TheMagic of Managing the BalanceSheet

the phrase managingthe balancesheeta couple of times in this book. Right We've mentioned of the now, we want to go into greater detail about how to do it. The reason?Astute management financialperfbrmance sheet is like financialmagic.It allows you to improveyour company's balance makesa business even without boostingsalesor lowering costs.Betterbalancesheetmanagement up the caslr conversion more efficient at convertinginputsto outputsand ultimatelyto cash.It speeds morecashin less that can generate thatwe'lI take up later in this part. Companies cycle, a concept or lenders. investors on outside freedom time havegteater ofaction;theyaren'tso dependent theywill haveday-to-day department, Ifyou company is big enough to havea CFO anda finance responsibility for managing most of the balancesheet.They'll help you figure out how much to and generallykeep an when necessary, borrow and on what terms,help you line up equity investment with or (especially) owner,, eye on the company's overall assets and tiabilities.But any br.siness the balance without a financedepartment, should ru-rderstand the key conceptsinvolved in managing working capitcrl.Learnto help your sheet.In particular,you needto understand the idea of managing people manage working capital better,and you will have a powerful eflect on both your company's position. profitability andits cash

THB ELEMENTS OF WORKING CAPITAL

Workingcapital is a categoryof resources minus that includescash,inventory,and receivables, whatever a companyowes in the short term. It comesstraightfrom the balancesheet,and it's often calculated according to the following formul a: - current workingcapital: current liabilities assets Of course, this equation can be brokendown flrther. Currentassets, as we have see4 includes itemssuchas castr, receivables, and inventory. payables liabilities includes andothershortCurrent term obligations. Btlt thesearen't isolatedline itemson the balancesheet; different they represent stages ofthe production cycleanddiflerenttbrmsof workingcapital. To understand this, imaginea small manufachling company. Every production cycle beginswith casll which is thefirst component ofworking capital.Thecompany takesthecashandbuyssomeraw materials. That creates raw-materials inventory, of working capital.Then the a secondcomponent raw materialsare usedin production,creatingwork-in-process inventoryand eventu,ally finishedgoodsinventory, also part of the "inventory" component of working capital. Finally, the company sellsthegoods to customers, creating receivables, which are thethird and last component of working capital(figure25-I). In a servicebusiness, oul own the cycle is similar but simpler.For example, company-theBusiness LiteracyInstitute-is partly a trainingbusiness. Its operating cycle involves thetime required to go fiom the initial development to thecompletion of training of trainingmaterials, classes, and finally to the collectionof the bill. The moreefficientwe are in finishinga projectand following up on collections, the healthielotu profitabilityandcashflow will be. L.rfact,thebestway to makemoney in a servicebu,siness is to providethe servicequickly andu.ell andthento collect as soonas possible. Tfroughout this cycle, the But theamount form takenby working capital changes. doesn't changeunless more cash enters the systenF-for example, liom loans or from equity investments. Of course, if the company buys on credit, then some of the cash remains intact-but a corresponding "payables"line is created sheet. So thatmustbe on the liabilities side of the balance deducted fromthethreeothercomponents pictLu'e workingcapital. to getan accurate ofthe company's

FIGURE 25-]

Workingcapitaland the productioncycle

Cash

Receivables

Raw-materials inventory

Finished-goods inventory

Overall, how muchr.r'orking This question doesn'thavean capital is appropriate for a company? easyanswer. Every company needsenough cashand inventory to do its job. The largerit is andthe fasterit is gowing, the more working capital it is likely to need.But the real challenge is to me working capital effrciently. The three working capital accountsthat you and your employeescan affectday in andday out are accounts payable. accor-uts receivable, inventory, and(to a lesserextent) We'll takeup eachonein turn. Before we do, thougll it's worth asking once again how much aft is involved in all these calcr.rlations. ln this casethe bestanswermightbe "some."Cashis a hardnumber, not easilysubject to manipulation. Receivables and payables are relativelyhard as well. lnventoryisn't quiteso hard. Variousaccounting ways. techniques in difierent andassumptions to valueinventory allow a company So a company's calculation of working capitalwill depend to an extenton the rules its accountant follows. Still, you can generallyassurne that working capital figures aren't subjectto as much discretion andiudement as manvofthe numbers we learned aboutearlier.

Your BslanceSheetLevers
Most companies purchase or services. use someof their cashto financecustomers' of products That's the "accourtsreceivable" line on the balancesheet-the amountof moneycustomers owe at a givenpointin time,based on thevalueof whattheyhavepurchased beforethatdate. The key ratio thatmeaswes or accounts receivable, as we saw in part 5, is dayssalesoutstanding, DSC!-that is, the averagenturber of days it takesto collect on thesereceivables. The longer a company s DSO,the moreworking capitcrlis reqttirecl to run the business.Cwtomershavemoreof the company's cashin the form ofproductsor services not yet paid for, so thatcashisn't availableto buy inventory, deliver more services, DSO, the less the shortera company's and so on. Conversely, workingcapitalis requiredto rr-ur DSO the business. It follows thatthe morepeoplewho understand andworkto bringit dow4 the morecashthecompany will haveat its disposal.

