Is The Smart Money Really All That Smart? Written By Albert D. Bates
Article Date: 03-01-2005
Copyright (C) 2005 Associated Equipment Distributors. All Rights Reserved.
Two approaches to improving financial performance in terms of the impact on profitability.
In recent years, a somewhat heated debate has developed regarding the most appropriate approach to improving financial performance. In simplest terms, the two approaches are an operations approach and a working capital approach.
The Profitability Impact The chart on page 40 presents financial results for the typical AED member. Typical means half of the firms will perform below the results shown and half will perform above the results.
- The Operations Approach – This view, which is more traditional, suggests that firms should focus on the income statement side of the business, emphasizing modest sales growth, gross margin management and the tight control of expenses. Small improvements in performance are suggested. In this perspective, inventory and accounts receivable are viewed as necessary investments to generate required levels of sales volume.
- The Working Capital Approach – This more-contemporary view suggests inventory and accounts receivables are major cash traps that must be drained. The cost savings associated with lower investment levels will provide the higher profit for the firm. The emphasis is on making dramatic changes in investment levels rather than small ones. From a Wall Street perspective, this would be characterized as the “smart money” approach to improved results.
This report examines the two approaches to improving financial performance in terms of their potential impact on profitability.
According to the most recent CODB Report, this typical firm generates $25 million in sales volume, operates on a gross margin of 22.0 percent, and produces a pre-tax profit of $375,000 or 1.5 percent of sales.
The key issue from a working capital perspective is that the firm requires $13.9 million in total asset investment in order to generate this level of sales and profit. Of this amount $10 million is in inventory and $2.5 million is in accounts receivables. With this investment, the firm produces a return on assets of 2.7 percent.
The second column of numbers, Operations Control, looks at how the same firm would have fared if it had been able to produce 2 percent improvements in three areas of business. That includes (1) a 2 percent higher sales volume, (2) 2 percent more gross margin dollars on those higher sales (moving the gross margin percentage from 22.0 percent to 22.4 percent) and (3) a 2 percent reduction in payroll expenses.
The operations impact is straightforward – an increase in both sales and gross margin and a decrease in payroll. There is also an increase in inventory and accounts receivables to support the sales. The overall result is that profits are increased sharply, from the $375,000 current level to $655,700, an increase of 74.9 percent. In addition, the ROA increases to 4.6 percent. In short, even modest improvements in operations have a large profit payout.
In contrast, the final column of numbers, Working Capital Control, examines the impact of a rather dramatic 10 percent reduction in both inventory and accounts receivables. To make the best case for the working capital approach, it is assumed that the investment reductions can be made with no decrease in sales. Clearly, there is the potential that such large changes could undermine the entire business.
The working capital approach rests upon generating costs savings from the lower level of investment. In the analysis, a carrying cost of 15 percent is assumed for both inventory and accounts receivables. This reflects the interest expense and related costs associated with maintaining such investments.
With the 10 percent reduction in both inventory and accounts receivables, total assets fall by $1,025,000. Using the 15 percent carrying cost, the total cost savings is $153,750. When the expense reduction and investment reduction are combined, the ROA is 4.1 percent.
Some financial observers suggest the actual carrying cost is in excess of 15 percent. However, in a low-interest-rate environment, 15 percent is high. This presents the best-case scenario for the working capital approach.
The net result is that small changes in operations are much more significant than even large improvements in working capital management. This is not to say that the working capital approach is without merit. Surely, excessive investment should be avoided. However, it clearly points out that massive changes in investment are required to generate a significant profit improvement.
The implication for AED members should be obvious. There is certainly a need to control the investment level. However, the operations side of the business must continue to be paramount.
An Integrated Approach
The debate as to whether firms are best served by dramatically reducing investment or by improving operations should not be a debate at all. Improv-ing operational performance will increase profitability quicker than any other approach and with less effort.
At the same time, the challenge of managing cash flow has led firms to look at the working capital approach more than ever. What most firms should focus on is making small improvements in investment levels, not large ones. They must make the changes without reducing the effort that must be devoted to the operational side of the business.
Following are some suggestions for highly specific goals for AED members. They are larger than the two factors used before, but are reasonable expectations for every firm. If implemented, they will allow the firm to grow without facing cash flow challenges and produce a sharp increase in profits.
This list is for a typical firm. Since no firm is exactly typical, every firm should tailor these goals slightly. Guidelines for doing so are contained in the Profit Improvement Profile that is contained in AED's Cost of Doing Business report.
- Sales increase - 3 percent to 5 percent
- Gross margin percentage increase - .2 to .3 percentage points
- Payroll percentage decrease - .1 to .2 percentage points
- Inventory turnover increase - .1 to .2 turns
- Average collection period decrease - .5 to 1.0 days
To ensure adequate profit levels in the future, AED dealer members must focus on the factors that matter. For the vast majority of firms, the factors that matter are on the operations side of the business. The control of both inventory and accounts receivables can be a valuable adjunct to improved operations. However, they should remain an adjunct only, not the primary focus of the firm.
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