Improve increase cash flow

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. [paragraph] 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 cashflow 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.

SWINGERS

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 PAY'NE, 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 chart, page 57). 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."