The Evils of Working Capital
by Rick Sidorowicz

Retailing companies know the value of inventory turnover and the powerful implications it can have on cashflow and financial performance. The one simple, tried and true formula for success in retailing can have a dramatic impact if applied in any business.

Buy it, sell it - and then pay for it. (Period!)

This simple and proven tenet works, and wins everytime to get your customers’ cash and vendors’ trade credit working on your behalf.

The formula is a key for success in a thin margin high volume operation as well as for others who may have enjoyed high margins and a more profitable ‘niche’ in the past. As margins decrease due to ever increasing competitive intensity retailers are best advised to carefully examine the proven formula for success. There is indeed more involved in putting the formula to work - such as selling the products your customers want and buying effectively - the approach does hold many insights for ‘breakthroughs’ in operating efficiencies and financial performance. Turnover is at the heart of the matter and is the key to a positive cashflow and financial leverage.

If we examine the buy - sell - pay formula closely we can see that the ultimate success implies a financial reality of ‘negative working capital.’ Is negative working capital a ‘negative?’ Not if we define the ‘operating’ working capital as inventories plus receivables less accounts payable. Is lower or negative working capital desirable? Most definitely in terms of our definition here - to save costs through lower operating capital requirements and operating efficiencies. Is a zero or negative working capital achievable? No doubt - and the great news is that the strategies and tactics employed to reduce or eliminate working capital are precisely those that can unleash significant cost savings and efficiencies to dramatically improve financial and operating performance. 

Consider the following implications:

Every dollar freed from inventories or receivables reduces financing requirements on a permanent basis, or at least for that level of activity.

Every dollar increase in accounts payable reduces your financing requirements from other sources, provided the new level can be sustained.

Every dollar freed from working capital creates a dollar of cash or financing available for another more productive purpose.

ROI’s increase as the investment base decreases, and inventories and receivables are significant investments in most businesses.

The forces of good and evil

We can usually accept that higher inventory turnover is better than lower inventory turnover, and lower receivables are better than higher receivables. Funds flow terminology provides an additional perspective on the matter:

An increase in working capital (i.e. increase in inventory, increase in receivables, or decrease in payables) reflects a ‘use’ of funds. As with all ‘uses’, the funds must come from somewhere i.e. operating cashflow, debt, or equity. A decrease in working capital, on the other hand, is a “source’ of funds, providing the funding for other ‘uses.’ 

Examine the positive implications of a decrease in working capital (source of funds). Assuming your business activity is sustained, a decrease in inventory reflects higher turnover - selling more with a lower investment. A decrease in receivables implies a faster collection of credit accounts and lower exposure to uncollectable accounts. An increase in payables implies more favourable trade credit terms and an increase in flexibility.

Let’s look at the ‘evils’ of the opposite situation. 

Inventories owe their existence to a variety of factors such as varying and unpredictable demand, bottlenecks in distribution, variances in forecasting, long lead times, unreliable supply, fluctuating pricing, lengthy production runs, etc. All of these factors reflect inefficiencies or buffers in the distribution process. In a perfect world we could assert that inventories would be unnecessary, or at least very minimal. Inventories in general reflect inefficiency somewhere in the process.

Receivables owe their existence to extending credit and financing others, billing delays, returns to suppliers, delays in collection, uncollected discounts and rebates, etc. These factors generally represent timing and performance inefficiencies. 

Working capital, as we have defined it owes its existence in large measure to inefficiency, and is the investment your firm makes in the inefficiencies of your processes and procedures. It also represents your firm’s investment in your suppliers’ inefficiencies, and your customers’ inefficiencies.

Working capital is your investment in inefficiency!

In many firms the investment in inefficiency is a significant untapped source of funds. Zero working capital can also be the key focal point of a breakthrough strategy of dramatically improving process efficiencies. The benefits? How about saving financing costs; reducing the size of or eliminating warehouses; reducing costs of inventory shrinkage, damage, pilferage, and obsolescence; reducing the overhead associated with managing the investment in inefficiency; challenging all existing practices in credit and payables; and achieving a host of savings through process improvement. 

How do you achieve it?

Step 1
Quantify your investment in inefficiency.

Step 2
Resolve not to let this investment in inefficiency increase.

Step 3
Look at the investment in efficiency every day until it drives you and everyone else absolutely crazy.

Step 4
Get at faster cycle times in all your key business processes. 

And, in the words of Eric Nutter:

“In business, it isn’t over until the fat lady sings. And I say she doesn’t sing until you’re at zero working capital.”


Rick Sidorowicz is the Publisher and Editor of The CEO Refresher and
the Minister of Culture of High Performance Retail.

Many more articles in The CFO Refresher in The CEO Refresher Archives

   


Copyright 1999 - 2002 by Rick Sidorowicz. All rights reserved.

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