The 2018 CFO/The Hackett Group Working Capital Scorecard
Companies’ liquidity is at record levels in the United States. According to the 2018 CFO/Hackett Group Working Capital Scorecard, cash on hand for the 1,000 largest U.S. companies rose by a whopping 17%, or $154 billion, in 2017. Much of that increase can be explained by what appears to be an unquenchable thirst for debt (up 10% over 2016), topped up by the liquidity effects of U.S. tax reform.
Under those circumstances, one would expect CFOs to be none too worried about tying up some capital in day-to-day operations — for example, keeping inventory on the books a couple of days longer than necessary. But one would be wrong.
Despite holding huge bundles of cash, many U.S. companies are still pushing hard to be working capital efficient. The cash conversion cycle is the most relied upon metric to determine how effectively a company is converting resources to cash. It consists of the length of time it takes companies to get receivables in the door, (days sales outstanding, or DSO); the length of time inventory is on the books before it’s sold (days inventory outstanding, or DIO); and the length of time a company takes to pay its suppliers (days payables outstanding, or DPO). The CCC equation, of course, is DSO + DIO – DPO.
In 2017, the 1,000 companies in the scorecard reduced their cash conversion cycle (CCC) by 0.8 days, to 36.5 from 37.3, the fifth straight year of improvement.
(The numbers exclude the oil and gas industry because oil & gas “by nature behaves quite different to other industries. Its performance is largely geared toward the price of oil, which is strongly influenced by the decisions OPEC and other oil-producing countries make on production,” according to Hackett.)
Digging into the backstory of the decline in the conversion cycle requires looking at the drivers of CCC performance. As it turns out, looking deeper into shorter cash conversion cycles reveals that companies are not necessarily getting better at collecting on receivables and managing inventory: Instead, for the third year in a row, it was the ability and willingness to lengthen payment terms (and thereby increase DPO) that primarily pushed CCCs lower.
Across the more than 50 industries covered in the scorecard, DPO reached its highest level in 10 years, 57.4 days, up from 53.3 days in 2016. Translation: Many organizations are taking almost two months to pay their suppliers. In contrast, a decade ago DPO clocked in at 40 days.
The flip side of higher DPOs is higher DSOs for suppliers. Sales took slightly longer to transform into cash in many industries. Overall, DSO deteriorated the most of all working capital measures in 2017, rising by 5% to 39.7 days (up from 37.8 days in 2016).
While pushing out supplier terms may not benefit the overall economy and can damage cash-strapped companies, it’s a trend that is not losing any momentum.
Craig Bailey, associate principal in the working capital practice of The Hackett Group, says that at this point lengthy DPOs are driven by a “me too” factor as much as a buyer’s market clout.
“It’s very much a knock-on effect amongst peers,” Bailey says. When company benchmarks its DPO against competitors, the immediate reaction is, “I could do this too and get the same benefits,” he says. Extending DPO has also become a competitive tactic.
“If I’m paying my supplier on very favorable terms, I’m actually financing their ability to offer much more attractive terms to my competitor,” explains Bailey. “So, you see this standardization, where extended terms become the new industry norm.”
Although 2017’s working capital results were impressive overall, many companies are still leaving a lot on the table when it comes minimizing the amount of capital tied up in receivables, payables, and inventory.
For example, the top performers (companies in the upper quartile in their industry) in DPO paid suppliers 3 weeks slower than the median performers did. The top performers in DSO collected receivables 2.7 weeks faster than those at the median, and the companies best at managing inventory held stock on the books for less than half the time that median performers did.
The inefficiency at some companies is evident in in this year’s “working capital opportunity” number — $1.13 trillion. That’s the potential value that subpar performers could capture if they brought their payment, receivables, and inventory management performance up to a level closer to the best performers in their industries. That opportunity number total represents about 6% of the U.S.’s 2017 fiscal-year GDP.
Much gets in the way of efficiency, however. One of the main challenges to capturing that missing value has been consistency. Only a few organizations have been able to demonstrate steady, multi-year working capital improvements. The results of the 2018 scorecard (the CFO/Hackett Group scorecard has been published since 1997) show the attention to working capital efficiency rarely lasts very long.
This year, out of the 1,000 companies, 100 had improved their CCC for the last three years, but only 34 managed to sustain that performance for 5 years. Moving further out, less than 10 companies in the study have kept it up for as long as 7 years. (Story continues below graphic.)
