CFOs in the U.S. can be forgiven for regarding the year-end with dread. While others attend parties, 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. Finance teams whose final quarter falls in other months may enjoy the holidays more, but none escapes the annual scramble.

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. 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. Many of today's investors, 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 cash-flow 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. 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, 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 can affect working-capital components at another. Joan Channell, director of accounting services for Ohio-based packaging firm Owens-Illinois, notes that some of its brewery customers shut down their plants at year-end. The short holiday weeks in December are ideal for filling-line maintenance. That affects the numbers for Owens-Illinois's beer-bottle business 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 (accounts receivable) balance [on December 31]," says Channell. "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 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 REL's survey analysis, the average percent decrease or increase in net working capital is cut in half.

The Seesaw

Even so, Steve Payne, REL's CEO, argues that US 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 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. 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," Payne says, and the numbers suggest that it's a corporate habit that varies only by degree.

The swing is remarkably symmetrical from one fiscal year to the next. From the 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, based in the US , 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

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. 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. Some companies 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. Before Corn Products instituted a working-capital management program in 2002, Beebe says, "managers' bonus payments were focused on the income statement and delivery of operating income." Unfortunately, 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. "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."

To help ensure that working-capital decisions are not swayed by the year-end reckoning, Corn Products bases bonuses on a 12-month average of total working-capital days. Notes Beebe: "We weren't looking for window dressing; we were looking for long-term continuous gains."

"Economic value is infinitely more important than year-end optics," echoes Owens-Illinois controller Ed White, who began a working-capital improvement program in late 2000 by revamping the accounts-receivable department. Like Corn Products, Owens-Illinois tracks working-capital metrics on a monthly basis and ties them to incentive compensation.

In fact, working capital is increasingly a part of compensation packages. At IBM, says treasurer Jesse Greene, business units that miss working-capital targets have their results - and a portion of their bonuses - docked by the cost of capital. Basing compensation in part on working capital is a way for companies to move incentive compensation closer to such core financial measures. "Ultimately, we will be holding managers accountable for return on capital employed," says Beebe of Corn Products. "Our working-capital effort is an element of that."

Short Term, Long Term

Of course, as more incentives are based on working capital, it is important for companies to put in place permanent process improvements. At Owens-Illinois, overly generous payment terms and discounts were brought under control by educating the sales force "that it all adds up," says Channell. The company also used the lessons it learned from its receivables department and applied them to payables, even cross-promoting a credit analyst from the AR department to an accounts-payable manager. Extending payables, says REL's Payne, is best accomplished not by delaying payments, but by collaborating with suppliers. Vendors are usually willing to negotiate favorable payment terms if they are confident that the customer will stick to those terms. "Suppliers want consistency," he notes.

Without such process improvements, companies are likely to continue to see wide swings in working capital, warns Payne. He also speculates that the year-end ups and downs are increasingly the result of poorly conceived incentive plans. Companies that regularly do a fair amount of housecleaning at year-end are causing themselves unnecessary stress as well. "It creates a vicious cycle," he says, since investors compare the company year-over-year. "Unless you do something substantial to permanently fix your working-capital processes, you'll be compelled to jump through those hoops every year."

There can be more serious financial consequences of such tricks as delaying a payment until the next fiscal year. "If you consistently screw them over at year-end," warns Payne, "vendors will build the cost of carrying that capital into their pricing models."

Tim Reason is a senior writer at CFO in the US.