Cash Management

Scrubbing the Numbers

Cleaning up the balance sheet boosts year-end cash flow, but it can leave some messy problems.
Tim ReasonMarch 8, 2004

The holiday season is not a happy time for many finance executives. While others attend parties and eat turkey, finance departments in companies with a calendar year-end often spend the two months between Halloween and New Year’s Eve frantically ducking check requests, dumping inventory, and chasing collections. The goal: a pretty cash-flow picture on December 31. Finance teams whose final quarter falls in other months may get to enjoy their holidays a bit more, but none of them escapes the annual scramble at fiscal year-end.

One of the easiest ways to beautify cash flow is by reducing days of working capital—a measure of how much of a company’s cash is tied up in payables, receivables, and inventory. Indeed, companies that consistently lower their overall working capital year-over-year are admired as best-practice leaders. But a look at several years of sales adjusted quarterly working-capital numbers, conducted for CFO magazine by London-based REL Consultancy Group, shows a widespread pattern: across industries, net working capital drops dramatically in the last quarter of the fiscal year, only to shoot back up once the annual report has gone to press.

Whether that swing is the result of a deliberate effort, a side effect of other year-end pushes, or a little of both, the upshot is that most corporate cash flows look better on the last day of the fourth quarter than they do at the end of the first, second, or third. While not illegal, such window dressing can be misleading. After all, many of today’s investors, already well aware that earnings tend to spike at the end of the fiscal year, now consider cash flow to be a more reliable measure of company performance.

Enron, of course, proved that cash-flow numbers are not immune to manipulation. But even without outright fraud, it appears that year after year, Corporate America manages its cash flow by adjustments to working capital—delaying payments to vendors, stepping up collection efforts, allowing inventory levels to fall, or some combination of the three. And beyond the potential for misleading investors who focus on cash flow, the annual seesaw in these numbers suggests companies actually could do a better job of managing working capital year-round.


Neri Bukspan, chief accountant for Standard & Poor’s rating service in New York, is cautious about drawing conclusions from REL’s results. While the numbers are “interesting,” he says, he notes that many year-end events can affect working capital. For example, he says, a company may keep a collection effort open until year-end tax time forces it to write off the effort for a tax deduction. And, he says, attempts to optimize inventory tend to happen periodically—once a year—so “it makes sense to get rid of most of it before you count.” Companies may also delay purchasing if their warehouse employees are busy counting what’s already there. “There are certain things you do once a year because it’s inefficient to do them every day,” he argues. “You clean the house before Christmas.”

And housekeeping at one company often affects working-capital components at another. Joan Channell, director of accounting services for Toledo, Ohio-based Owens-Illinois Inc., which makes plastic and glass packaging, notes that some of its brewery customers shut down their plants at year-end, because the short holiday weeks in December are a good time to schedule filling-line maintenance. “That schedule, in turn, affects the numbers for Owens-Illinois’s beer-bottle business,” says Channell, because it reduces sales while collections from earlier periods continue. “If the payment terms with that customer are relatively short, we can have a low AR balance [on December 31]. This is a significant goodie that happens at year-end for us.”

Nowhere is the impact of year-end goodies more pronounced than among companies dependent on holiday sales. In 2002, the toy industry, for example, showed a sales-adjusted 42 percent decrease in inventory—a major influence on working capital—during the make-or-break Christmas season.

In fact, when the retail clothing, household appliance, and toy industries are excluded from our survey analysis, the average percent decrease or increase in net working capital is cut in half.

The Seesaw

Steve Payne, REL’s chief executive officer, argues that U.S. companies still tend to leave far too much for year-end housecleaning. Even excluding seasonal businesses, a strong pattern of last-quarter improvements and first-quarter deteriorations is still evident. Better continuous management of payables, receivables, and inventory, he argues, would go a long way toward minimizing the financial equivalent of giant dust bunnies under the bed. Indeed, he says, REL is often approached by potential clients looking to improve working capital in order to boost fiscal year-end results. “It’s pure short-termism,” he says, and the numbers suggest that it’s a corporate habit that varies only by degree.

Particularly remarkable is how symmetrical the swing is from one fiscal year to the next (see our chart on “The 10-K Sway“). From their third to fourth quarter of 2000, companies in 20 industries examined by REL reduced their net working capital by an average of 6.7 percent, then wiped out those gains with a 7.9 percent increase in the first quarter of 2001. A 4.8 percent reduction at the end of 2001 was offset by a 6.6 percent first-quarter 2002 increase. Net working capital dropped by 4.8 percent again at the end of 2002, only to tick up 5.2 percent in the first quarter of last year. (As this article went to press, most companies were still releasing their 2003 year-end results.) In specific industries, the numbers were sometimes much higher—as high as 50 percent in some cases.

