From the March 2012 issue of Treasury & Risk magazine

The Case for Working Capital

Shareholders dont seem to care, but a strategic approach to working capital management brings
other benefits, says Gregory Milano of Fortuna Advisors.

Over the last few decades, companies sharpened their focus on delivering desirable returns to
shareholders and embraced some form of return on capital, economic profit or a comparable
performance measure. This focus on high returns led companies to scrutinize not just their capital
investments, but their use of net operating working capital as well. Net operating working capital
consists primarily of inventory and accounts receivable less accounts payable and accrued
expenses. Cash balances are often excluded, although it could be argued that some balance of
cash is required to run operations. Short-term debt and debt equivalents are also excluded as
these are sources of capital provided by entities that expect a return on their investment.

T&R: How can working capital management be improved?

Milano: Companies improve working capital efficiency by reducing inventory levels using
better management techniques such as just-in-time, lean manufacturing and process
reengineering. Invoicing systems, payment clauses in contracts, tighter credit scrutiny and
improved collections have reduced accounts receivable. And many adopt accounts payable
practices designed to pay vendors on the last possible day to take advantage of supplier capital.
Indeed for many companies, reducing the investment in working capital has become a way of
life.

I initiated and was heavily involved in a working capital improvement program at the Grumman
Corp. (now part of Northrop Grumman) in the early 1990s and can attest to the challenges of
improving performance in this area. We dramatically improved work-in-process, raw materials
and accounts receivable, and I became convinced that the sizable jump in our share price was
related to the substantial improvements in return on capital that resulted from our efforts.

T&R: Is there any downside to working capital efforts?

Milano: Like many good things, there are companies that push working capital efficiency too
far, causing the performance of the business to suffer. For example, pharmaceutical companies
generally should hold more inventory than manufacturing companies because the gross margins
are so superior that the opportunity cost of stock-outs is dramatically higher. Of course, simple
economic order quantity models make this point clear, but the obsession with efficiency has led
to working capital practices that push too far in some companies.

T&R: Do investors value working capital efficiency?

Milano: We examined whether companies with more efficient working capital practices deliver
higher total shareholder returns (TSR) in the form of dividends and capital gains on their share
price.
To test this, we examined quarterly performance and share price data for the 500 largest non-
financial U.S. companies from the start of 2006 through mid-2011. For each company, we
examined net operating working capital and the individual components: accounts receivable,
inventory, accounts payable and accrued expenses.

To normalize for the companies relative sizes, we related each capital item to revenue to
determine the days on hand (DOH). Companies were ranked on this dimension and separated
into four equal groups, or quartiles. We then compared the median TSR of those in the most
efficient quartile with those in the least efficient quartile to determine if companies with more
efficient working capital were rewarded with better share price performance.

T&R: What did your study show?

Milano: The results are anything but encouraging for companies that devote significant time to
working capital management. The companies with more efficient inventory balances delivered
15.3% lower TSR over the 5-year period than the less efficient inventory managers. Accounts
receivable and accrued expenses also were negative but to a lesser degree. Accounts payable was
the only true positive as those with higher (better) levels delivered 18.2% higher TSR.

When we combine all four into a measure of overall net operating working capital, those with
more efficient overall working capital delivered 3.2% higher TSR. This is positive but to a much
lesser degree than expected. It amounts to only 0.7% per year and is not very material given that
the median DOH of net operating working capital is 369 days higher for the less efficient
quartile. They carry an extra full year of revenue in working capital and do not seem to be
penalized for it.

Perhaps a better way to examine this data is to normalize the level of working capital based on
some measure of profit or cash flow instead of revenue, so we can adjust for the differences in
profitability. To test this, we determined an alternative DOH measure based on days of EBITDA,
or earnings before interest, tax, depreciation and amortization. What appears to be a large
working capital balance when compared to revenue may not seem so large when compared to
EBITDA in a highly profitable company.

Although this makes logical sense, the results are less favorable. The quartile of companies with
more efficient net operating working capital based on days of EBITDA delivered 6.1% lower
TSR than the least efficient quartile.

T&R: Why dont investors care more about working capital efficiency?

Milano: Perhaps investors just do not focus on it as much as they should. Financial newspapers,
business TV programs and investor presentations rarely spend much time on working capital
management. Indeed, the questions are typically about revenue, cash flow and EPS, with any
capital efficiency discussions mostly relating to capital expenditures and acquisitions.

Maybe investors are justified in paying little attention. At the end of their last fiscal year, the 500
companies held $283 billion in net operating working capital, which is certainly a large number
but only reflects 3% of their $9.6 trillion in revenue or 4% of their $7.1 trillion in debt and equity
capital. If we assume the average companys cost of capital is 10%, the required return on the net
operating working capital is only about 0.3% of revenue. That pales in comparison to all the
other drivers of growth, profitability and capital efficiency.

T&R: Does this mean that companies should ease up on their efforts?

Milano: Not at all, but they should take a more strategic perspective on using working capital
effectively.

Companies should also consider working capital as an investment that can be increased to
achieve some greater good. Would customers purchase more or pay higher prices if they received
more generous payment terms? Would they commit to sole source their purchases if inventory
was held free of charge on their behalf? These techniques for generating sales and/or profit
growth succeed particularly well with customers that are themselves heavily focused on working
capital efficiency.

The pursuit of working capital efficiency can provide other benefits, such as streamlined
production processes, lower risk of obsolescence or future markdowns, and reduced client credit
troubles. When evaluating working capital alternatives, be sure to consider these side effects as
they can, at times, be the most important improvements realized.

A company that is managing working capital particularly well should not hesitate to make it part
of the overall investor relations story. Let investors know about the improvement, how it affects
the overall cost profile, including the cost of capital, and the ways in which this is used as a
competitive advantage. Although working capital does not appear to be an important driver of
share prices across the whole market, it could make the investment case more compelling.

Gregory V. Milano is the co-founder and CEO of Fortuna Advisors, a value-based strategic
advisory firm.