586 CHAPTER 16 Working Capital Management
The Best at Managing Working Capital
What do Boeing, Ford, Gillette, Coca-Cola, Herman Miller,
Timberland, Southwest Airlines, and Burlington Northern
Santa Fe have in common? Each of these companies leads its
industry in CFOmagazine’s annual survey of working capital
management, which covers 1,000 firms with sales greater
than $500 million. Each company is rated on the number of
days to its cash conversion cycle and on its cash conversion
efficiency (CCE), defined as cash flow from operations di-
vided by sales.
According to this survey, the median number of days in
the cash conversion cycle is about 57. Burlington Northern
Santa Fe (BNSF) has an outstanding cash conversion cycle
of51 days, versus an industry average of 12! BNSF achieved
this by reengineering its accounts receivable process, starting
with the number of days it takes to submit a bill to
customers. In 1997 it had about 50,000 bills on hand each
day that had not yet been priced and renderd to customers.
By working on its information systems, BNSF was able to
automate much of the process, and it reduced unprocessed
bills to about 15,000. BNSF then turned its attention to the
number of days it takes a customer to pay. They found that
their large customers would receive a batch of bills, but not
pay any of them if the customer disputed any single bill in
the batch. Working closely with marketing and sales, BNSF
was able to greatly reduce the number of disputed bills. The
net result of these efforts was a decrease in the days sales
outstanding from 50 to 16. When coupled with very little
inventory and its own ability to delay payments to its
suppliers, BNSF’s cash conversion cycle came in at 51
days. This increased its free cash flow to such an extent that
BNSF was able to implement a large stock repurchase pro-
gram.Source:Various issues of CFO. For an update, seehttp://www.cfo.com/ and
search for “working capital annual survey.”However, the picture changes when uncertainty is introduced. Here the firm re-
quires some minimum amount of cash and inventories based on expected payments,
expected sales, expected order lead times, and so on, plus additional holdings, or
safety stocks,which enable it to deal with departures from the expected values. Simi-
larly, accounts receivable levels are determined by credit terms, and the tougher the
credit terms, the lower the receivables for any given level of sales. With a restricted
policy, the firm would hold minimal safety stocks of cash and inventories, and it
would have a tight credit policy even though this meant running the risk of losing
sales. A restricted, lean-and-mean working capital policy generally provides the high-
est expected return on this investment, but it entails the greatest risk, while the
reverse is true under a relaxed policy. The moderate policy falls in between the two
extremes in terms of expected risk and return.
Changing technology can lead to dramatic changes in the optimal working capi-
tal policy. For example, if new technology makes it possible for a manufacturer to
speed up the production of a given product from 10 days to five days, then its work-
in-progress inventory can be cut in half. Similarly, retailers such as Wal-Mart or
Home Depot have installed systems under which bar codes on all merchandise are
read at the cash register. The information on the sale is electronically transmitted to
a computer that maintains a record of the inventory of each item, and the computer
automatically transmits orders to suppliers’ computers when stocks fall to prescribed
levels. With such a system, inventories will be held at optimal levels; orders will
reflect exactly what styles, colors, and sizes consumers are buying; and the firm’s free
cash flows will be maximized.
Recall that NOWC consists of cash, inventory, and accounts receivable, less
accruals and accounts payable. Firms face a fundamental trade-off: Working capital is
necessary to conduct business, and the greater the working capital, the smaller the
danger of running short, hence the lower the firm’s operating risk. However, holding
working capital is costly — it reduces a firm’s return on invested capital (ROIC), free