Cheryl Beebe, vice president of finance and corporate treasurer at Corn Products International Inc., based in Westchester, Illinois, says she hopes such year-end games are decreasing. “With the changes in corporate governance, and the scrutiny put on companies with regards to the quality of their financial reporting,” she says, “my perception is that there will be less and less of this year-end push.”

Annual Pay

Indeed, given the scrutiny of financial results each quarter, it may at first seem curious that it would be worth fiddling with fiscal year-end results. What, after all, is so special about the fourth quarter? New regulations now require faster financial reporting year-round. And investors and analysts have long been skeptical of annual reports that are as much gloss as glossy.

But there are important differences between 10-Q quarterly Securities and Exchange Commission filings and the annual 10-K. Most significant, quarterly results are not audited. And since the focus of quarterly results tends to be on earnings, there are subtle differences in the amount of detail provided on the balance sheet. Indeed, the quarterly financial announcements made directly to the public sometimes do not provide a balance sheet at all.

Greater balance-sheet detail also makes year-end results the numbers of choice for all kinds of marketwide studies of corporate performance—including CFO magazine’s own annual working- capital survey. For example, Johnson & Johnson, a first-quartile working-capital performer in a survey CFO published last September, reduced its 2002 working capital by 3 percent over 2001—a modest improvement. But a quarter-by-quarter look at the company shows that the firm reduced its days working capital in the last quarter of 2002 by 20 percent—only to jump back up by 19 percent during the first quarter of 2003.

The most significant driver of year-end bumps, however, is compensation. “You get the behavior that you reward,” notes Beebe. Before Corn Products instituted a working-capital management program in 2002, she says, “managers’ bonus payments were focused on the income statement and delivery of operating income.” Unfortunately, she says, that meant managers didn’t have to worry about the cost to the company of holding an overdue receivable. “In some cases, your financing costs could be higher than your profit margin.”

Corn Products fixed that by tying 20 percent of each manager’s bonus to working-capital targets and providing education and training. “It’s not some corporate geek at headquarters dictating the decision,” says Beebe. “If it is a more-appropriate decision for a manager to make the sale and carry the receivable or carry inventory, they can make that decision, but they will be rewarded for their operating income and penalized for their working capital.”

More important, however, is that Corn Products’s bonuses are based on a 12-month average of total working-capital days. That helps ensure that working- capital decisions aren’t swayed by the year-end reckoning. Notes Beebe: “We weren’t looking for window dressing; we were looking for long-term continuous gains.”

“Economic value is infinitely more important than year-end optics,” echoes Owens-Illinois controller Ed White, who began a working-capital improvement program in late 2000 by revamping the accounts-receivable department. “This is not a fad,” declares Channell, who runs the working-capital initiative for White. “We are looking for continuous improvement.” Like Corn Products, Owens-Illinois tracks working-capital metrics on a monthly basis and ties them to incentive compensation.

In fact, working capital is increasingly a part of compensation packages. At IBM, says treasurer Jesse Greene, business units that miss working-capital targets have their results—and, ultimately, a portion of their bonuses—docked by the cost of capital. Basing compensation in part on working capital is, in fact, a way for companies to move incentive compensation closer to such core financial measures. “Ultimately, we will be holding managers accountable for return on capital employed,” says Beebe. “Our working- capital effort is an element of that.”

Short Term, Long Term

Of course, as more incentives are based on working capital, it is important for companies to put in place permanent process improvements. At Owens-Illinois, for example, overly generous payment terms and discounts were brought under control by educating the sales force “that it all adds up,” says Channell.

Moreover, the company used the lessons it learned from its receivables department and applied them to payables, even cross-promoting a credit analyst from the AR department to an accounts-payable manager. “We took all the good things we learned in receivables and applied them to payables,” says Channell. Extending payables, says REL’s Payne, is best accomplished not by delaying payments, but by collaborating with suppliers. Vendors are usually willing to negotiate favorable payment terms if they are confident that the customer will stick to those terms. “Suppliers want consistency,” he notes.

Without such process improvements, companies are likely to continue to see wide swings in working capital, notes Payne. He also speculates that the year-end ups and downs are increasingly the result of poorly conceived incentive plans. Either way, he argues, companies that regularly do a fair amount of housecleaning at year-end are causing themselves unnecessary stress as well. “It creates a vicious cycle,” he says, since investors compare the company year-over-year. “Unless you do something substantial to permanently fix your working-capital processes, you’ll be compelled to jump through those hoops every year.”

And while avoiding year-end stress is as good a reason as any to break out of this cycle, there can be other, more-serious financial consequences of such tricks as delaying a payment until the next fiscal year. “If you consistently screw them over at year-end,” warns Payne, “vendors will build the cost of carrying that capital into their pricing models.”

Tim Reason is a senior writer at CFO.

The online tables for “Scrubbing the Numbers” feature an overview and a browsable version of all 21 industry sectors included in the magazine.
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To ask questions about REL Consultancy Group’s methodology, or to benchmark your own company using the REL methodology, visit

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