Corporate Finance

Dollars in the Details

The 1999 Working Capital Survey
S.L. MintzJuly 1, 1999
(Note and link omitted)

As levers of financial management go, none bears more weight than working capital. The viability of every business activity rests on daily changes in receivables, inventory, and payables.

“We focus on all three,” declares CFO and executive vice president Larry Waisanen of building-materials supplier Lafarge Corp., which has logged steady improvement since 1997. Such success is a rare feat, especially for a low-tech, labor- and capital-intensive business.

Improving working capital management is not an arcane science. It comes down to blocking and tackling more efficiently than your competitors. Where companies pay rigorous attention to working capital and help workers see how more efficiency boosts profitability, improvements are generally visible. “We focus like crazy,” declares executive vice president and CFO Bill Brown, of Plum Creek Timber Co., in Seattle, which sells more than half of its lumber to The Home Depot Inc., Payless Cashways Inc., and other big-box retailers. “We’ve tightened up everywhere incrementally, but there is no overarching program.” Plum Timber posted the best overall ranking in the forest products and paper industry.

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The 1999 Working Capital Scoreboard, a joint project between CFO magazine and REL Consultancy Group, a global management consultancy in San Francisco and New York, measures performance by 1,000 public companies that posted 1998 sales in excess of $450 million. Overall results combine cash conversion efficiency (CCE), calculated as cash flow from operations divided by sales, with days working capital (DWC), a summary of unweighted days sales outstanding (DSO). The Scoreboard presents CCE and DWC together with days sales outstanding, days payable outstanding (DPO), and inventory turns for the top 10 companies in each industry. Rankings compare companies against their industry peers and also against the whole field. As before, results measure average working capital over three years of published performance figures.

All told, in the current Scoreboard, 15 industries, or 58 percent of the field, posted better CCE versus last year. This compares unfavorably with the 1998 Scoreboard, when 16 industries improved their CCE. Meanwhile, 15 industries posted better DWC this year. Last year, 14 industry groups reduced their average DWC, 3 stayed the same, and 16 lost ground.

Besides identifying the top 10 managers of working capital in 31 industries, the 1999 Scoreboard highlights areas for improvement. Preeminence in a single category, or even good but less than top performance in two or more categories, propelled many companies to the front of their respective industries. At the same time, these industry leaders often lagged behind rivals in other categories.

Florida Rock Industries Inc., for example, took top honors this year in the building- materials industry, thanks to superior cash conversion efficiency. On average, building- materials companies converted 9.2 percent of sales to cash flow. At Florida Rock, the figure was 14.7 percent. In other words, Florida Rock transformed sales to cash flow with greater efficiency than its competitors.

Meantime, Florida Rock ceded best-in-class to Owens Corning in DWC, to Fluor Corp. in DSO, and to Granite Construction Inc. in inventory turns.

In the electronics and electrical-equipment industry, Hadco Corp. garnered first place by outpacing rivals in DWC and average inventory turns. But Molex Inc. posted the highest conversion efficiency, and Sanmina Corp. recorded the fewest DSO.

Investing in customer relationships helped Plum Creek Timber log exemplary performance in DSO and CCE, reckons CFO Brown. To boost sales through other retailers, Plum Creek recently hired outside consultants to help a customer develop merchandising programs. The customer welcomed the pilot program, which is designed to help boost sales. Benefits, aimed at fattening Plum Creek’s top line, should spill over into working capital by converting days sales outstanding to cash flow much faster than all other manufacturers of forest and paper products. Such attention to working capital helped Plum Creek transform 26.2 percent of net sales to cash flow during the three years through year-end 1998, nearly 10 percentage points above average for its industry.

Champion International Corp., also in forest and paper products, locked up first place in days working capital and average inventory turns. To minimize invested capital, Champion’s distribution arm, Nationwide Papers, has made inventory turns a high priority, says finance vice president Tom Hart. The means to faster turns include good communication between the finance department and the sales force, which now appreciates the dollar value of every inventory turn. With nearly $500 million in inventory, an extra turn adds that much to annual sales. A net profit margin of 1 percent, according to Value Line, means that every additional turn would add $5 million to Champion’s annual earnings.

