ARE CASH, A/R, AND INVENTORY NON-EARNING ASSETS?

 

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.

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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