Compensation and Cash Flow

Why many companies are using metrics from the cash flow statement, and not just the income statement, to measure annual performance and award bonuses.
Marie LeoneJanuary 21, 2004

Jeffery Immelt doesn’t believe that General Electric Co. should offer stock options and similar incentives to retain its chief executive. That’s one reason the CEO worked with his company’s compensation committee to connect his paycheck more directly to cash-flow performance metrics.

Starting in January 2004, GE will use performance share units in calculating Immelt’s equity compensation. In addition to his $3 million annual salary and a bonus not connected to cash flow (in 2002, $3.9 million), Immelt will receive 250,000 PSUs with a potential value of $7.5 million. The PSUs will vest in five years if — and only if — cash flow from operating actitivities rises an average of 10 percent annually during that time.

Although most companies haven’t gone so far as General Electric, many are headed in the same direction. There seems to be a groundswell of support for using metrics from the cash flow statement, and not just the income statement, to measure annual performance and to award bonuses.

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Last fall, during an industry meeting produced by CFO Enterprises (the conferences division of CFO Publishing Corp.), IBM Corp. treasurer Jesse Greene told attendees that when managers at Big Blue miss working capital targets, their business units are charged the cost of capital — deflating their units’ cash flow numbers and ultimately lowering bonuses. (IBM will also reverse commissions in certain cases when sales managers fail to reach working capital goals.)

Other large companies, such as auto industry supplier Lear Corp. and food products maker Corn Products International, also tie part of their bonus compensation to cash flow. And relatively small private enterprises like Jamba Juice, a San Francisco-based maker of smoothies and healthy snacks, use the cash-flow connection to attract and retain employees.

In all, 20 percent of the largest U.S.-based, publicly held companies use a cash-flow metric to calculate short-term compensation, says Russell Miller, a principal at Mercer Human Resources Consulting. Although historical data is unavailable to measure the exact increase, Miller is confident that the number of companies linking bonus compensation to cash flow is rising.

Why Now?

Miller says that tethering bonuses to cash flow is not a new idea. Executives at private companies, who generally manage for cash flow and not earnings per share, usually make the connection. Adds Miller, “more-mature companies, like manufacturers (as opposed to dot-commers), have always considered the metric important.”

In general, companies are spending more time scrutinizing cash-flow metrics because there’s pressure on executives and compensation committees to ferret out more-accurate performance indicators, adds Miller. As a result, executives at public companies are being asked to report on cash flow, working capital, and return on invested capital as much as on earnings and revenues. “Behind the move to link compensation to cash flow is a governance mandate to ensure that bonuses are paid out for the right reason,” maintains Miller.

Post-Enron governance concerns have also inspired companies to cozy up to cash flow. Earnings per share, revenues, and net income are more easily manipulated than cash metrics, says Espen Eckbo, a finance professor at the Tuck School of Management at Dartmouth University. The professor reckons that the backlash from corporate malfeasance — as well as a rule expected this year from the Financial Accounting Standards Board, which would require companies to expense stock options — is likely driving the change in attitude regarding incentive compensation.

In the past, executive wealth was created when a stock performed well because bonuses were based on stock options, comments Tom Wamberg, chairman and CEO of Clark Consulting. But when impending accounting rules placed stock options in the “uncertain” category, notes Wamberg, cash seemed to become the new bonus criteria.

Wamberg asserts that compensation committees are focused on measuring performance properly, especially in light of the lingering din surrounding the compensation of New York Stock Exchange chairman Richard Grasso. He says that, in general, board members are applying more rigor to creating incentive formulas to bring realistic expectations to performance measures.

Taking Responsibility for the Longer Term

In addition to personal performance, annual bonuses are traditionally tied to metrics reflected on the income statement, such as revenue or net earnings. These targets “focus managers on driving income-statement results without a lot of regard to the balance sheet,” says Cheryl Beebe, treasurer and vice president of finance at Corn Products International. That was the case at her company, too, quips Beebe, before management decided to “put skin in the game.”

