March 2005                        return to newsletter contents page

Is the Smart Money Really all that Smart?

by Dr. Albert D. Bates

In recent years a somewhat heated debate has developed regarding the most appropriate approach to improve financial performance. In simplest terms the two approaches can be thought of as an operations approach and a working capital approach.

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 that inventory and accounts receivable are major cash traps which 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 different approaches to improving financial performance in terms of their potential impact on profitability. It will do so in two ways. First, it will compare the financial impact of small operating improvements versus large working capital ones. Second, it will attempt to integrate the two diverse philosophies into a unified profit improvement plan.

The Profitability Impact of Operations and Working Capital

Exhibit 1 presents financial results for the typical AVDA member. Typical means that half of the firms will perform below the results shown and half will perform above the results.

According to the most recent PROFIT Report, this typical firm generates $120,000,000 in sales volume, operates on a gross margin of 20.5%, and produces a pre-tax profit of $2,400,000 or 2.0% of sales.

The key issue from a working capital perspective is that the firm requires $38,700,000 in total asset investment in order to generate this level of sales and profit. Of this amount $14,200,000 is in inventory and $14,600,000 is in accounts receivable. With this investment, the firm produces a return on assets of 6.2%

The second column of numbers, Operations Control, looks at how the same firm would have fared if it had been able to produce two percent improvements in three areas of the business: (1) Two percent higher sales volume, (2) two percent more gross margin dollars on those higher sales (moving the gross margin percentage from 20.5% to 20.9%) and (3) a two percent reduction in payroll expenses.

As can be seen, the operations impact is fairly straightforward, with an increase in both sales and gross margin and a decrease in payroll. There is also an increase in both inventory and accounts receivable to support the sales. The overall result is that profits are increased sharply, from the $2,400,000 current level to $3,626,640, an increase of 51.1%. In addition, the ROA increases to 9.2%. 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 ten percent reduction in both inventory and accounts receivable. 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 lowered level of investment. In the analysis, a carrying cost of fifteen percent is assumed for both inventory and accounts receivable. This reflects the interest expense and related costs associated with maintaining such investments.

With the ten percent reduction in both inventory and accounts receivable, total assets falls by $2,361,600. Using the fifteen percent carrying cost, the total cost savings is $354,240. When the expense reduction and investment reduction are combined, the ROA becomes 7.6%.

Some financial observers suggest that the actual carrying cost is in excess of fifteen percent. However, in a low interest rate environment, fifteen percent is more likely high than low. 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 not 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 AVDA 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.

Developing 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. Improving 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 approvingly than ever before. 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.

The following table suggests some highly specific goals for AVDA 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 also produce a sharp increase in profits.

• Sales Increase: 3 to 5%

• 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

The above list is for the typical firm. Since no single firm is exactly typical, every firm must tailor the goals slightly. Guidelines for doing so are contained in the Profit Improvement Profile that every AVDA member receives by taking part in the PROFIT survey.

Moving Forward

To ensure adequate profit levels in the future, AVDA 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 businesses. The control of both inventory and accounts receivable can be a valuable adjunct to improved operations. However, they should remain an adjunct only, not the primary focus of the firm.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2005 Profit Planning Group. AVDA has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.

A Managerial Sidebar on Calculating the Carrying Cost

The investment in both inventory and accounts receivable causes firms to incur some expenses simply to maintain the investment. Unfortunately, these expenses are scattered throughout the income statement and are somewhat difficult to aggregate.

When they are aggregated they are commonly referred to as carrying costs. The idea of a carrying cost for inventory is well known. The idea of one for accounts receivable is not widely discussed.

The following table suggests the carrying costs for both inventory and accounts receivable. In both cases the cost is expressed as a percentage of the investment. As can be seen, the inventory carrying cost is probably close to 15.0%, while the accounts receivable carrying cost is closer to 8.0%.

The other expenses for both inventory and inventory include the cost of administration and maintenance. For inventory they include maintaining inventory records, cycle counting and related expenses. For accounts receivable they simply include the cost of the accounting function.