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Capital Agenda Insights, November 2010 - Year-end cash game is not over - EY - Global

Capital Agenda Insights, November 2010Year-end cash game is not over

Change in quarterly C2C performance, Q2, 2002–Q1, 2010

Source: Publicly available quarterly financial statements

Change in quarterly working capital performance by component, Q2, 2002–Q1, 2010

Source: Publicly available quarterly financial statements

Proportion of companies reporting positive quarterly changes in C2C, Q2, 2002–Q1, 2010

Source: Publicly available quarterly financial statements

Many companies still apply some common ingrained practices to drive down working capital (WC) levels at year-end. This is the conclusion of a survey carried out on the quarterly working capital performance of the 500 largest companies (by sales) in the US.

By acting in this way, a company not only potentially risks giving a misleading representation of its liquidity and operational effectiveness, but it can also damage its own business performance, as well as those of its suppliers and customers.

Practices such as these have the effect of diverting management attention from the implementation of a truly effective working capital management strategy, while also putting the business in a “vicious cycle” of having to repeat the exercise every year.

Much bigger working capital changes in both Q4 and Q1

Change in quarterly C2C
performance, Q2, 2002–Q1, 2010

The analysis of the quarterly working capital performance of US companies for each of the past eight years reveals consistently much bigger C2C (cash-to-cash) changes in Q4/Q3 (year-end) and then in Q1/Q4 than in prior quarterly periods.

On average during the years under review, there was a decline of 4.9% in C2C in Q4/Q3, followed by an increase of 6.5% in Q1/Q4. This quarterly performance pattern implies that the level of working capital in relation to sales at the end of Q1 returned to within just over 1 percentage point of the level recorded at the end of Q3, illustrating the year-end illusion of good working capital and cash performance.

By comparison, the average C2C was down 2.7% in Q2/Q1 and then up 1.9% in Q3/Q2. This indicates that C2C changes for both Q4/Q3 and Q1/Q4 were from 2.2% to 3.0%, and from 3.8% to 4.6% higher than for prior quarterly periods.

  • For each working capital component, quarterly performance patterns were similar to those found in the overall C2C.
  • Analysis at the industry and company levels corroborates the high-level working capital findings, with generally higher levels of quarterly changes in C2C performance in both Q4/Q3 and Q1/Q4.

The effect of seasonality in sales and working capital has been mitigated to a significant extent by the use of quarterly C2C metrics. In addition, some highly seasonal industries, such as apparel retailers and toy manufacturers, have been excluded from our calculations.

  • In the past two years, there has been some moderation in the working capital fluctuation patterns, which may be explained to a degree by the disruptive impact of the global downturn.
  • It is also known that a performance skew exists within each quarter, with the third month of each quarter (and the end of Q4 in particular, and, to a lesser extent, the end of Q2) getting a higher level of attention.
  • For the companies analyzed, the above-average degree of quarterly swing in working capital — which could also be defined as the level of working capital that has been removed in Q4 and then “reconstituted” in Q1 — would be equivalent to from US$20b to US$27b in Q4, and then from US$32b to US$38b in Q1.

Above-average quarterly C2C performance
changes, Q2, 2002–Q1, 2010

  Q4/Q3 Q1/Q4
  Low High Low High
Above-average performance in % sales 2.2% .3.0% 3.8% 4.6%
$b value 20 27 32 38

Source: Publicly available quarterly financial statements

Looking specifically at each working capital metric, an analysis of quarterly performance changes indicates similar fluctuation patterns to those seen for C2C, with higher changes in both Q4/Q3 and Q1/Q4.

Quarterly working capital performance by component

Change in quarterly working
capital performance by component,
Q2, 2002–Q1, 2010

Among the specific components of working capital, inventory shows the biggest changes in Q4/Q3 and Q1/Q4, while the fluctuations in receivables and payables were more moderate.

Our analysis has not revealed any direct relationship between changes in working capital performance and sales. For example, sales in Q4/Q3 and Q2/Q1 during the years under review rose by almost 6% on average, but the swings in working capital between the same quarters were almost as twice as large (-5.0% versus -2.7%).


  Average quarterly changes
  Q3/Q2 Q4/Q3 Q1/Q4 Q2/Q1
DSO 0.5% -2.3% 3.4% -1.3%
DIO 3.0% -5.7% 7.1% -3.0%
DPO -1.7% 3.9% -3.9% 1.5%

Source: Publicly available quarterly financial statements

Also, Q1/Q4 showed the biggest changes in working capital (+6.6%) when the fall in sales was also close to 6%. In Q3/Q2, variations in sales were marginal, but the changes in working capital performance were still relatively significant (+1.9%).

With companies trading with each other, the year-end cash game is also very competitive. As one company is trying to collect its receivables, its customers try to stretch out payment terms.

As one tries to push back supplies, its suppliers are trying to sell and ship more products as fast as possible. So there are competing and conflicting strategies taking place, with the ground rules determined by the various players' year-end cash goals.

