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One of the persistent challenges faced by virtually every business is producing enough cash flow to ensure successful operations. Naturally, the cash-flow challenge has caused firms to look closely at what they have invested in their assets — two of the largest being inventory and accounts receivable. Because these assets are so large and also fairly controllable, many firms decide to reduce inventory or accounts receivable — or both — as a way of increasing the cash they have available.
For example, a wood flooring business might decide to stock only the most popular species of flooring, making everything else "special order." Or, the business might tighten its credit policies to reduce outstanding balances. However, most customers buy from businesses that offer a wide product selection and attractive credit terms, so having less inventory on hand and being unwilling to extend credit can mean that you will end up with fewer sales.
In fact, it may be that assets are really not too high and that management is worrying about the wrong issues. 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 three issues:
• The impact of reducing inventory and accounts receivable.
• How managing profitability can affect cash flow.
• Guidelines for managing inventory and accounts receivable.
The Myth of Reducing Inventory and Accounts Receivable
Intuitively, the quickest and most effective way to increase the cash in a business is to reduce the investment in non-productive assets — slow moving products, for example, or non-interest-earning account balances — and reallocate the funds to cash. While it is certainly the quickest way, it may not be the most effective.
Table 1 (on page 76), looks at the two key financial statements — the income statement and balance sheet — for a hypothetical wood flooring company, which we'll call Woody's Floor Store. The first column of numbers represents where the firm stands today. Cash is adequate, but not in oversupply.
The second column of numbers indicates where Woody's Floor Store would be if it could reduce both its inventory and accounts receivable by 10 percent. It should be pointed out that 10 percent is a major reduction, requiring the business to make some significant changes in both its merchandise assortment and its collection practices — a dramatic reduction in inventory or a more aggressive collections policy. Whether or not such large changes can — or even should —be made is subject to some debate.
Assuming the changes can be made, both accounts receivable and inventory are reduced by 10 percent. All of the reductions then become an increase in cash. Woody's has exchanged some of its non-cash assets for cash, improving its immediate cash-flow position.
However, that column of numbers rests on the assumption that the reductions can be made without impacting sales. For most firms, this is a very dubious assumption. While it may be feasible to reduce inventory and accounts receivable to a more appropriate level, decreasing these two key asset categories by 10 percent each will almost inevitably depress sales volume.
Therefore, the final column represents a more realistic picture, in which a 10 percent reduction in inventory and accounts receivable is accompanied by a modest 5 percent sales decline. The effect is devastating to the Woody's profits. In addition, lower after-tax profits reduces the cash available to reinvest in the business.
Let's be clear on this point: Efforts to reduce inventory and accounts receivable to acceptable levels are certainly appropriate, but most acceptable reductions are unlikely to produce significant improvements in cash flow. Only a large reduction will drive cash to desired levels, but such reductions will likely come at the risk of reducing sales.
The Reality of Profit Enhancement Strategies
Instead of focusing exclusively on asset reduction efforts, most companies would probably do better if they switched their focus to enhancing profitability. In doing so, they must turn their attention away from the factors that drive down investment and toward those that drive up profitability, examining the productivity of its operation 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 (on page 76), 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 of Woody's Floor Store. The second and third columns both demonstrate the impact of minor changes in key areas.
The second column involves a 1 percent increase in sales, generating 1 percent more dollars of gross margin on those sales and a reduction in operating expenses of 1 percent. This scenario assumes that an increase in sales and a decrease in operating expenses can be generated while holding both accounts receivable and inventory constant. The third column replicates this strategy, but makes 2 percent changes rather than 1 percent changes.
Clearly, profitability literally explodes with either 1 percent or 2 percent changes. Of equal importance, in each case the cash position is greatly strengthened, without resorting to any attempt at 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.
Two points should come to mind:
• Make modest changes: If the firm follows a profit-based approach to improvement, then changes of the magnitude of 1 or 2 percent can produce substantial profit improvements and resulting cash flow improvements. In contrast, reducing the asset base requires much larger changes.
• Utilize assets realistically: 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 firms.
Guidelines for Managing Inventory and Accounts Receivable
Whenever 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, without serious planning, 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 items tend to be where 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-upon past-due accounts, holding the investment constant should not be terribly difficult.
Moving Forward
Maintaining adequate cash balances is a serious issue for many firms, especially those with a strong desire for growth. Every effort must be made to utilize key asset factors as productively as possible.
However, firms 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 negatives.
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. And profitability is what it's all about.