Lafarge, in Reston, Virginia, has baked working capital goals into its incentive structure, and the effects are dramatic. Although it settled into fourth place behind Florida Rock Industries in building materials, and still falls short of excellence in any one category, Lafarge has moved up the overall rankings by 262 places since 1997. CFO Larry Waisanen attributes improvements to a measurement system that encompasses changes in working capital. “The key financial indicator to judge performance is economic RONA [return on net assets],” he says.

Economic RONA differs from standard RONA calculations because net assets reflect annual reductions in working capital. Because net assets constitute the denominator in Lafarge’s economic RONA (earnings before interest and taxes, or EBIT, supplies the numerator), hefty reductions in working capital can have a big impact on the result. “As people worked through the system and came to understand the levers of success,” Waisanen observes, “working capital became a focus.” Just in case the company’s emphasis on working capital fell on deaf ears, Lafarge links compensation schemes to economic RONA.

Progress shows up most clearly in the company’s western Canadian construction- materials operation, based in Calgary. Thanks to tighter management, this unit slashed working capital by 38 percent, to around $36 million. Meanwhile, sales increased by 10 percent, to $425 million, giving a boost to EBIT. “When you increase the numerator and decrease the denominator, you get magic,” says vice president and controller Pete Sacripanti. He attributes much of this accomplishment to 12 steps that lowered days sales outstanding to 52 days from 64 days in 1997 and also cut down on Lafarge’s bad debt experience.

This improvement caps a three-year program aimed at reducing working capital. In 1996, Lafarge’s western Canadian operation set a 15 percent hurdle for economic RONA and considered it a stretch. In 1997, it raised the bar to 20 percent. Last year, economic RONA exceeded 25 percent, and marked the first time that building products beat the figure etched by the higher-margin cement business.

There are shortcuts to trimming receivables. Some positions on the scoreboard reflect the sale of receivables to factors or through securitization techniques. Cosmetic benefits notwithstanding, Eric Wright, executive vice president at REL, warns against taking these steps without considering the loss of contact with customers at critical points. When problems arise over payment terms, deliveries, financing, or any other issue, retaining customers often depends on service that only a vendor can provide. CFOs concur. “No one will do it with more intensity than we will and also keep an eye on the customer and the bottom line,” says Champion’s Hart. “We have been approached by every service that can provide outsourcing [of receivables],” he adds, “but we have been very reluctant to give it up.”

Zero working capital, a much-talked-about ideal, remains a distant goal for most companies outside the petroleum industry. These companies occupy the top eight overall positions, largely because off-balance-sheet assets, such as oil rigs, generate hefty cash flow. For similar reasons, chiefly leased aircraft, 3 of the top 10 competitors in the transportation group recorded negative working capital. Delta Air Lines Inc. recorded the lowest overall days working capital, at minus 38.8 days. CSX Corp. and Continental Airlines Inc. both posted around minus 12 days.

In other industries, the spirit is willing but competitive circumstances do not foster such scant working capital. Don Sheley, CFO and vice president of finance for Dearborn, Michigan-based auto-parts maker The Standard Products Co., for example, appreciates the case for eliminating working capital. That’s unrealistic, however, for a company smaller than many of its customers and vendors. So, instead of aiming to eliminate working capital, Standard Products works toward matching days sales outstanding and days payable outstanding.

Short of achieving zero working capital, matching receivables and payables neutralizes the company’s investment in inventory. “The closer we can get to matching, the more economical it is,” Sheley says. In calendar 1998, Standard trimmed average receivables to 60.2 days, while extending average payables to 58.1 days, according to REL. This 2-day gap compared favorably with a 16-day gap in calendar 1997.

As such results make clear, there is no “big answer” to improving working capital: just focus on the benefits of improved efficiencies, communicate those benefits to employees, and pay attention to the details.