The 2017 CFO/Hackett Group Working Capital Scorecard
Cash is the lifeblood of a company, so managing short-term assets and liabilities to a strong working capital position is one of the things a company has to be great at. After all, efficiently managing cash leads to higher liquidity and a reduction in the debt and equity needed to sustain operations.
Therefore, it’s good news when a company’s cash conversion cycle (CCC) — the amount of time it has cash tied up in working capital — shrinks. That’s exactly what happened overall for America’s largest companies in 2016, according to this year’s CFO/Hackett Group Working Capital Scorecard.
The CCC for the 1,000 largest nonfinancial U.S. companies surveyed by The Hackett Group fell by 1.4 days in 2016, to 35.7. Excluding the still ailing oil and gas sector, which represents about 10% of the Hackett 1,000’s revenue, the improvement was even better—a decline of 2.7 days.
But when examined closely, large companies’ working capital performance is not as stellar as the CCC number suggests. First, with sales in the global economy relatively healthy and the cash to pay receivables plentiful, an improvement over a very mediocre performance in 2015 was almost expected. And despite the downtick in days, the CCC in 2016 was still relatively high. It was at nearly the same level in the depths of the Great Recession, when banks pulled company credit lines and businesses put off payments to suppliers in order to stay liquid.
The second reason the overall CCC improvement invites skepticism is that the trends in the components of working capital — days sales outstanding (DSO), days payables outstanding (DPO), and days inventory outstanding (DIO) — reveal a disconcerting trend: a degradation in DSO performance, a slight deterioration in DIO, and an improvement in DPO. In short, companies were less efficient at managing their inventory and receivables in 2016, but they took longer to pay their suppliers.
The takeaway? For many finance chiefs of large companies, freeing up the billions of dollars of cash they have tied up in working capital is not a priority in this economy. And why would it be? The Hackett 1,000 had $921 billion in cash on hand at the end of 2016, a collective 71% increase since 2008. A 7.3% increase in outstanding debt last year, to $5.1 trillion, helped fuel the buildup.
“Increasingly, companies say working capital is not a focus, because cash is so cheap,” says Veronica Wills, associate principal and North American working capital practice lead at Hackett. “For some companies, cash debt financing is almost free compared with inflation, so for them [working capital] is not a burning platform.” In other words, as of the end of 2016, large companies’ working capital wasn’t working nearly as hard as it could have been.
Pushing Out Payables
One element of working capital has received some scrutiny from companies, according to the survey: days payables outstanding. In 2016, for all industries DPO increased 7.6%, from 49.5 days to 53.2 days. A longer DPO means a shorter cash conversion cycle. (See “How Working Capital Works.”) DPO has been on an almost steady climb since 2009, as many market-leading large companies have extended payment terms to at least 60 days and sometimes up to 90 to 120 days.
Stretching payables so long can destabilize suppliers’ finances, and it’s also the easiest way for a large company to improve its working capital numbers. Delaying payments requires no optimization of processes or operations management buy-in. But since the trend has been occurring for a few years, some companies may not be doing it to improve their working capital position as much as to “stabilize [working capital] and counter any impacts of payment term extensions being pushed onto them,” says Craig Bailey, a senior director at Hackett.
Companies that don’t make their suppliers finance their purchases with longer payables periods may be at a competitive disadvantage, says Scott Pezza, director of financial supply chain research at SAP Ariba. “Buyers using net 30 keep suppliers healthy, which benefits other buyers who have extended those same suppliers to net 90,” Pezza explains. “The ‘extenders’ gain the dual benefits of a healthy supply chain and their own bolstered working capital.”
Buyers also triple payment terms as a gambit: when a supplier is moved to net 90, based on Pezza’s observations, they’re more likely to agree to an early payment discount than those suppliers that are already at net 90. “Extending terms … is a means to make accepting discounts more palatable,” Pezza says.
But large companies aren’t deserting their suppliers, either. In parallel with lengthening payment terms, they are injecting liquidity through supply chain finance (SCF) programs, says Shawn Townsend, a Hackett Group director. In such programs, the supplier sells its receivables prior to maturity to a designated financial institution. The supplier has to take a discount to get paid more quickly, but the discount is based on the buyer’s credit strength, not the supplier’s. In addition, the discount is lower than that paid to sell a receivable on an open market, says Townsend.
But here some companies may have been making a mistake in the last couple of years, says Hackett’s Wills, by jumping to supply chain financing prematurely, in part because banks are pushing the programs heavily.
“SCF programs should be part of an overall integrated strategy, but they should come toward the back end,” Wills says, after a company has done other things to improve DPO. These other steps include eliminating early payments to suppliers; changing the payment due date to the date an invoice is received instead of the date printed on the invoice; renegotiating payment terms; and optimizing payment run frequency.