In 2001, Corn Products tied annual bonuses to cash flow. Now in its third year, the program links 20 percent of yearly bonuses to total working capital (current assets minus current liabilities, excluding short-term debt). The rest of the bonus is determined by operating income and personal performance. Beebe maintains that the working-capital program has cut down on dysfunctional behavior because executives are less likely to manage for top-line sales and revenue numbers.

The Corn Products plan links bonuses “to what it takes to earn a profit on sales,” asserts Beebe. “It’s great to make a sale, but if it takes 120 days to collect the money, profit margins won’t be very sturdy, and that’s not the business model we want to encourage.”

She emphasizes that managers still have an incentive to make the right business decision, “but there are tradeoffs now.” For example, if a unit manager wants to build inventory because he believes sales will be stronger next quarter, he should proceed with the build-up. But if the assumption turns out to be wrong, the working-capital portion of his bonus will be penalized “because he placed assets on the balance sheet without earning a return.”

“Yes, it’s tough love,” says Beebe, “but it’s a balanced approach.” She notes that unit executives can choose to manage their working capital by concentrating on payables, on receivables, or on inventory. In addition, the targets — for example, days sales outstanding or days inventory outstanding — are set not in a vacuum, but rather with input from local management teams.

It’s Not for Everyone

Improving cash flow is a natural for large manufacturers that have significant capital expenses and depreciation. At General Electric, says company spokesman Gary Sheffer, cash flow has always been “a very important metric.”

Not all companies are interested in linking bonuses to cash flow, however, says Clark Consulting’s Wamberg. Although many analysts want to see more financial reporting on cash earnings, smaller companies tend to be hesitant about changing their shareholder reporting metrics, which tend to be based on earnings or net income.

In addition, smaller companies with an intense focus on cash flow run a risk when they improve their working capital — they many squeeze their clients and vendors. That’s a surefire way to hurt business relationships and impede quality and service, says Robert Williamson, a former CFO and now the chairman of privately held CityMerch Corp. in Miami Beach. Although Williamson agrees that cash-flow numbers are harder to manipulate than EPS or revenue, he maintains that the gaming can’t be stopped completely — there always will be attempts to “starve cash flow to [manipulate the metric], in much the same way channels are artificially stuffed to improve earnings.”

Another caveat, says Mercer’s Miller, is that linking bonuses and cash flow may sidetrack high-growth companies, which usually seek to reinvest cash to spur long-term growth. If bonus payouts are based on improvements in cash flow, opines Miller, managers may cut costs and underinvest in the business.

A Spoonful of Sugar

Connecting compensation and cash flow is not a cure-all for corporate scandals or dysfunctional business behavior. But it does steer executives toward a more holistic approach to management — from “managing only for the profit and loss statement toward managing for capital and the balance sheet as well,” contends Miller.

Achieving that balance also can work nicely as a risk management tool for protecting annual bonuses, especially when control for making the numbers may be taken out of a manager’s hands. Witness the Corn Products divisional bonuses that were almost completely wiped out, had it not been for its ties to cash flow.

On January 1, 2002, the Mexican Congress imposed a 20 percent tax on beverages sweetened with high-fructose corn syrup 55 (HFCS 55). The idea was to encourage local bottlers to use domestic sugar, rather than imported sweeteners. The strategy worked: The tax hike effectively raised the cost of a US$1.00 can of Coca-Cola to US$1.20, and Mexican bottlers promptly abandoned HFCS 55.

Corn Products, which makes HFCS 55, took a big hit that year. Operating income sank 14 percent — from $65 million in 2001 to $56 million in 2002 — and earnings per share dropped 38 percent.

As a result, the bonus-eligible employees working in the division that manufactures HFCS 55 were headed for a big disappointment; based on the decline in operating income, they were not scheduled to receive a bonus payout. Fortunately, the division had contributed to the company’s $65 million working capital improvement, and employees were awarded the 20 percent of their bonus that was linked to working capital.

That 20 percent might not seem like much, but had Corn Products not connected compensation and cash flow, it would have been the Mexican Congress that determined those bonuses. Seen in that light, you might even say that Corn Products gave their employees a sweet deal.