Working Capital Scorecard: The Hard Part of Boosting Liquidity

With payables stretched to the limit, wringing more cash out of working capital will be a challenge.

Vincent Ryan, Editor in Chief, June 27, 2019.

What CFO doesn’t want working capital to generate cash rather than consume it? To not have to answer pesky analyst questions about lower quarterly cash levels? To not have to draw on a line of credit because customers are paying on time?

No, CFOs would rather be confident that the accounts receivables and payables departments are operating optimally. But that requires attention to detail, and few organizations can focus on this core area consistently.

The 2019 CFO/The Hackett Group Working Capital Scorecard shows that the largest 1,000 U.S. companies remain efficient users of working capital. But, as in most years, they could be doing better, especially at managing inventories.

The 1,000 companies (benchmarked every year the past decade) didn’t perform poorly in 2018. Total net working capital dropped as a percentage of revenue last year despite robust sales, and the average cash conversion cycle (roughly, the time it takes to turn resources into cash) fell to 34.8 days from 35.5 the prior year. To boot, operating cash flow rose 17%.

However, the needle barely moved on the key working capital metrics, and one, days payables outstanding, actually worsened. Why does that matter? These companies’ balance sheets may not be as resilient as they think.

While profitability and sales rose in 2018 for the 1,000 U.S. companies in the scorecard, cash on hand fell 9% from 2017. And many of them are significantly leveraged — they had an average debt of 47% of revenue, up from 35% in 2008. The gap between debt and cash levels is much wider today compared with the period prior to the Great Recession, points out Gerhardt Urbasch, a senior director at The Hackett.

More ominously, many experts see some external sources of cash from the past two years drying up. The Trump tax cuts and greater incentives to repatriate foreign cash put less pressure on working capital efficiency, but now their effect is dwindling, Urbasch says. Meanwhile, tariff tit-for-tat is driving up the costs of imports and raw materials, eating into profit margins when costs can’t be passed on to customers.

All that could put a new emphasis on cash flow. In addition, some companies face internal challenges. For example, DowDuPont, in the midst of a complex spinoff transaction, is spending cash on separating out three entities’ IT systems. To combat that, the chemical giant is “actively working” on days sales outstanding, days payables outstanding, and days inventory outstanding, said Howard Ungerleider, the company’s CFO, at a May conference. Every day of efficiency DowDuPont finds in these working capital areas generates $100 million of additional cash flow, Ungerleider said.

The Easy Part

For the last 10 years, getting better at managing working capital has been largely about fixing only one leg of a three-legged stool: days payables outstanding. Working capital benchmarks have remained respectable because large companies have extended payment terms with suppliers. That has elevated their cash levels.

The scorecard companies gradually went from paying their suppliers in about 45 days in 2009 to about 56 days (almost two full months) in 2017. But the rubber band stretches only so far. Supply chain finance programs ensured that suppliers’ own liquidity didn’t suffer; now, it appears, resistance from suppliers has kept customers from lengthening terms any farther.

While average days payables outstanding (DPO) has risen by 38% since 2008, in 2018 average DPO actually fell (worsened). On average, the 1,000 companies paid their suppliers almost two days faster (in 54.8 days, compared with 56.4 the prior year). A majority (53%) of the 1,000 companies saw this DPO deterioration.

Of course, not all companies have reached the zenith of optimizing payables. The top-quartile performers in the Working Capital Scorecard had an astonishing average DPO of 64.7 days. However, median performers had an average DPO of just 45.3 days.

Columbus McKinnon, for example, a provider of electric hoists and crane components, improved its DPO by 6 days in the first quarter of 2019. That helped push down working capital as a percentage of sales by 70 basis points. Management thinks the company still has an opportunity to delay payments even longer.

The average large company, though, has done as much as it can to stretch terms and gain efficiencies from its procure-to-pay processes, say The Hackett Group’s consultants. For most of them, 2019 will be quite a different animal.

“The easiest component of working capital to improve is DPO, because large companies tend to have leverage there,” says Shawn Townsend, director at The Hackett Group. Once an organization exhausts that avenue, however, it has to move on to another leg of the stool: receivables, inventory, or both.

Tightening Up

Those are much more difficult areas from which to wring cash.

With companies lengthening payment terms the past decade, tightening up on receivables has been tough. For 2018, the scorecard’s 1,000 companies improved receivables performance (days sales outstanding, or DSO) by eight-tenths of a day in 2018 (to 38.5), largely due to increases in revenue. (The DSO equation is accounts receivables at year-end divided by one day of revenue.) Nearly 600 of the scorecard companies saw DSO improvements in 2018. But as a group they have pushed DSO to under 36 days only twice in 10 years, and among scorecard companies DSO is still near its all-time high.