By moving to supply chain finance before optimizing payment strategies, a company “is getting a similar result [in DPO] at great expense,” she explains, “because it is sharing the benefit with the bank. It’s almost an artificial way of improving working capital.”
Echoes Townsend: “Fix your internal processes first, then consider a supply chain finance program.”
The flip side of DPO, of course, is days sales outstanding, and here, the trend is unhealthy. Overall, DSO increased in 2016 by 1.9 days, or 5.3%, to 38.2 days. That’s the apex for DSO in the Hackett Group survey in the past 10 years. While the increase in DPO plays a part in companies getting paid later, presumably most of the largest 1,000 companies have the leverage to force customers to adhere to net 30 terms. But at this point in the economic cycle, they may also be extending credit to less creditworthy customers or negotiating looser terms to increase sales.
Internally, there is plenty companies can do to improve DSO performance, including more stringent credit analysis, faster invoicing, and tighter collection policies.
The upper quartile of U.S. companies in the Hackett universe had a DSO of 28 days in 2016, compared with the overall median of 45.6 days. The total accounts receivable improvement opportunity — defined as the amount of cash that could be freed up if all the companies in Hackett’s survey performed at the level of the top quartile in their industries — stood at $323 billion.
Wills cautions CFOs against “taking their eyes off the element of financial control” that DSO represents. “If you negotiate terms to make a sale, when times do get tough again, or maybe you want to invest in an acquisition and suddenly need bigger cash reserves, you can’t take those terms away from your customer,” she says. And if a company decides it is going to be lax on payment terms because of an abundance of liquidity, “to reverse a change in customer behavior can take years of optimized collections strategy to bring the [customer’s] behavior back to ‘good.’”
Finally, if a company is publicly traded, market analysts are constantly monitoring its DSO numbers. “Companies can’t artificially make their accounts receivables look good,” Wills says. “If I want to see how well a company is managing its cash, I’m going to look at DSO, and that’s going to tell me how much control they have.”
Of the three pieces of working capital opportunity, the largest is inventory, at $412 billion. Including the oil and gas industries, DIO lengthened 0.3 days in 2016, to 50.6; without oil and gas, DIO fell 0.8 days, to 53.0. That performance compares with a DIO deterioration of 2.6 days in 2015. Inventory is the most complex area of working capital to manage, and “the benefits can take longer to run down,” says The Hackett Group’s Bailey. Improvements don’t show up on the bottom line for two to three years. In addition, DIO improvement “can never be led just by finance, in the way DSO and DPO can,” Bailey says. “It really requires a cross-functional approach and buy-in.”
Many factors have raised DIO the last few years, including the troubles U.S. companies had forecasting when consumer demand would rebound following the Great Recession. “Generally most organizations were expecting demand to pick up earlier than it did,” Bailey says.
The 2015 port strike in Long Beach, Calif., has also had a long-lasting effect, as many companies had stocks stranded and as a result decided to institute a practice to keep inventory buffers higher. “The obvious reaction was, “We’re going to hold more inventory, we’re going to stock more inventory into the pipeline to rebuild customer confidence but also in case this happens again,’” Bailey says.
The sourcing of goods to western China, Bangladesh, and Vietnam over the past few years has also extended lead times for companies. The question now is whether large U.S. companies are starting to burn off some of the excess inventory that has accumulated during that time, says Bailey. The truth is it’s hard to tell, he says, although some industries have had isolated success.
For example, the Internet catalog and retail sector, which includes Wayfair, Amazon.com, and Overstock.com, saw DIO fall about 5 days in 2016. These retailers are “pushing for suppliers to deliver directly to customers,” Bailey says, which could explain the drop in DIO. Ironically, it’s just such a trend that could lead to an increased global focus on DIO. “If companies find they are coming under pressure to hold inventories longer for their customers, that’s when they’ll proactively look at how to manage their own inventory levels,” he explains.
In reality, better management of inventory, like the other elements of working capital, is often something companies are forced to do, not something they proactively tackle. And they rarely focus on working capital for a sustained period: In the Hackett survey, for example, only 102 of the 1,000 companies improved their CCC every year in the last three years.
The only thing that might change that in the near future is higher U.S. interest rates, says Wills.
“Once interest rates rise, companies are going to be less willing to obtain third-party financing or issue debt to pay for their endeavors — it will limit the things they want to do that require cash,” says Wills. “The cost of financing is a direct hit to overall profitability. But by tying up less cash in working capital, companies will be able to rely less on financing.”
Vincent Ryan is editor-in-chief of CFO.