MANAGING DSO

The first stepin managing DSO is to understand what it is and in which directionit hasbeenheading. If it's higher thanit ought to be, andparticularly if it's trending upward(which it nearlyalwaysseems you to be), needto beginasking questions. Ask yow operations Inanager, for example, whetherthereare any problemswith the products or servicesthat might make crstomersless willing to pay their bills. Is the companyselling what crtstomers want and expect? Is therea problemwith delivery?Qualityproblemsand late deliveries j r,st becawe customers often provoke late payment, are not pleasedwith the productsthey're receiving and decide that they will take their own sweet time about payment. The people in production andshipping thushavean eflecton receivables you needto as well. In a servicecompany, be askingthe samequestions of the peoplewho are out deliveringthe service.lf servicecustomers aren'tsatisfied with what they'regetting, theytoo will taketheir time aboutpaying. Ask your customer-facing nunagersand employees-thosein sales and customerservice-a similar setof questions. Are our customers in their industry Whatis the standard financiallyhealthy? for payingbills? Salespeople typically havethe first contact with a customer, so it is up to themto flag anyconcerns aboutthe customer's ice reps customerserv financialhealth. Oncethe saleis rnade, need to pick up the ball and learn what's going on. What's happeningat the customer'sshop?Are employees working overtime?Is the company needto laying people ot{? Meanwhile,salespeople work with the credit fflanager and customerservice so that everybodyunderstands the termsup front andwill noticewhena customer is late.At onecompany we worked with, the deliverypeopleknew the mostaboutcustomers' situations because theywere at their facilitieseveryday.Theywould alert salesandaccowrting ifthere seemed to be issues business. cropping up in a customer's Chancesare you have someoneother than yowself reviewing the credit of customers and prospectivecustomers. That personneedsto ask whetherthe terms oflered are good for the company and whetherthey fit the credit histories of the customers. He or she also needsto makej udgmentsmaybein consultation with you-about whether is giving credit too easilyor whetherit the company is too toughin its credit policies. There'salways a trade-offbetweenincreasing saleson the one handandissuing creditto poorercreditrisks on theother. need You andyour salesor creditmanager to settheprecise you allow net termsyou're willing to oftbr.Is netthirty dayssatisfactory-or should sixty?You needto determine "2/10 strategies for early pay.For example, suchas offeringdiscorurts net 30" means that customers get a discountof 2 percentif they pay their bill in ten days and no discowrtif theywait thiny-* days.Sometimes or 2 percent discountcan help a struggling a I percent company collect its receivables and therebylower its DSO-but of course,it doesso by eatinginto profitability. We know of a small company to the issueof giving credit thathasa simple,homegrown approach to customers. The companyhas identified the traits it wants in its customers and has evennamedits ideal crstomer Bob. Bob's qualitiesincludethefollowing: . He works for a large company.

a a

His company is knownfor payingits bills on time. He canmaintain and understand the productprovided(this company makes complex technologyintensive products). He is lookingfbr an ongoing relationship.

If a new customer meets these criteria,it will getcreditliom this smallmanufactLrer. Otherwise, it won't. As a resultof this policy, the company hasbeenable to keepits DSO quitelow andto gow without additionalequity i nvestment. All thesedecisions greatlyaflect accorutsreceivableand thus working capital.Anclthe fact is, _ theycanhavea hugeimpact.Reducing DSO evenby oneday cansaveu .o-puny a lot ofmoney.For example, checkbackto the DSO calculation in chapter 22, andyou cancalcJatethatoneday of sales in ow sample company is just over $24,000. Reducing DSO from fifty-five daysto fifo-fow in this company wottld thw increase cashby $24,000.That'scashthat can be usedfor otherthinssin the business.

