Corporate Finance

Barely Working

The availability of cheap debt has reduced companies’ incentive to improve working capital management.
Edward TeachJune 11, 2015

The amount of cash held by America’s largest companies has grown markedly in recent years. For the 967 large nonfinancial public companies in the 2015 REL Working Capital Survey, total cash on hand at the end of 2014 was $932 billion, a 74% increase since 2007 and a 2 point rise as a percentage of revenue, to 8%.

Where did the cash come from? In part from revenues, which grew 39% since 2007, according to REL, a working capital consultancy and division of The Hackett Group. But companies also generated cash by issuing debt, taking advantage of historically low interest rates. All but 219 companies in REL’s survey increased their debt since 2007, and 328 did so by 100% or more. Overall, debt for the survey companies rose by 62%.

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The ability to raise cash through cheap debt has reduced companies’ incentive to release cash tied up in working capital, says REL. “Apathy is a strong word, but we are generally seeing it regarding working capital management,” says Derrick Steiner, a senior manager at REL. “Companies are saying, why should we do all this hard work improving our processes, when we can just go to the market and get cash today, at a very low interest rate?”

The apathy shows up in working capital measures. Last year, the cash conversion cycle (CCC), a measure of overall working capital performance, improved by just 0.7 days, or 2%, for the companies in the survey. “The cash conversion cycle is really deteriorating in those companies taking on the most debt,” comments Craig Bailey, a director at REL.

Meanwhile, the components of working capital were essentially static in 2014. Days inventory outstanding (DIO) improved slightly, falling from 43.2 to 43.1 days; days payables outstanding (DPO) deteriorated, falling from 46.8 to 46.4 days; and days sales outstanding (DSO) improved by one day, falling from 37.4 days to 36.4 days.

Even the 2.7% improvement in DSO was mostly the result of a one-time improvement in the oil and gas industry, which accounts for 14.7% of total revenues for companies in the working capital survey. (By the same token, DPO performance would have improved by 1.4% had the oil and gas industry’s results been excluded.)

The Trillion-Dollar Opportunity
When credit is cheap and plentiful, why should companies care about generating cash from working capital? For one thing, any money unnecessarily tied up in inventory, receivables, and payables is money that could be invested in the business or returned to shareholders. REL reckons that if all 967 companies in its survey operated with the same efficiency of the top quartile in their industries, they could release $1.054 trillion tied up in working capital.

15Jun_WorkingCap_JumpBoxOf that eye-popping amount, inventory represents the largest opportunity ($375.5 billion), followed by accounts payable ($373.6 billion) and accounts receivable ($304.4 billion). Companies in the upper quartile of REL’s survey hold less than half the inventory of the median company, while paying suppliers more than two weeks slower and collecting from customers more than two weeks faster (see “Performance Gaps,” below).

Another reason companies should care about working capital efficiency is that sooner or later interest rates will rise, making debt less attractive. Cash extracted from working capital doesn’t have to be repaid and doesn’t add leverage to the balance sheet. The 219 companies in REL’s survey that reduced their debt since 2007 also improved their cash conversion cycles by an average of 31% over the same period, thus increasing cash on hand. By comparison, companies that increased debt by 100% or more since 2007 saw their CCCs lengthen by 113%.

Unfortunately, persistence in improving working capital management wanes. “The weeds grow back,” says Steiner. Only 96 companies improved their CCCs each year over the last three years, while only 20 did so over the last five years.

And since 2007, just five companies in REL’s survey improved their CCCs every year: AmerisourceBergen, Diebold, EQT, Goodyear Tire & Rubber, and Masco. Their cash on hand during that period grew by an average of 293%, compared with a 74% overall increase for the companies in the survey; their cash as a percentage of revenue grew by 9%, compared with 2% overall; and their debt grew by 41%, compared with 62% for all survey companies.

Industry Specifics
Ironically, Diebold appears as a worst performer in the 2015 CFO/REL Working Capital Scorecard, which lists the best and worst working capital performers in 27 industries (see the scorecard here). The company improved its cash conversion cycle by “only” 5 days last year, to 80 days. That was well above the 30-day median for the technology hardware, storage and peripherals industry and far above the best performer — Apple, whose negative CCC of -56 days means that customers pay it long before it pays its suppliers. Overall, the industry’s average CCC improved by 8 days in 2014, to 29 days.

15Jun_WorkingCap_p26Of course, working capital performance is industry dependent; service companies typically have little or no inventory, and every industry faces external influences and market shifts that can affect working capital performance. For example, the overall CCC for the personal products industry increased (that is, deteriorated) for the second year in a row, by seven days. In part that was because of retailer consolidation, which affected DSO by reducing the negotiating power of supplier companies, says Craig Bailey. Also, the 5% increase in DIO for the industry was driven in part by companies producing inventory to meet demand that didn’t materialize, points out Dan Georgescu, a senior consultant at REL.

The sharp drop in oil prices in the second half of 2014 lowered the value of receivables in the oil and gas industry, while the harsh winter at the beginning of the year affected receivables in construction and engineering, delaying work and causing DSO for the industry to rise to its highest level in 10 years. On the other hand, the same winter weather caused DSO to fall 12% at gas utilities, due to an increase in demand affecting revenues, notes Bailey. That led to an average 15% improvement in the CCC for the sector.

Of the 58 industries in REL’s survey, the technology, hardware, storage and peripherals sector improved CCC performance the most in 2014, by 186%, followed by biotechnology at 26%. Diversified consumer services and autos saw the biggest changes for the worse in their CCCs, which deteriorated 51% and 22%, respectively.

From DWC to CCC
The use of the cash conversion cycle in this year’s working capital survey represents a significant change in methodology. Previously, REL used days working capital to assess overall working capital performance, but access to a more extensive data set has enabled it to switch to the CCC, which measures how long it takes companies to convert inventory and other resource inputs into cash.

Whereas days working capital uses revenue to assess inventory and payables, the cash conversion cycle relies on cost of goods sold (see “How Working Capital Works,” here). “In our view, cost of goods sold has a closer relationship to inventory and payables than revenue does,” says Bailey. The cash conversion cycle “gives a more accurate expression of the number of days that cash is locked into a business” and is a more widely recognized measure of working capital performance than days working capital, he says.

One thing remains the same: whether measured by the cash conversion cycle or by days working capital, working capital is potentially a significant source of cash at many companies. Whether they can summon the will to tap it is the question.

Edward Teach is editor-in-chief of CFO.