Why do businesses struggle to maintain long-run working capital productivity improvements? It comes down to management diligence and an appetite for change, suggests Todd Glassmaker, director, strategy and business transformation at The Hackett Group.
“Due to low interest rates, companies haven’t necessarily been willing to take on fundamental process improvements to working capital management,” says Glassmaker.
“Also, when companies see a deterioration in CCC, they’re not [always] quite sure why it’s happening or how it’s happening. Companies need to be more rigorous in understanding where their exposure is.” For example, customers may be withholding payments due to disputes and deductions caused by internally controllable issues, such as errors in pricing, discounts, and quantities.
The sustainability of working capital efficiency is also not helped by the increasing volume of M&A deals. Acquirers and their targets often experience post-transaction setbacks in all aspects of working capital management, explains Bailey.
“Organizations are so busy with the post-merger integration that they’re distracted from managing working capital and focusing on the quality of the processes,” he says. “When a company’s working capital position has significantly deteriorated after [a transaction], it’s generally due to very different cultures, processes, and [enterprise resource planning systems] trying to merge together.”
The companies that are suppliers to the participants in a takeover transaction experience knock-on effects. Collections problems tend to arise, for example, “due to new market data, new contacts, and new processes to follow, all of which take time [for the merged company] to set up,” Bailey says.
The way forward to sustained improvements in working capital efficiency is not a mystery.
“Payables are the most natural focus for companies when it comes to optimizing working capital,” explains Shawn Townsend, director, strategy and operations, at The Hackett Group, “however it’s also important that the organization’s supply chain remains stable.”
For companies that have suppliers in need of cash or those that are unable to extend terms further than they already have, CCCs can be reduced by other means, like investing in new technologies designed to streamline the procure-to-pay cycle.
Organizations are also turning to the often ignored domain of inventory optimization to improve their working capital positions. In 2017, overall DIO rose by 2.4% for the 1,000 companies, reaching 54.2 days. The metric has been on a steady upswing since 2014.
“Inventory often comes last for an organization which is just starting to look at working capital, the reason being that payables and receivables are the domain of finance,” says Gerhard Urbasch, senior director at The Hackett Group. “Inventory management is rarely cross-functional, and operations will often be wary to reduce inventory due to the risk of supply chain disruption.”
However, as Urbasch explains, that dynamic is changing.
“What we’re seeing is that organizations with world-class levels of DPO and DSO are now starting to look at inventories, and we expect this focus on inventories to continue to increase,” he says. An inventory focus may hold the most promise for industries that can’t dictate payment terms, like chemicals or commodity producers.
“There are a lot of things that can be done to help offset many of the adverse macro factors that confront such industries,” says Urbasch. Among those “things that can be done”: making sure the business has the right tools for deciding replenishment parameters; improving master data quality; and understanding which products should be made-to-stock versus made-to-order.
“I see many organizations that are not managing this optimally,” he says.
“Inventories are unbalanced, products are out of stock, or excess inventory exists for items that are not needed at the moment. If items are out of stock, then there’s a lost revenue opportunity and a lost opportunity for growth.” In such cases, the cost of excess inventory overall is actually much higher than is reflected in DIO, Urbasch adds.
While 2017 was a year of overall improvement in working capital efficiency, it is clear that the way companies have managed their payables, receivables, and inventories in 2017 may not work in 2018 and beyond.
Forecasting the results of next year’s working capital scorecard is particularly difficult, according to Hackett’s Bailey, as “what we see is a lot of uncertainty going forward which will bring some interesting working capital management challenges.”
Tariff disputes among the United States and its trading partners, for example, threaten to disrupt international sources of supply. That will create uncertainty around inventory holding requirements and, ultimately, lead to a wait-and-see approach around investing in new technologies. In Europe, on the other hand, Brexit could disrupt cross-border trade.
Finally, because global supply chains are still expanding, companies may have to deal with longer lead times and more complexity, says Urbasch.
To keep on top of working capital, especially the inventory piece, organizations will have to improve their use of technology.
“Now we have the internet of things and companies have invested significantly in that technology,” Urbasch says. “But what we see is that even with the new technologies in place, companies are hardly leveraging their ERP systems. So, if they maintain the level of globalization in their supply chain without optimizing technology, as many are doing at the moment, we could probably see an increase in inventory and DIO going forward.”
For companies looking to keep their cash conversion cycles low, the second half of 2018 may be a constant battle. More than ever, having world-class processes in place and managing ongoing performance will be essential.
Ramona Dzinkowski is a business journalist and president of RND Research Group.