MANAGING INVENTORY

Many business ownersthesedaysare focusingon inventory.They work to reduceinventorywherever possible. They are learning concepts such as lean manufacturing,just-in-time inventory management, andeconomicorder quantity. The reasonfor all this attention is exactlywhat we're talkingabouthere.Managing inventory etTiciently workingcapitalrequirements by freeingup reduces large amounts of cash. The challenge for inventory management, ofcourse,isn't to reduceinventory to zero,which would probablyleavea lot of customers ursatisfied. level while The challenge is to reduceit to a minimum still ensuring thatevery raw materialand every part will be availablewhen needed and that every productwill be ready for sale when a customer needsto be constantly wants it. A manufacturer ordering raw materials, making things, andholdingthosefinishedproducts fbr deliveryto customers. Wholesalers andretailersneedto replenish their stocks regularlyto avoid the dreaded stockout-an item that isn't availablewhen a customer wants it. Yet every item in inventorycan be regarded as frozencash,which is to say cashthatthe company Exactlyhow much cannot usefor otherpurposes. inventory is requiredto satislycustomers while minimizing that trozencash,well, that'sthe milliondollar question (andthereason for all thatattention beingpaid to inventory). The techniques for managing inventoryare beyondthe scopeof this book. But we do want to emphasize thatmanydifferent peoplein your company levels,which means thatall of affectinventory themcanhavean impacton reducing workingcapitalrequirements. For example: Salespeople love to tell customers theycanhaveexactlywhat theywant. ("Have ityour way," as the old Br.rgerKing jingle put it.) Custom paintjob? No problem.Bells and whistles?No problem. Everyvariation,however,requires meaning a little morecash. a little moreinventory, Obviously, customers mwt be satisfied. requirement hasto be balanced But that cofilmonsense against the factthatinventory products costsmoney. cansell standard The morethatsalespeople with limitedvariations, the lessinventory will haveto carry. their company Engineers love thosesamebells and whistles.In fact, they're constantly working to improve their company's products, replacingversion2.54 with version2.55 and so on. Again,this is a laudable business objective,but it's onethathasto be balanced inventory requirements. against A proliferation of product versions adds to frozen cash and puts a burden on inventory rnanagement. Whena productline is kept simplewith a fbw easily interchangeable options, the amount of inventory needed is likely to be lessandtherefore lesscashis tied up. Productiondepartments greatly affect inventory.For instance, of machine what's the percentage downtime? Frequent inventory breakdowns requirethe company to carry morework-in-process and more finished-goods inventory. And what's the average time betvveenchangeovers? Decisions abouthow muchto build of a particularpart havean enormous impacton inventory requirements. production Even the layout of a plant affectsinventory:an etlciently designed plant flow in an eltrcient minimizes theneedfor inventory.

Along theselines, it's worth noting that many U.S. plants operateon a principle that eats up tremendouamounts of working capital.Whenbr.siness is slow, they neverthel.r,k .p on churning out-product with the goal of maintainingfactory efficiency.Factory owners and plant managers foc,-,i on keeping uiit costsdown, oftenbecause theylearned thatgoal early in their careers and no longer q u e s t i oin r. WhenbL'siness is good,the goal makes perfectsense: keepingLuit costsdown is simplya way of managing all the costsofproduction in an efficient manner. litrl s is the old approachof focusingonly on the incomestatement, u'hich is fine as far as it goes.)Whendemand is sl'ow,however, the owner or plantmanager mwt consider the company's .urliu, well as its Lurit costs. A plantthatcontinues to turn out product in these circumstances just is creating moreinventory thatwill ,it on u shelftaking up spaceandcash.Comingto work and readinga book mightbe betteithanbuildingproduct thatis not readyto be sold. How much can a companysave througl-r astuteinventorymanagement? Look again at our sample company:cuttingjust one day out of the DII number-reclucingit from seventy-fotr clays to seventythree-would increase cash by nearly $19,000.Any company with inventorycan save significant amounts of money, and thereby reduce r.vorking capitai requirements,jrxt by making modest improvements in its inventorymanagement.

Homing In on Cash Conversion

[n this chapter we'll takeup thecashconversion how effectively a company cycle,which measures collects its cash.But there's one little wrinkle we have to considerfirst-how fast a company decides to paythemoneyit owes its vendors. Accorurtspayable is a tough numberto get right. It's an area where flnance meetsphiiosophy. Financial considerations alone wor-rldencourage bminess owners to maximize days payable (DPO),thusconserving outstanding their company's A change in this ratio is as powerfulas a cash. changein the other ratios we've been discussing. in the imaginaryconrpany we've For instance, lookedat in manychapters now, if managers increased DPO byjust one day,theywould add about to thecompany's $ 19,000 cashbalance. But thereare otherconsiderations, as we mentioned 22. Wl:r;rkind of a relationship in chapter do you want with you vendors?What l<indof reputationdo you \\'ant? In practical terms, how much leverage do you havewith your vendors-will theyevencontinue doingbusiness with your company if it is a late payer? Anotherpracticalconsideration rating.D&B basesits is the Dtur& Bradstreet scores, in part,on a company's payment history. payslate may find An organization thatconsistently thatit hastroublegetting a loan later on. A personal storymayillustrate thepoint.Joe'scompany, neverletsan invoicego beyond Setpoint, thirty days.The company's philosophy is thatslow payments Wheredid simplyaren'tgoodbusiness. that philosophycome llom? When Joe's partners,both engineers, startedSetpoint,they had recently lelt anothercompany.There, they had been project rnanagers, designingcustom products for the company's customers. But whentheysenttheir designs nobodywould build parts outto be fabricated, for them. When they asked why not, they tbud that their employer regularly took more than one hundreddays to pay its bills. In etfect, the engineershad to becomenegotiators just to get their projectsbuilt! Whenthey startedtheir own bminess,they vowed they would never put their new company's engineers in thatposition.While the philosophy putsconstraints on cashflow, Setpoint's leaders believethatit positivelyaflectsthecompany's with its vendorsreputation andrelationship and inthe longtermhelps Setpoint build a stronger around itself. community of bminesses In general, if you noticethatyour company's DPO is climbing-and particularlyif it is higherthan your DSG-you might want to stalt askinga few questions. of the company After all, the success probably dependson good relationships don't want to mess up those with vendors,and _'-ou relationships unnec essari lv.

