Do not let the finance area manage ROI and Working Capital

Studying Physics we learn that force is product of mass (weigh) times acceleration (velocity). Or, that as fast as we move, our weigh being constant, greater the force. Flash is a super hero that impersonates this reality.

In business management there are similar concepts. One being that faster the “turnover” (number of times the inventory is turned (sold); “velocity” of sale) applied to a “margin” (profit on the sale divided by the value of the sale times 100) greater will be the return. If one sells (turns) its stock 12 times a year at a 10% margin, its return will be 120%. Or imagine that each time the stock is sold, one makes 10, and if it is turned 12 times the total gain will be 120.

 

Both variables – margin and speed – are important to determine the return of the business. In the jewelry or goods by ordering business the turnover will be lower thus the need of practicing a higher margin. If, however, it is a business selling baked or staple goods, turnover will be higher hence margin will be lower. Ideally the best would, taking Apple, Nike or Ambev, combine high margins and high turnover, nevertheless, it demands high investment in technology and-or a band (that allows charging a premium over the competition). Surely, margin impacts the turnover; nevertheless, in this text we assume that margin is a result of a selling price in line with the market. Thus, is always important to reflect on and compare prices to those of competition and running calculations on margins and turnover, and certainly inconsistencies will be identified! Adjust one and the other will increase!

 

Another important learning is to refrain from trust or “bet” that the situation (environment) will always keep stability or tending to betterment. This is a big mistake of any manager or entrepreneur. Enterprises are influenced by the economy. The economy is cyclical living through periods of expansion and retraction (or correction). As a result there will be moments that, independently, of any effort sales will be affected. Thus, the importance of a good working capital management.

 

Working capital is, basically, comprised of: accounts receivable, stocks and accounts payable. One other important element to take into account is the time of their conversion in cash. If a given company can turn its stock in 30 days, selling it at sight and pays suppliers in 60 days, this company will be on an enviable situation as it will work with its suppliers’ capital. This was the situation of Brazilian supermarkets in the 90s (when then the term payment means were limited). Now if the situation of this company is another, or, it turns over its stock in 30 days but providing a credit term of 30 days to the customer and its suppliers must be paid in cash this company will have to work with its own capital (equity) or with debt. In this illustration we are not taking into account margin or profit but only working capital management. There is confusion between profit and cash: it is not true that if there is profit, there is cash. Let’s assume in the two earlier examples that that given company has purchased its stock for 100 and sold it for 200, thus, producing a 100 profit. In the first example this company would be with 200 for 30 days (60 days of payment term minus 30 days to sell the stock) and then would pay 100, keeping the 100 profit. In the second situation this company would be with -100 (negative) for 60 days and then after collecting the 200 (30 days after the sale), would keep the same 100!

 

This is the reason why is important to always spend time on analyzing the conversion time in cash of each of the 3 main elements of working capital (accounts receivable, stock and accounts payable) having always in mind that a good working capital management is a combination of anticipating receivables (or offering as short as possible terms to customers) and postponing payables (obtaining as larger as possible terms from the suppliers).

 

Managing returns and working capital is too fundamental to be restricted to the financial area!

 

From the book of Proverbs of Salomon two quotes: “A hard worker has plenty of food, but a person who chases fantasies has no sense. Work hard and become a leader; be lazy and become a slave.”