The games companies play
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REL analysed the quarterly filings of the largest 1,000 US-headquartered public companies (by sales and excluding the financial sector) during financial year 2006 and the start of 2007. It found that they achieved a total working capital improvement of $100bn in the final quarter of 2006, followed by a $122bn deterioration in the first quarter of 2007. Of the 609 companies in REL’s sample that improved working capital in Q4 2006, 80% went on to see a deterioration in Q1 2007.
“There’s no doubt that analyst expectation makes people do things that they just wouldn’t do in a private company,” says Stephen Payne, president of REL. “Sometimes even if you hit your own targets, but analysts think you could do better, they pan you. You can see why private equity firms take companies private so that they can do all the restructuring work without having to show the external world.” REL also cites the linking of executive remuneration to year-end results as a cause for year-end results massaging.
Tricks of the trade
The games companies play include some classic moves. Trying to boost Q4 sales is widespread. REL says companies dangle discounted sales incentives, encouraging customers to bulk buy. The result is artificial volatility of customer demand and lower margin sales. REL’s analysis found that companies’ sales increased from $2.2bn in Q3 2006 to $2.3bn in Q4, then slipped back to $2.2bn in Q1 2007. However, their gross margin weakened in Q4 (falling from 32.2% in Q3 to 31.7%), before improving again in Q1 (32.4%).
Companies also chase after overdue debts, even at the risk of damaging customer relationships. REL’s research shows that days sales outstanding fell in Q4 2006, only to increase again in Q1 2007. On the payables side, too, companies play games, REL says, going further than the traditional stalling strategy of telling suppliers “the cheque is in the post”. Some companies, REL suggests, will even post cheques from a point as far away as possible from recipients’ addresses. Such tactics can create problems for the future, however, with suppliers raising their selling prices next time round.
Another tactic is to delay or stop buying in supplies. This reduces stock levels, giving the impression of better inventory and working capital management. However, this can also cause problems later. Delayed production schedules can mean that companies have to incur overtime costs later on in order to catch up. On the other hand, some companies start running at full capacity when they don’t need to, as a way to optimise overhead absorption. Though profitability is improved, REL warns that this means cash can be tied up unnecessarily in the making of products not yet needed.
“These games are definitely taking place,” says Payne and he believes that the appetite for such games is as strong among European companies as it is among US ones. Payne has witnessed a large European truck manufacturer pulling orders forward into its fourth quarter, letting sales slump in the first quarter of the following year.
Activities to improve year-end results take place in multiple sectors. Of the 57 industry sectors REL studied, 23 gained improvements in Q4 2006 followed by a deterioration in Q1 2007. While some industries are seasonal and can justify some such swings in working capital, others are clearly playing year-end games, REL says. Its research found the airline industry showing the strongest swings ¬ enjoying a working capital improvement of 38.8% from Q3 2006 to Q4, followed by a 41.2% deterioration in Q1 2007 (see box).
Even if companies want to kick the manipulation habit, breaking the cycle of undesirable behaviour isn’t easy. “Working capital you can fix in a given year,” Payne says. “But companies might struggle with sales ¬ you can’t fix them in one financial year.” If sales have been reduced in Q1 by the desire to boost the previous end of year’s results, unless the company plays the game again at the next year end, its annual sales results will suffer. “A new chairman could take it on the chin, but most companies would probably deal with it bit by bit, in bite-sized chunks,” says Payne.
REL suggests that the incentive to play such games could be lessened if companies changed their compensation structures. Performance over the full 12 months of the financial year should be considered, rather than the focus being on annual reported results.
Payne says: “Everything these companies do is perfectly legal. But is it ethical? The analyst and investor community doesn’t see the inside of these companies to see what they do to achieve these great results.” What they are doing is akin to “binge dieting”, he adds. Companies make themselves appear attractive at year end, but this corporate beauty is unsustainable and fades again in the first quarter of the following year.
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