Quarterly working capital performance by industry


Most significant changes in industry quarterly C2C performance,
Q2, 2002–Q1, 2010

  Average C2C quarterly changes
  Q3/Q2 Q4/Q3 Q1/Q4 Q2/Q1
Aerospace and defense 4% -6% 12% -7%
Automotive parts suppliers 3% -6% 9% -3%
Communications technology 0% -4% 5% -5%
Computer makers 4% -11% 12% -6%
Diversified materials 2% -5% 7% -3%
Food producers 3% -5% 5% -3%
Food and general retailers 15% -20% 13% -6%
Medical devices and supplies 3% -5% 5% -1%
Pharmaceuticals -1% -5% 6% 0%

Source: Publicly available quarterly financial statements

The “by component” table shows a selection of the largest quarterly changes in C2C in both Q4/Q3 and Q1/Q4 in major US industries that mirror the overall quarterly working capital performance patterns. These 11 industries account for over half of total US sales.

The biggest changes in both Q4/Q3 and Q1/Q4 were reported by airlines, computer makers, and food and general retailers. For some of these industries, the relative size of the change was exaggerated by the relatively low level of working capital inherent in this type of business.

In diversified industrials (one of the largest industries by sales), C2C changes for Q4/Q3 and Q1/Q4 were from 2% to 5% higher than for Q2/Q1 and Q3/Q2.

By contrast, very different fluctuation patterns emerged in a number of other industries. Most of these still displayed a fall in C2C in Q4/Q3 and then a rebound in Q1/Q4, but with lower magnitude and with distinctive trends in other quarterly periods compared with the market as a whole.

These sectors included, for example, chemicals, industrial and commercial services, semiconductors and steel. Several factors may have contributed to this divergence in performance, including differences in sales seasonality patterns, variations in capital expenditure and volatility in commodity prices.

Quarterly working capital performance by company


  Proportion of companies reporting C2C changes
  Q4/Q3 Q1/Q4
Increase 35% 67%
Decrease 65% 33%

Source: Publicly available quarterly financial statements

Proportion of companies
reporting positive quarterly changes
in C2C, Q2, 2002–Q1, 2010

On average, 65% of companies analyzed reported lower C2C in Q4/Q3 and then over two-thirds of them posted an increase in Q1/Q4. For both periods, the change was higher than in other quarters.

Common working capital ingrained practices

While each industry and every company has its own business characteristics and drivers, evidence shows that they also apply some common ingrained practices to drive down working capital levels at year-end:

  • Discounts are offered at year-end to boost sales volume and reduce inventories, at the risk of stuffing distribution channels.
  • Customers are chased for payment, but in an uncontrolled way.
  • Early payment discounts are offered to customers to drive cash.
  • Supplier payment terms are stretched.
  • Purchases of materials and capital expenditure are postponed to the following quarter. In capital-intensive industries, capital expenditure is often regarded as an important adjustable variable for managing year-end cash and cash flow.
  • Additional write-offs and provisions on receivables and inventories are taken, with an accordingly negative impact on the profit and loss account.

It could be argued that the year-end fluctuation patterns revealed by our analysis may have been exacerbated by a degree of company "housecleaning."

While this may have some effect in a few cases, it is unlikely to have had a material impact on the overall figures, given the relative size of the change in C2C (inverse close symmetry) when comparing Q4/Q3 with Q1/Q4.

Why such working capital behavior does not constitute good business practice

There are several reasons why such working capital behavior, while commonly applied, does not constitute good business practice:

  • It misrepresents the company's liquidity and operational performance at year-end by showing a lower level of net debt than should actually be the case.
  • It does not generate cash that can be deployed elsewhere, as it drains away in Q1.
  • It diverts management focus and attention from the implementation of an effective working capital management strategy, while adding unnecessary costs to the business and potentially affecting service levels.
  • It undermines the business relationships and trust built up through the year with customers and suppliers by shifting the financial burden up and down the working capital value chain.

This also implies that the net financial impact across industries and companies may vary widely, with some more severely affected than others. The extent of this impact will be determined by factors such as companies' relative buying power, position in the working capital value chain and strength of balance sheets.

It influences and affects judgment and performance within the organization, as many individual incentive plans are partly tied to company cash performance at year-end. Because these targets are also revised every year, people are likely to be under renewed pressure to repeat the tactics.

Effective working capital management is a crucial route to genuine business benefits

For all these reasons, we believe it is critical for organizations to move away from this deceptive and damaging year-end stop-and-go practice, and to focus instead on implementing a truly effective working capital management strategy.

Such a strategy needs to consider its activities by reference to a maturity model. Short-term tactical levers at period-end might help to achieve desired benefits at a point in time, but operational and structural changes will drive more substantial and sustainable improvements. Getting the balance right between these levers is important for the success of the strategy.

Implemented well, this can offer benefits in terms of cash, cost and relationships. It requires an organization to identify, adapt and continuously improve leading practices and to work closely and collaboratively within and across the supply chain in pursuit of common operating, financial and service objectives.

This requires full commitment from management and a shift to new behaviors at all levels within the organization. The changes should also include a review of individual incentives, using monthly or year-average working capital improvements rather than calculated on year-end targets, in combination with improved communication with the financial community.

Other editions

Jon Morris and Steve Payne

Contacts

  • Jon Morris, Working Capital Services Leader, EMEIA
    +44 20 7951 9869
  • Steve Payne, Working Capital Services Leader, Americas
    +1 212 773 0562

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