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
“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
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.