Working capital is the funding that a company needs to support its accounts receivable and inventory, and is offset by the amount of funding it obtains from its suppliers through accounts payable. Working capital can have a much greater impact on a company’s cash flows than the results of its operations. One of the best ways to positively impact the amount of cash flow that a company spins off is to take tight control of its working capital and eliminate much of the investment in this area. For example: a company with modest profits of 5 percent on sales of $10 million will achieve cash flows due to profits of $50,000. However, if its controls over inventory collapse and inventory turns worsen from one per month to once every two months, the increase in inventory, assuming a cost of goods sold of 50 percent, will grow by $416,667! In this example, which is by no means an extreme one, management may be patting itself on the back for achieving a profit, only to find that it is running out of money because all of its excess cash has been soaked up by new inventory requirements. Because shareholder value is tied to cash flows, management has just succeeded in reducing the value of the company despite earning a profit.
How can a controller spots and solves such problems? This post isolates the potential problem areas and reviews them one at a time.
The area that causes the most trouble is usually inventory. However, a simple increase in inventory tells one nothing about what has caused the increase. To do that, one must delve deeper and look at each of the main categories: raw materials, work-in-process (WIP), finished goods and accounts receivable.
How to review and spot any potential problem on each category above? Read on….”
Raw Materials Review
In the first category, raw materials, an inventory increase can be caused by overpurchasing by a specific buyer, the elimination of a finished good that used to require specific raw materials, or deliberate overpurchasing by a buyer because of a very low level of inventory accuracy that requires a company to keep excessive stocks on hand in order to avoid stock-out problems. In the first instance, it is a simple matter to track raw material inventory levels by buyer, as long as certain categories of parts are assigned to specific buyers. If so, a daily or weekly graph of total raw material inventories assigned to each buyer can be printed and distributed to management. Any excessive increases will become immediately apparent, possibly leading to the replacement of or additional training for the buyer. This is not a good measure if the product sales for which the buyer is obtaining raw materials is rising at a rapid rate, however, because inventories must increase to some extent to ensure that sales targets are met. If such is the case, an alternative is to graph the daily or weekly inventory turnover alongside the raw material dollar levels to see if inventories are actually being exceeded by an excessive amount.
In the second case, that of finished products no longer being produced, it may be possible to access the computer system and run a “where used” report to identify which raw materials will become obsolete. This report is a common feature of most material requirements planning systems. It accesses the BOM of all products in the company database and identifies those raw materials in stock that are not currently used in any of those products. With this report, management can quickly identify and dispose of any raw materials that are no longer being used. If taken further, management can also use the report to question the sales and engineering departments with regard to why they have discontinued products without first using up all raw materials in the warehouse. The controller’s main role in this process is to frequently distribute a listing of all raw materials in stock that are no longer being used and follow up on actions that other departments are supposed to take to eliminate these materials.
The third item is buying too much inventory in order to cover for expected inventory inaccuracy problems. In this situation, the purchasing staff must buy more than it really needs in order to avoid stock-out conditions for which it will be blamed. The best way to avoid this problem is to compile a weekly report on inventory accuracy and present it to management, which can then take action based on the reported results. To do so, the controller can assign a staff person to compare the quantities and locations reported in the inventory database to the actual amounts and locations noted in the warehouse, and then compile this information into a report.
Although the controller has no direct control over how to fix inventory issues, the accuracy report is a crucial feedback report that management needs to determine the amount of effort to bear on this problem. All three of these problems are common ones that lead to excessive increases in the quantity of raw materials inventory. Only by continually addressing them with periodic reports will a controller be able to keep management informed of the key underlying reasons for excessive investments
in raw materials.
Work In Process [WIP] Review
There are different reasons why WIP inventory can increase. One is improper production scheduling, and another is inefficient downstream production.
In the first case, the person who schedules work for each machine in the production facility may be mistakenly scheduling too much production, which results in a buildup of WIP inventory either between machines or facilities. This problem is easily remedied by working with the scheduler to reduce the amount of work scheduled for production, though it will probably have the downside impact of seriously reducing the utilization of the production facility, which must occur until the excess WIP is used up by downstream production facilities. The other problem is inefficient downstream production. The WIP inventory can increase when the correct amount of WIP is produced, but the facilities or machines that use it become bottlenecks due to inefficient production practices, which results in an increase in WIP in front of those operations.
Once again, the best solution is to work closely with the production scheduler to ascertain where production bottlenecks are developing, and then schedule reduced production in front of those locations to gradually reduce the amount of WIP. The analysis that a controller can perform to give appropriate feedback to the production scheduler is to issue a daily list of on-hand WIP inventory valuations, as well as a daily graph that shows the current cost of all WIP on hand. These reports, along with an active production scheduler who is partially compensated based on keeping WIP levels low, are normally sufficient for ensuring that the level of WIP inventory does not increase.
