How Lean and Mean Are You?

November 2004

The Second Way We Use the Balance Sheet to Make Decisions

The balance sheet tells us three crucial stories. First, it tells us who owns the business. Second, it tells us how lean and mean the organization is running. And third, it tells us how liquid the organization is. In the October newsletter, we covered the first story. Let’s cover the second story in this newsletter.

How Lean and Mean Is the Organization Running?

The best business in the world is one where you put a dime in and get a dollar out. The less we waste our resources, the more return we will generate, which makes business worthwhile.

One of the most important things to examine to determine if a company is running lean and mean is how it manages working capital.

What Is Working Capital?

There is the traditional view of working capital and the innovative view of working capital. Many accountants will tell you that they like to see a large balance in working capital. I will argue that the balance of working capital should be as small as possible. A small working capital balance indicates good management of resources.

The Textbook Definition of Working Capital

The formal, textbook definition of working capital is

Working capital = Current Assets less Current Liabilities

Now, you ask, what are a current asset and a current liability?

Generally, we segregate our assets and liabilities into groups – one group is long-term and one is current.

For example, long-term assets would include fixed assets. These are things that we are going to hold onto for a while. A long-term liability would be a 10-year bank loan.

Current assets and current liabilities, on the other hand, are assets and liabilities that will generate or use cash in the current or near period. For example, we consider accounts receivable to be a current asset because we believe we will collect on our receivables in a month. We consider accounts payable to be current liabilities because they will use cash in the near period.

Back to our definition:

Working capital = current assets-current liabilities
Current assets = cash, accounts receivable, inventory
Current liabilities = accounts payable

Let’s put cash aside for a minute. Let’s talk about the other components of working capital.

Should Accounts Receivable Be Large?

Do we want our accounts receivable balance to be large? No, we don’t. If it were, that would indicate that our customers are getting to use our products and services without paying for them. They are using our money and we like to minimize that. We would prefer to be paid up front for our services and products. At the least, we want to be paid as soon as possible after we provide our products and services.

Should Inventory Be Large?

Do we want our inventory balances to be large? No. Because that would mean that we have tied up our cash in stuff and if we needed our cash we might not be able to get it quickly. We also don’t want to hold out of fashion or obsolete inventory – we want our inventory to be fresh and new. We want to be as liquid as possible (we’ll talk more about liquidity next month).

Should Accounts Payable Be Large?

Looking at the other side of the equation, we do want to have a relatively large accounts payable balance. This would indicate that we are using other people’s money – the vendor’s money, as much as possible. Isn’t that tricky? We want our cash up front but prefer to pay our vendors later. This allows us to have as much cash on hand at all times as we can.

So given these selfish, “I’d rather have the resources than you!” concerns, and leaving cash out of the equation for a minute, if we have a small accounts receivable and inventory balance and a large accounts payable balance, we would necessarily have a small working capital balance.

The Real Meaning of Working Capital

Now let’s go beyond the textbook definition of working capital, to the real meaning. Working capital is the resources, or capital, you have tied up in your business that is “working” for you. Working capital is the money you have tied up in your product or service.

Another way to look at it is “How many resources do we have to keep plowed into the business in order to make our product or service? How much do we have to invest on a regular basis in inventory, how much in payments to vendors and employees, how much in granting our customers credit, and how much in rents, utilities, and other day-to-day necessities?”

In the ideal world, this investment of resources is minimal. The best businesses in the world are the businesses where we put a little in and get a whole lot out. Wouldn’t it be great if you could just invest ten cents in a business yet make five dollars when you sold your product?

So, now let’s consider the cash component. I see cash in two categories, day-to-day cash and rainy-day cash. To get a true calculation of working capital, you have to take out rainy-day cash. Rainy-day cash is sort of like your reserve in case of emergency or in case of cool business opportunity. Some organizations may have millions, even billions, of dollars of rainy day cash. On the balance sheet, the cash balance will be enormous. This does not mean they need this much money to operate on a day-to-day basis.

The cash they may need working for them every day may be minimal.

So a true calculation of working capital should take rainy day cash out and only look at the cash needed to operate on a regular basis and the resources tied up in receivables, inventory and payables. If day-to-day cash needs are minimal, if receivables and inventory are minimal and payables are maximized, then want working capital will be as small as possible. And a small working capital balance is one key indication of a lean, mean operation.

For more on this topic – sign up for Leita’s webcast on February 8, 2005 on The Four Principles of Great Cash Flow – The Way the Big Boys Do It at http://si.learnlivetech.com/.

Also, see Leita live at The University of Texas on December 8, 2005 for Finance for Non-Financial Managers. To sign up, go to http://www.utexas.edu/cee/pdc/workshops/finance/nonfinancial.shtml.