One of the obstacles is the lag in adopting the latest technologies. Companies are struggling with applying them on the receivables side of the cash conversion cycle, says Todd Glassmaker, a director at The Hackett Group. The end-to-end solutions that are available for payables just aren’t ready yet for AR teams. “There are a host of technologies in play but they’re a still a bit immature — it’s also a customer-facing solution, so there is a lot more complexity,” Glassmaker notes.

While companies have leveraged older technology to evaluate customer creditworthiness and prioritize account collections, as well as to automate some collections messaging, they are still figuring out how artificial intelligence and robotic process automation can improve receivables performance.

There are other reasons why lowering DSO may be difficult. As with DPO, the top-quartile performers are bumping up against the natural limits. They posted an average DSO of 26.7 days in 2018, which seemingly would be pretty difficult to improve upon in most industries. “That is probably right up against best possible, given the nature of standard payment terms,” says Craig Bailey, an associate principal at The Hackett Group.

In addition, large companies are unlikely to revert back to paying suppliers in 45 days (like they did a decade ago) and lose their working capital cash cushion.

Instead of sitting on their hands while awaiting better tools, though, many receivables departments will need to work on (1) tightening up internal billing processes and (2) building cash awareness among sales and collection teams, Glassmaker says. In collections, that means giving agents visibility into how they impact corporate targets and, in sales, introducing a working capital element into sales teams’ compensation.

Stock Answers

To make real headway on lowering the cash that working capital ties up, organizations will to have to look in a forbidding place: days inventory outstanding (DIO). DIO among the 1,000 companies fell slightly, to 51.2 days in 2018. That was down from 52.6 in 2017, and the first drop since 2011. But inventory levels still increased 7.4% for the year, and DIO performance was merely adequate — the average DIO among the 1,000 companies was at its second-highest point since 2009.

For many reasons, inventory levels are the most difficult nut to crack in the working capital realm. Economic and industry trends have been working against the notion that holding fewer days’ worth of inventory is a best practice.

The perennially low interest rate environment has made it less painful for companies to carry excess inventory. In addition, some see a competitive advantage in having higher minimum or safety inventory levels due to the complexity of global supply chains.

Inside organizations, finance just hasn’t been able to put the screws to the inventory operations side. What’s been missing is a “burning platform” for the discussion of cutting back on inventory levels, says Bailey. While finance may wish to optimize inventory on a cash-flow basis, manufacturing or operations managers tend to look at costs. In the cash vs. cost trade-off, cash has been losing — in other words, optimizing cash in inventory management has not been a priority.

“From a cost perspective it may make sense for a manufacturer to have very large production runs, but from a cash perspective that might not be the right thing to do, because it’s increasing average inventory,” Bailey explains.

More organizations are beginning to focus on tackling inflated and excess inventory levels, says Bailey. So much so that The Hackett Group’s experts expect 2019 to be an inflection point.

For example, beverage maker Mondelez maintains that it is best-in-class with its low cash conversion cycle. In a late May earnings call, CFO Luca Zaramella said the company tracks payment terms closely and uses advanced receivables and collections management. But its biggest opportunity going forward is inventory management.

“We still have opportunities both in … making the right product available at the right time in the right location, and reducing quite significantly days inventories on hand,” Zaramella said.

Helen of Troy Limited, a marketer of brand-name housewares, is also targeting inventory levels. “We have a lot of improvement we can make in just getting our forecasting and demand planning into a good place where we don’t need to have safety stocks and those types of things that we’ve held in the past,” Brian Grass, Helen of Troy’s finance chief, told investors in May.

Helen of Troy is also trying to consolidate suppliers. Grass said having fewer, more strategic partners that it can use to shorten cycle times and lead times could have “a multiplier effect, along with the demand planning, to get the inventory balances down.”

Lower inventories will be a blessing for any organization if global growth slows and demand from consumers and businesses wanes. The smartest companies will be preparing for it. Some of Hackett’s clients, for example, are paying down debt with the cash they generate through better working capital management. They plan to continue doing that even if the direction of U.S. interest rates later this year is down rather than up.

For most companies, finding that cash won’t come easily, since for many payables are already optimized. They’ll have to look in other areas to make any headway in cutting working capital bloat.

One response to “Working Capital Scorecard:

The Hard Part of Boosting Liquidity”

Steven McLendon says:

Excellent report! We commend you for addressing the key obstacle of boosting liquidity – inventory investment – and to how to “make real headway” companies must gain control by viewing inventory in Days Inventory Outstanding (DIO). While many try to reduce the risk of stock-outs by building up inventories, this strategy is not sustainable as variations in demand/supply and long lead times continue to grow. We routinely see companies holding 2 to 3 times the inventory required to effectively meet demand. While inventory has indeed been the toughest obstacle to date, a new class of advanced analytics replenishment software gives companies the visibility and confidence to eliminate stock-outs and cut stock levels by 20-30%. While a pending economic downturn may drive change for some, others are adopting new strategies to gain a competitive advantage right now. New technology is making this much faster, simpler, and less risky to achieve.

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