Quite naturally, the cash flow challenge has caused companies to look closely at their asset investments. Inevitably this leads to an analysis of inventory and accounts receivable.
In almost every company, these are the two largest asset categories. They are certainly the most controllable. Given the combination of size and controllability, many companies have embarked on major asset-reduction programs.
The reality is that most customers buy from companies that offer a wide product selection and a means for financing transactions. If you have less inventory on hand and less credit extended, it’s very possible that you will make fewer sales.
In fact, it may be that assets are really not too high and that management is worrying about the wrong issues. Very possibly, the real issue may be that the profits generated from those assets are too low, thereby causing a cash flow challenge.
This article will examine that challenge by focusing on these three issues:
1.Â The impact on cash flow of reducing inventory and accounts receivable;
2.Â The impact that managing profitability can have on cash flow; and
3.Â Guidelines for managing inventory and accounts receivable.
Reduce the base, improve cash flowIntuitively, the quickest and most effective way to increase the cash in the business would be to reduce the investment in non-productive assets and reallocate the funds to cash.
While it is certainly the quickest way, it may not be the most effective.
Table 1 looks at the two key financial statements for the typical NHRAW member: the income statement and balance sheet. The first column of numbers represents where the typical company in the industry stands today. Cash is adequate, but not in over abundance.
The next column of numbers indicates where the company would be if it could reduce both its inventory and accounts receivable by 10%.
It should be pointed out that 10% is a major reduction. Such a change would require the company to make some significant changes in both its merchandise assortment and its collection practices.
Whether or not such large changes can (or even should) be made is subject to some debate.
Assuming that the changes can be made, both accounts receivable and inventory are reduced by 10%. All the reductions then become an increase in cash. The company has exchanged one asset for another with major implications for its cash position. The cash challenge for the company goes away.
The second column of numbers rests on the specific assumption that the reduction in investment can be generated without impacting sales. For most companies, this is a very dubious assumption.
While investment levels may not be at optimal levels, decreasing these two key asset categories by 10% each will almost inevitably produce some sales challenges.
The most likely consequence of an inventory reduction is an increase in the percent of time the company is out of stock, particularly on key items. Such problems have short-term sales and long-term survival implications.
On the accounts receivable side, any potential challenges are much more subtle. Tighter credit policies and more stringent collection arrangements almost inevitably depress sales volume, though.
The final column of numbers examines the same sort of asset redeployment as the second column, but factors in a sales decline.
Specifically, the table looks at a 5% sales decline, half as large as the 10% reductions in both inventory and accounts receivable. The effect is devastating to the company’s profits.
In addition, lower after-tax profits reduce the cash available to reinvest in the business. This sends the cash balances moving backwards by the amount of after-tax profit given up.
None of this suggests that efforts to control inventory and accounts receivable are inappropriate. As stated earlier, they represent the largest share of asset investment.
The real point to this discussion is two-fold: A large reduction is necessary to drive cash to desired levels, and such reduction will likely come at the risk of reducing sales.
A profit-based cash flow approachInstead of focusing exclusively on asset reduction, most companies would probably be much better served to switch their focus to enhancing profitability. In so doing, they must turn their attention away from the factors that drive down investment and toward those that drive up profitability.
Foremost among these, the company must examine the productivity of its operations and its gross margin percentage.
In attacking the cash problem through a profit-based strategy, it soon becomes apparent that only modest changes in sales productivity and gross margin are required to greatly impact the cash on hand.
Table 2 looks at two specific scenarios, both involving small changes, and the profit and cash results that would be produced.
The first column of numbers again reflects the current position for the typical NHRAW member. The second and third sets both demonstrate the impact of minor changes in key areas.
The second column involves a 1% increase in sales, generating 1% more dollars of gross margin on those sales than before, and a reduction in operating expenses of 1%. This column also assumes that the sales increase can be generated while holding both accounts receivable and inventory constant.
The third column of numbers replicates this strategy, but makes 2% changes rather than 1% change.
Clearly, profitability explodes with either 1% or 2% changes. Of equal importance, in each case the cash position is greatly strengthened without resorting to any asset reduction.
These changes are certainly not the only set of improvements that could have been examined. Any number of other changes in sales, gross margin, and expenses could have been used. However, any similar set of changes would have produced the same sort of result.
Systematic changes in sales, gross margin, and expenses will always impact both profit and cash in a significant way. The exact goals are unimportant; the real issue is a commitment to systematic change.
In reviewing these results, two points should come to mind:
Modest changes — If the company follows a profit-based approach to improvement, then changes of the magnitude of 1% or 2% can produce substantial profit improvements and resulting cash flow improvements. In contrast, reducing the asset base requires much larger changes.
Asset utilization — There is no denying that asset utilization is an important factor. However, assets were not reduced in the profit-based approach; they were kept constant as sales increased. This is a realistic goal for most companies.
Inventory, receivablesWhenever a plan calls for no change, there is a tendency to view the goal as easily attainable. In this case, increasing sales without increasing either inventory or accounts receivable almost seems like an automatic event with no planning required.
In fact, unless serious planning efforts are brought to bear, accounts receivable will automatically increase right along with sales. In addition, inventory will also generally tend to increase. Vigilant review is absolutely essential.
Inventory is by far the easier of the two factors to control. To maintain inventory at its current level will require some serious redeployment of inventory from slower moving items to faster moving ones. In most instances, slower moving inventory is excessive. Fast-selling items are almost always under-inventoried.
Accounts receivable management is much more challenging. However, experience indicates that accounts receivable is an area where attention to detail almost always produces positive results.
By focusing on proper maintenance of terms of sale, correct billing procedures and strict follow-up on past-due accounts, holding the investment constant should not be an excessively stringent undertaking.
Moving forwardMaintaining adequate cash balances is a serious issue for many companies, especially those with a strong desire for growth. Every effort must be made to utilize key asset factors as productively as possible.
However, companies must make a distinction between two very different strategies: asset reduction and profit management. Simply reducing assets is nothing more than a short-term expedient that in many instances carries long-term negative effects.
A much more successful strategy is one that focuses on improving performance while maintaining the current investment levels in key asset categories, particularly inventory and accounts receivable. It is a strategy that requires only modest changes and is a workable approach for every company.
Reprinted with permission from NHRAW’s November 1999 “Profit Improvement Report.” Bates is founder and president of Profit Planning Group, a distribution consulting firm in Boulder, CO.