THE CASH CONVERSIONCYCLE

Anotherway to tnderstand working capital is to studythe cashconversion cycle. It's essentially a timeline relating the stagesof production(the operatingcycle) to the company'sinvestment in workingcapital.The timelinehasmultiplelevels,andyou can seehow the levelsare linkedin igue 27- L Understanding theselevels andtheir measr.res your providesa powerful way of ur.rderstanding business andshould helpyou makefinanciallyintelligent decisions. Starting at the left, the company pwchases payable period raw materials. Thatbeginsthe accourts and the inventoryperiod. In the next phase,the companyhas to pay for those raw materials.That begins the cashconversion cycle itself-that is, the cashhasnow beenpaid out,, andthejob is to see how fastit cancomeback.Yet the company period;it hasn'tactuallysold any is still in its inventory finishedsoods vet.

FIGURE 27-]

The operatingcycle

period lnventory

<-

Accounts receivable-------------) period

+_

Accounts payable _________---_) {period

Cash conversioncycle

Raw materials purchased

Payment for raw materials

of Sale finished goods

Cash collected on sales

Eventually, the company does sell its finishedgoods,endingthe inventoryperiod. But it is just entering the accowtts receivableperiod; it still hasn'treceivedany cash.Finally, it doescollectthe cashon its sales'which endsboththeaccouts receivable periodandthecashconversion cycle. Why is this important? Becausewith it, we can determine how manydays the cycle takesand then understand how many days a company'scash is tied up. That's an imporlant numberfor company owners to know. Armed with the number,entrepreneurs may be able to find ways to "save" lots of cashfor their company. To ligure it out, usethe following formula: cashconversion cycle: DSO + Dll - DPO In otherwords, take days salesoutstanding, add days in inventory,and subtractthe numberofdays payable outstanding. That tells yoq in days, how fast your companyrecovers its cash, from the moment it paysits payables to themoment it collectsits receivables. The cashconversion cycle also givesyou a way of calculating how muchcashit takesto finance youjLrst the business: takesalesper day andmultiplyit by the nunrber ofdays in the cashconversion cycle.Herearethecalculations for our sample company:

- 55 days = 73 days 54 days+ 74 days

73 days x $24,136salesld &y= $ 1,767,928
This bminessrequiresworking capital of around$ 1.8 million jr"stto f-rnance its operations. That isn't urusualfor a gowing company. Even smallcompanies requirea lot of workingcapitalrelative to their salesiftheir cashconversion cycle is as longas sixtydays. Companiesof any size can get themselvesinto trouble on this score. Tyco Internationalmentionedearlier in this book-was famor.sfor acquiring six hr.rndred companiesin two years.All thoseacquisitions entaileda lot ofchallenges, involvedhugeincreases but one seriow challenge in the cashconversion cycle.The reason? Tycooftenwas acquiring companies in thesame indutry, and competing products were addedto its productlist. With severalvcry similar products in inventory, the company couldn't move tl.rat inventoryas fast as it oncehad. lnventorydaysbeganto spiral out of control, increasingin someparts of the businessby more than ten days. In a multinationalcompany with morethan$30 billion in revenue, increases on that scalecan depletecashby severalhudred million dollars. (This is an issue that Tyco has addressed in recentyears by closing down the acquisition pipelineandfocusing on theoperations ofthe business.) The cashconversion cycle canbe shortened discussed in this part:decreasing by all thetechniques DSO, decreasing inventory, and increasing DPO.Figureout what your company's cycleis andwhich direction it's heading in. You may want to discrss it with your managers.That might start a conversation thatwill resultin a fastercashconversion cycle, lower working capitalrequirements, andmorecash. Thatwill benefiteverybody in thebuiness.