January 2009: A Note from Jeff Mack
The Bottom Line: Improving Your Cash Performance with Better Inventory Control

News flash - we are in a challenging and unprecedented economic environment. In spite of that, we are finding opportunities for new business, and countless opportunities to attack and tame the stormy seas. We all know that a boat caught in an angry ocean without fuel and power is doomed. A business is much the same way. The difference is that cash is the fuel and power that enables us to ride out the waves. We’ve all heard the expression that CASH is KING and that’s because it‘s a great equalizer when all else fails.

So how do we ensure that our cash is working as hard and efficiently as possible for us and our business? Fortunately there are a number of tools available, some of them more applicable for one type of business than another. One common measure that applies almost universally is your measure of working capital. Just in case it‘s been too long to remember (I can relate to that), it’s defined as follows:

Working Capital = Current Assets - Current Liabilities

This is also another way of looking at your operating liquidity, or put another way, the ease and volume at which cash flows through the business. Be careful not to confuse cash with profits, as they are two different things. In general, a lot of working capital provides you with the liquidity to expand and grow your business. Conversely, negative working capital will constrict your ability to grow and take advantage of market opportunities. At first glance, you might think that more working capital is always better. But is it really? That of course depends upon what you are trying to accomplish and whether you are looking at a short term or a long term perspective. You will get no argument from me that some working capital is good, but there may be situations where a lot of working capital, or rapidly increasing working capital, might be cause for concern.

Let’s explore how too much working capital could possibly be a concern. To do that, we need to peel back the onion to understand what makes working capital tick. There are 2 primary functions that consume your cash flow, and those are inventory (raw materials, work in progress, finished goods), and accounts receivables (clients that borrow money from you). Notice that both inventory and accounts receivables are classified as assets on your balance sheet. On the flip side, there are 2 primary functions that supply cash flow, and those are accounts payable (suppliers that loan you money), and equity and loans. Notice that accounts payable and current loans are classified as liabilities on your balance sheet.

Getting back to our original equation for working capital, can you now see how having an excessive amount of assets might not be so good? For example, having more inventory than you need or accounts receivables sitting on the books longer than necessary is not in your best interest. Can you see how having too few liabilities might not always be in your best interest either? For instance, if none of your vendors gave you credit, you would be forced to pay cash for everything. Granted your liabilities would be minimal, but you would also be very restricted in how you operated the business.

Clearly, there is no right answer in terms of where your working capital should be. The answer inevitably is “it depends.” Does that mean that we should not concern ourselves with it? Of course not. Rather, it means we should attempt to optimize working capital for our given situation. Doing so can dramatically enhance the all important Cash Conversion Cycle (CCC):

Cash Conversion Cycle = DSO + DIO – DPO, where
DSO = Days Sales Outstanding
DIO = Days Inventory Outstanding
DPO = Days Payable Outstanding

The CCC tells you at a glance in absolute numbers how many days it is currently taking to convert your buying and selling into cold hard cash. The Aberdeen Group reports that best in class companies (top 20%) run an average cash conversion cycle of 11 days. Contrast that with the average company (middle 46%) that runs an average cash conversion cycle of 54 days. That’s nearly a 500% improvement in cash efficiency between best in class and average companies. Just think of the possibilities!

Back to keeping it real - many of you utilize inventory in the production and sale of your goods and services. What are some ways you can optimize working capital when managing your inventory?

• Improve forecasting accuracy associated with demand management
• Optimize inventory routes
• Reduce lead times
• Reduce just in case inventory
• Optimize inventory levels in response to the most profitable demand
• Move inventory (particularly aged) off balance sheet, i.e. in-transit inventory or supplier held inventory
• Increase visibility of shipment status and in-transit inventory
• Increase inventory turns

Just how do you go about achieving these goals? You may only need a new way of looking at your business, or a tool for using the data you already have. For example, a Business Intelligence tool such as DataSelf BI can help you transform your ERP and CRM data into performance indicators specific to your mid-size business and your customers. DataSelf also provides a solution for inventory replenishment planning for mid-size organizations.

These are but just a few ideas to address one piece of the working capital equation. Granted, these steps might not always be easy, but they can be done. We have tools and methodologies in various forms to tackle these challenges - talk to us about the one that's right for you. Using them can have a positive impact on your bottom line, and that’s the bottom line!

 

Best in class companies (top 20%) run an average cash conversion cycle of 11 days. Contrast that with the average company (middle 46%) that runs an average cash conversion cycle of 54 days. That’s nearly a 500% improvement in cash efficiency between best in class and average companies.