Finished Goods Review
The next inventory problem is finished goods. An excessive amount of this type of inventory can be caused by incorrect forecasting of customer purchasing patterns, an excessive number of product configurations, product obsolescence, the conversion of too much WIP into finished goods, or the capitalization of excessive amounts of overhead by management in order to increase the reported level of profits. In most cases, several of these issues are present. The first problem, incorrectly forecasting customer demand, is the most common one, and can result in a massive oversupply of products. A controller can easily analyze this problem by comparing actual to projected sales by product line and distributing the report to management.
The second problem involves a company producing so many product configurations that it cannot accurately forecast the exact configuration that customers are purchasing. The answer is the same as the last item—to supply management with a complete list of budgeted versus actual sales, but at a greater level of detail than by product line, so management can see that some product configurations are not selling well. The third problem involves not being able to sell finished goods at all. To analyze whether something is obsolete, one can continue to use the same report just described, but also add a column that lists how long it will take to use up the existing inventory of each item, based on current sales rates.
A separate analysis can also review how long it has been since anything was purchased for a particular item. The next item, converting too much WIP into finished goods, is a rare and short-term problem, and results from a production scheduler’s trying to eliminate an excessive amount of WIP. When this happens, there is a brief surge in the amount of finished goods when the conversion takes place. This is rarely worthy of much analysis, because the problem lasts only as long as it takes to sell off the finished goods.
For a really large increase in finished goods inventory, one can graph the amount of WIP and finished goods inventory side-by-side in order to see that the decrease in one led to the increase in the other. The final item, which is the intentional buildup of inventory in order to capitalize expenses, is an excessively common one. In this case, a manager realizes that profits can be artificially enhanced by greatly increasing production, which thereby increases the amount of finished goods inventory and allows the accountants to add overhead costs to inventory rather than expensing it in the current period. This approach is a great drain on cash, and so is anathema to anyone trying to improve shareholder value. Though the analysis is obvious—a simple graph showing the run-up in inventory dollars—the real problem is that the senior manager receiving the report is possibly the same one who authorized the increase in inventory. All of these problems with increases in finished goods inventory are easily analyzed either by graphical comparisons or presentations, or by comparing inventory levels to sales projections.
It is very important for a controller to work with other departments, especially the sales department that provides sales forecasts, when distributing this information, so that production levels can be reduced on those finished goods items for which there are excessive amounts already in stock.
A lesser and relatively uncommon inventory issue that can also impact cash flow is the use of consignment inventory. Under this method, a company sends finished goods inventory to the location of a customer, but still owns the inventory until the customer sells it. Under this method, it is important for a company to continue to record the inventory in the balance sheet until a payment for it has been made by customers, thereby signifying the completion of a sale transaction. If this is not done, a company will record a sale transaction even though there has been no payment by the customer, which is a drain on cash, since there will be no payment by the customer that will result in a cash payment. In those rare cases in which a company has such inventory stored at customer locations, especially if large quantities are involved, it is critical for a controller to keep close track of the off-site inventories and to chart this information by location, so that management knows the size of its investment at these locations. It is also useful to include in this analysis a calculation of the inventory turnover rate at each consignment location, in case some customers are not able to sell the product. When this happens, management can see that its inventory investment is languishing at certain customer locations, and can then act to pull back the product and send it to other locations where sales are better.
Accounts Receivable Review
Another key component of working capital that can have a major impact on cash flow is accounts receivable. If a company does a poor job of granting credit to customers or in collecting money from them, the investment in this category can rapidly become excessive, possibly leading to a large proportion of write-offs or at least a great deal of collection effort to bring the investment in this area back down to size. As noted, the first problem is the granting of credit. If a customer is sold something on credit without a pre-established credit level, or if that level is exceeded, there is a high risk that the customer will not pay its bills.
A simple way to analyze this issue is to prepare a summary listing by customer that shows the customer name, maximum credit allowed, current balance owed, and the percentage of credit limit used. The report can be sorted to show those whose current credit levels are close to or being exceeded by actual accounts receivable. An additional column that may be of use is one that lists the proportion of accounts receivable that is currently overdue.
The second issue related to accounts receivable is a company’s ability to collect on payments from customers in a timely manner. If not, the cash absorbed by a large accounts receivable balance can quickly become excessive. The best way to analyze this problem in detail is to print an accounts receivable aging report and review each overdue invoice for the specifics of why payments are not being made. One can also measure collection problems by collections person, to see if some collections personnel are better at this work than others.
The only key measure that should be tracked at least weekly is the “accounts receivable turnover“ number, which is:
Days of accounts receivable = [Accounts receivable / Annualized sales] x 365
This measure calculates the proportion of accounts receivable to annualized sales. A good turnover proportion should roughly match the average number of day’s credit granted to customers. For example: a turnover rate of 35 days is excellent if the average invoice must be paid in 30 days, but is not good at all if the average invoice must be paid in 10 days. A significant increase in the accounts receivable turnover figure leads to an increased cash investment in this area and should be dealt with immediately.
The various types of analysis and other actions noted in this post are designed to reduce a company’s cash investment in working capital, which is one of the most significant sources of cash in a company. A sharp reduction in the cash used in this area has a direct positive impact on shareholder value.