Not all roads lead to ROIC
Sep 25, 10:44 pm in Business
One of the most popular continuous business improvement techniques is Working Capital Reduction initiatives. The idea is straight forward – Minimise your capital in places where it is not generating a return. It is not obvious however that this translates into greater shareholder value. The danger is that the released capital is not put to valuable use.
Working Capital is defined as the difference between Current Assets and Current Liabilities. Current Assets consist of Operating Cash, Accounts Receivables, Inventories and Other current assets. Current Liabilities of Accounts Payable, Short term debt and the Current portion of long term debt and Accrued Liabilities.
There are four key strategies for reducing working capital.
- Reduce inventories
- Improve Order-to-Cash processes to reduce Accounts Receivables
- Work with suppliers to obtain more generous payment terms resulting in a slower turn-over of Accounts Payables
- Move operating cash to a non current item in the balance sheet. (E.g. pay off debt, invest in new products/markets, pay dividends, buy-back shares etc.)
Whilst all of these, if executed successfully, will result in reduced working capital only Strategy 4 will directly impact the Return on Invested Capital and hence Shareholder Value.
Strategy 1-3, if successful, will result in a reduced requirement of operating cash used to cover the duration between having to pay the company’s stakeholders and getting paid from its customers. The reduced cash requirement will eventually manifest itself as surplus cash. Management must take a conscious decision how to use this extra cash to generate the sought after additional shareholder value. If it’s allowed to just sit there this very tangible benefit will not contribute to an increase in value creation.
Shareholder Value is created from Working Capital Reduction when it results in the difference between required operating cash and operating cash is positive and that surplus cash is used to reduce invested capital or increase the net operating profit less adj. taxes. I.e. the company has more cash on hand than it needs to run its operations and can hence use that cash to reduce dept or equity liabilities or invest in new products or markets to increase net operating profit.
As a value oriented business improver it is not enough to successfully deliver a reduction of working capital we must also ensure that released capital is deployed where it can generate optimum shareholder value. Why not use the released capital as a ticket into the CFO’s office and your next big sell?
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