Improving ROAI - Lowering Asset Investment, Part 6

Previous posts discussed the impact of improving a key metric, such as:

1. Increasing Prices

2. Boosting Sales Volume

3. Cutting Variable Costs

4. Decreasing Fixed Costs

Exploring the impact of managing and reducing the Asset Investment component of the ROAI formula on financial performance, various advantages and drawbacks were revealed when each strategy was applied in isolation while holding all other factors constant.

Example:

Revenues $500,000

Cost of Goods Sold $240,000 (Variable)

Other Variable Expenses $60,000 (Variable)

Contribution Margin = Revenues - Variable Costs = 500,000-300,000 = 200,000

Operating Expenses $150,000 (Fixed)

EBIT = $50,000

Assets Invested $400,000

ROAI = 12.5%, Target 20%.

Assume that EBIT stays at $50,000 in the example, to obtain an ROAI of 20%, a little math:

ROAI = EBIT/Asset Investment:New

20% = 50,000/AI:New

20%(AI:New) = $50,000

AI:New = $50,000/20%

AI New = $250,000

ROAI = $50,000/$250,000

ROAI = 20%

To get to the target ROAI in this example, Asset Investment would need to be reduced from $400,000 to $250,000, or $150,000. A 37.5% decline. OUCH.

Asset Investment - Connecting to Operations

Many times, Asset Investment is thought of as a financial metric where Total Equity (E) + Interest Bearing Debt (IBD). Some key issues to note:

• IBD includes Current Portion of Long-Term Debt, Notes Payable, Long-Term Debt (bank loans, Lines of Credit), and interest-bearing obligations.

• An issue arises regarding the treatment of leases for real estate, machinery, equipment, etc., in AI calculation.

• AI finances the Assets of the firm offset by Non-Interest Bearing Current Liabilities. Using the Accounting Equation:

• CA - NICL + NCA = ICL + INCL + E

• Accounts Payable, Accrued Expenses, and other Current Liabilities are Non-Interest Bearing, part of Net Working Capital (CA - NICL).

• Non-Interest Bearing Current Liabilities are "spontaneous liabilities" arising from daily operations, providing short-term financing.

Lowering Accounts Receivable

Practical recommendations:

1. Establish clear credit policies with payment due dates, early payment discounts, and penalties for late payments.

2. Automate invoicing and payments using electronic systems to reduce errors. Set up automated reminders for payments.

3. Maintain accurate customer records for correct invoicing and contact information.

4. Enforce late payment penalties to discourage delays.

5. Regularly review aging reports to identify overdue accounts and take action.

6. Monitor KPIs like Days Sales Outstanding (DSO) to improve Accounts Receivable efficiency.

Reducing Inventory

Most businesses don't possses inventory since they are not retail, manufacturing or distribution firms/ With that said, efficient inventory management is crucial for businesses, offering benefits such as cost control, preventing overstocking, enhancing customer satisfaction, and boosting operational efficiency. Small businesses can enhance inventory management by utilizing software for automated tracking, implementing the ABC Analysis Method, accurately forecasting demand, optimizing storage, and establishing reorder points.

Increasing Accounts Payable

Enhancing ROAI through decreased Asset Investment can also be achieved by allowing Accounts Payable to increase. Boosting accounts payable (AP) can serve as a strategic method to enhance cash flow for a small business. This strategy entails prolonging the payment period for suppliers, thus keeping cash within the business for an extended duration. Here are various advantages and disadvantages of this strategy:

Advantages:

• Enhanced Cash Flow: Postponing payments allows companies to maintain a higher cash reserve for other operational needs or investments.

• Cost Reduction: Keeping cash longer reduces the need for high-interest short-term loans.

• Interest Gains: Businesses can potentially earn interest on retained funds in interest-bearing accounts.

• Operational Versatility: Extending payment deadlines helps companies manage cash flow fluctuations during low income or high expense periods.

Disadvantages

• Adverse Impact on Supplier Relationships: Delaying payments can damage trust, resulting in stricter credit terms or higher prices.
  

• Risk of Supply Chain Interruptions: Payment delays could disrupt the supply chain, leading to delays in receiving goods.

• Possible Rise in Expenses: Late payments may incur penalties or cause missed early payment discounts, increasing overall costs.

• Harm to Reputation: Consistent delays can tarnish a company's reputation, making it more challenging to form new relationships.

Summary

A reduction in Asset Investment is another way to improve target profitability numbers like Return on Asset Investment. In this example, the reduction is so significant, it would increase the risk of harming operations 'cutting the asset muscle' of the firm. Yet, there are a number of steps a firm can take to incrementally improve asset efficiency driving a lower asset investment that results in a higher ROAI. Before doing such cutting, attention has to be paid to the possible effect on customer service, inventory management and supplier relations, among others.