, Zebra has kept its bad-debt expense at less than half a percent of revenue.

Naughton also argues that well-managed working capital can be a competitive advantage. "At 90 days of DSO, one of our competitors is probably at the limit of risk it can tolerate," he explains, "whereas if we are at 45 days, we can take a little risk on extended terms or extra credit limits if we have a good feel for a deal. A company stretched to the limit on its working capital can't do that."


"Working capital is a very good barometer of operational efficiency," says Payne. "Yes, companies are awash in cash, but most of it comes from reducing cap ex. But if working capital deteriorates, the company is probably not focusing on the core of its business."

At Whose Cost?
Overall, companies in our survey (excluding the automotive industry) continued to reduce their DWC, but at a slower rate (2.5 percent) than in last year's survey (4.2 percent). "It looks harder and harder to deliver on working capital performance," notes REL's chief financial analyst, Marc Loneux, who compiled the survey. At the same time, he says, "the decline also suggests that management focus is switching from the balance sheet back to the P&L as companies try to grow EPS and revenues."

Of the 78 industries surveyed, 55 improved DWC — up from 45 last year. But while more showed gains in payables (51 versus 35), the number of sectors improving receivables fell from 47 to 43. Inventory results also deteriorated, from 52 industries last year to 42. That's unfortunate; although delaying payables delivers a quick boost to cash, the resources payables represent are generally the least valuable portion of the cash tied up in working capital. Raw materials are worth less to a manufacturer than work in process or the finished product. A similar increase in value holds true for nonmanufacturers — the total value of airline tickets, for example, should be worth more than the airline pays out in fuel and other costs. "You get a bigger bang for your buck improving receivables or inventory, because they are worth more," notes Payne.

While companies may be managing supplier relationships more effectively, the widespread rise in days payables outstanding (DPO) suggests more companies are simply squeezing their suppliers through delayed payments or tougher terms. That can hurt a company in the long run, as suppliers raise prices to cover the cost of financing the goods.

Improving working capital on the backs of suppliers is usually counterproductive, argues Martin Jarvis, head of global sales and operations for consumer-products giant Unilever. Extending DPO, he says, could mean "trying to extract credit from olive growers in Spain who produce olive oil." That's absurd for a company with Unilever's access to capital. Even worse, he says, "one of the more obvious things that happens if you push on working capital blindly is that sister companies stop paying each other. That improves their numbers, but does nothing for the overall working capital of the company."

Forcing suppliers to hold inventory can also be self-defeating, even though it is cheaper to have more raw goods than finished products in the supply chain. "A supplier's cost of capital is actually going to be greater that Unilever's," explains Jarvis. "So by putting inventory back in its hands, you're probably costing yourself money." Not only are suppliers likely to raise prices, but the supply chain as a whole will still be carrying excess working capital.

At Unilever, a shipment of tea bought at auction in Kenya, Sri Lanka, or Indonesia might change hands three or four times before finding its way into Lipton tea bags or the iced-tea formula brewed in Ireland by UK-based Lipton Ltd. Along the way, it passes through both independent suppliers and Unilever companies. Historically, each supplier was urged to reduce working capital. "At each stage," recalls Jarvis, "companies would try to get the unit upstream or downstream from them to carry their working capital."

Today, says Jarvis, Unilever focuses on reducing working capital for the entire supply chain. "In the total chain of stock, ownership becomes secondary," he says. That means sharing information and resources. For example, Unilever works with its Kenyan bankers to make sure its independent tea suppliers have access to credit at Unilever rates. The result? According to Unilever's calculations, working capital fell 40 percent, or about $2 billion, from 2001 to 2004. "It's in everybody's interest to lower the total amount of working capital," says Jarvis, "but you need a fairly mature relationship to do that."

Tim Reason is a senior editor at CFO.


Top Performers
Companies with substantial year-on-year reductions in DWC (%)
2004 2003
3M -7 -12
Boeing -13 -5
Dell -1 +7
Gillette -12 -15
Heinz -16 -19
HP -16 -20
Motorola -28 -13
Wal-Mart -1 -25
Source: REL Consultancy Group


Best and Worst
Changes in DWC (% by industry)
Most Improved
Aerospace and Defense -8
Broadline Retailers -4
Computers -13
Containers and Packaging -12
Cosmetics/Personal Care -7
Food Retailers and Wholesalers -15
Major Oil Companies -10
Worst Deterioration
Air-freight Couriers +13
Construction +12
Pharmaceuticals +1
Soft Drinks +4
Telecommunications +6
Source: REL Consultancy Group

Slowing Down
U.S. and European companies demonstrated similar, slowing levels of working capital improvements.
COMPANY DSO
2004 Change 2004-2003 Change 2003-2002
Total U.S. (excluding automotive) 40.9 -1.0% -3.7%
Total U.S. 50.8 -2.5% -3.5%
Total Europe (excluding automotive) 50.9 -1.7% -1.9%
Total Europe 61.1 -1.1% -0.2%
COMPANY DIO
2004 Change 2004-2003 Change 2003-2002
Total U.S. (excluding automotive) 30.7 -1.5% -2.9%
Total U.S. 30.5 -1.2% -2.7%
Total Europe (excluding automotive) 33.7 -1.4% -3.2%
Total Europe 34.7 -1.3% -2.3%
COMPANY DPO
2004 Change 2004-2003 Change 2003-2002
Total U.S. (excluding automotive) 28.1 0.8% -2.0%
Total U.S. 28.8 0.9% -1.4%
Total Europe (excluding automotive) 40.7 0.4% 0.6%
Total Europe 41.2 0.2% 0.9%
COMPANY DWC
2004 Change 2004-2003 Change 2003-2002
Total U.S. (excluding automotive) 43.5 -2.5% -4.2%
Total U.S. 52.5 -3.6% -4.1%
Total Europe (excluding automotive) 43.9 -3.3% -5.1%
Total Europe 54.6 -2.2% -2.3%
Source: REL Consultancy Group


How Working Capital Works

Day Sales Outstanding: AR/(net sales/365)
Year-end trade receivables net of allowance for doubtful accounts, plus financial receivables, divided by net sales per day.

A decrease in DSO represents and improvement; an increase indicates a deterioration. On the chart, companies marked with an asterisk have securitized receivables, which can artificially improve DSO without changing actual cash-to-order processes. The survey eliminates this distortion by adding the receivables back on the balance sheet before calculating DSO.

Days Payables Outstanding: AP/(net sales/365)
Year-end trade payables divided by sales per day.*

An increase in DPO is an improvement, a decrease is a deterioration. For purposes of this survey, payables exclude accrued expenses.

Days Inventory Outstanding: inventory/(net sales/365)
Year-end inventories divided by sales per day.*

A decrease in DIO is an improvement, an increase is deterioration.

Days Working Capital: (AR + inventory - AP)/(net sales/365)
Year-end net working capital (trade receivables plus inventory, minus AP) divided by sales per day.

The lower the number of days working capital, the better. On the survey table, a DWC change of -X% reflects an improvement (even if DWC itself is negative), while a DWC change of + X% reflects a deterioration. The percent 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. REL Consultancy Group, which conducts CFO's survey, uses net sales across each working capital component to allow a balanced comparison across each DWC element and provide true comparisons between industries. Reported sales have been adjusted for acquisitions and disposals during the year.




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