ARE CASH,
A/R, AND INVENTORY NON-EARNING ASSETS?
In business, cash, accounts receivable, and inventory are
often classified - or at least perceived - as non-earning assets.
That perception is incomplete; The real question should not
be:
Does this
asset generate income directly?
but rather:
How effectively does management employ the capital invested
in this asset?
A well-managed WC asset can contribute to profitability,
reduce financing costs, improve liquidity, and ultimately increase shareholder
value.
Let us look
at the three major components.
1. CASH:
NOT ALL CASH HAS TO SIT IDLE
Cash is often regarded as a non-earning asset because money
sitting in a bank account may generate little or no return.
But the
problem is not cash; The problem is idle cash.
A company needs an adequate operating cash balance to meet
payroll, suppliers, taxes, debt obligations, and unexpected requirements.
Beyond that necessary operating balance, however, effective treasury management
can turn surplus liquidity to earning asset.
Depending on the company's risk policy and liquidity
requirements, surplus cash may be invested in relatively secure, short-term
instruments such as:
- Treasury bills
- Certificates of deposit
- Short-term bank deposits
- Money-market instruments
- Other highly liquid, low-risk
investments
But do you
know what is your surplus cash? Treasury management will answer that for you.
The objective is not to speculate with corporate
liquidity. The objective is simple:
Make surplus
liquidity earn something while remaining available when the business needs it.
Therefore,
the appropriate question is not:
How much
cash does the company have?
but:
How much
cash does the company need, and what is it doing with the surplus?
2.
ACCOUNTS RECEIVABLE: CREDIT HAS A PRICE
Accounts receivables are often treated as a non-earning
asset.
Let us
challenge that perception.
A/R is not simply an amount owed to the company. It is also
the result of a credit decision, and every credit decision has an economic
cost.
Consider the
familiar payment term:
2/10, Net
30
The customer receives a 2% discount for paying within 10
days. If the customer chooses to pay on day 30, the customer effectively gives
up a 2% discount in exchange for keeping (borrowing) the money for an
additional 20 days.
That 2% is
not insignificant. If annualized on a
simple basis:
2% ÷ 20
days × 360 days = 36%
In other words, the customer is effectively paying (and we
are earning) approximately 36% per annum for those additional 20 days of
financing, before considering compounding. On an effective annual basis, the
implied cost is even higher.
Now consider
the following situation:
A company
has the option to pay its supplier within 10 days and receive the 2% discount.
Instead, it forgoes the discount and borrows the money for
another 20 days.
At the same
time, the company borrows from its bank at an effective annual interest rate
of, say, 19%.
If that company were to borrow from its bank to pay the
higher cost trade credit it saves 17%.
But taking the trade credit and incurring a financing cost
economically partially destroy shareholders’ wealth.
The company
has effectively:
forgone a financing benefit equivalent to approximately 36%
per annum, while simultaneously ncurring a financing cost of 19% per
annum.
The company
is therefore paying the bank 19% while voluntarily giving up an opportunity
that carries a much higher implied annualized value.
This is why effective credit and working capital management
requires looking beyond the balance sheet.
The question
is not simply:
How large
are our accounts receivable?
Or
How our
aging schedule lokks like?
It should
also be:
What is the economic cost of the credit we are granting—and
what is the economic cost of the credit we are taking?
A rigorous credit-management function should therefore
evaluate:
- customer creditworthiness;
- payment terms;
- early-payment discounts;
- collection periods;
- overdue balances;
- bad-debt risk;
- the company's own cost of funds;
and
- the opportunity cost of capital
tied up in receivables.
The same
principle applies in the opposite direction.
If a company can accelerate its own collections without
damaging customer relationships, it can release capital from A/R, reduce
borrowing requirements, reduce financing costs, and improve cash generation.
Therefore,
A/R is not necessarily a non-earning asset.
It is better
viewed as capital deployed in the credit cycle.
The return - or the cost - depends on how intelligently
management structures and manages that credit.
So A/R
management is not simply about:
How quickly
can we collect?
It is about
striking an optimal balance between the following drivers:
sales growth
customer
credit
Credit terms
collection
risk
financing
cost
return on
capital.
A strong credit department can therefore create economic
value even though receivables themselves do not normally produce interest
income.
3.
INVENTORY: THE COST IS NOT ONLY STORAGE
Inventory is
perhaps the clearest example.
Inventory is
necessary for most businesses. Without it, production can stop, customers can
be disappointed, and sales can be lost.
But
excessive inventory represents capital that is temporarily frozen in the
operating cycle.
That capital
has an opportunity cost.
If a company
holds EGP 100 million of unnecessary inventory, the economic cost is not
limited to:
- warehousing
- insurance
- handling
- deterioration
- obsolescence
There is
another cost that is often overlooked:
the return the company could have earned if that EGP 100
million had not been unnecessarily tied up in inventory.
This is where effective inventory management becomes
important.
Where operationally feasible, Just-in-Time (JIT)
principles can reduce unnecessary inventory.
Where JIT is not practical - because of supplychain
uncertainty, import lead times, production requirements, or other operational
considerations the objective can instead be to establish an appropriate minimum
operating balance, set adequate reorder levels, and/or vertical
collaboration/alliance with suppliers.
The appropriate level depends on the nature of the business
and duration of production cycle in the industrial business.
The point is
not minimum inventory at any cost.
The point
is: Optimum inventory.
Too little
inventory can destroy sales.
Too much
inventory destroys value.
The
overall issue: WORKING CAPITAL IS A FUNCTION OF MANAGEMENT DECISION
Cash,
receivables, and inventory should therefore not automatically be viewed as non-earning
assets.
They are
better understood as capital employed in the operating cycle.
Their
economic contribution depends heavily on management quality.
Consider two
companies with exactly the same:
- revenue
- gross margin
- EBITDA
- assets
- and accounting profit.
Company A
maintains excessive cash, grants loose credit, and carries excessive inventory.
Company B maintains disciplined liquidity, collects
receivables efficiently, and keeps inventory at an economically appropriate
level.
Their
reported profits may initially look similar.
But Company
B may require substantially less capital to generate the same level of revenue.
That means:
higher asset
turnover
lower
financing requirements
lower
financing costs
better cash
generation
higher
return on invested capital
and
potentially:
higher
shareholder value.
This is why
working-capital management deserves to be viewed not merely as an accounting
exercise, but as a value-creation discipline.
FROM
“NON-EARNING ASSETS” TO “PRODUCTIVE CAPITAL”
Perhaps we
should change the terminology.
Instead of asking whether cash, A/R, and inventory are
“earning assets,” we should ask whether the capital invested in them is being
productively employed.
Cash can
earn a return.
Receivables
can create economic value through disciplined credit terms and collection.
Inventory
can support sales while minimizing the opportunity cost of tied-up capital.
None of
these assets should be managed in isolation.
They are interconnected components of the cash conversion
cycle.
The ultimate objective of management should therefore be:
Not to
minimize working capital, but to optimize the amount of capital required to
operate the business profitably and safely.
That
distinction is important.
Too little working capital can damage a business.
Too much working capital can quietly destroy shareholder
value.
The driver that makes the difference is management quality,
or at least “how management is perceiving these three invested capital items”
Perhaps the
most important question for an analyst is therefore not:
How much
working capital does this company have?
but:
How
efficiently does this company turn working capital into profit and cash?
That is
where the real story may be hiding behind the balance sheet.
Best Regards
