![]() The information provided here is not investment, tax or financial advice. Management seeking to create more value and increase their share price may want to consider adopting EP. Improved working capital management is just one benefit of using economic profit in goal-setting, planning, allocating resources, making decisions and measuring performance. Lastly, you can dispose of assets that show no ability to earn their required return. You can operate better by improving pricing and cost efficiency, as well as capital productivity such as the working capital improvements discussed above.ģ. You can invest in new assets to grow the business as long as the incremental gross cash earnings more than cover the added capital charge.Ģ. There are three ways to improve any measure of EP.ġ. The average balance is multiplied by a required return on capital, which I've found for most companies is 8% to 10% now, to determine the capital charge, which we subtract from gross cash earnings to get what we call residual cash earnings. To this, we add net working capital, excluding cash and short-term debt, and net long-term operating assets. Since we ignore depreciation, capital employed must add back accumulated depreciation. The result is gross cash earnings, and from this, we need to subtract one more cost: the cost of capital. Calculate earnings before interest, taxes, depreciation and amortization (known as EBITDA), and subtract operating taxes. I prefer cash-based EP measures as my own capital market research shows improvements relate better to movements in share prices. You must decide to use either an accrual or cash version of EP. But, at the same time, it’s okay, for example, to invest in higher inventories as long as you receive enough incremental profits to exceed the incremental capital charge. With EP, reducing net working capital reduces the capital charge and EP rises. This takes us back to the concept of EP mentioned above, which by definition, measures profit or cash flow less a charge for capital deployed. I think the ideal solution is not to hand out working capital reduction goals but to use a more comprehensive measure that captures profit and capital implications and encourages the proper trade-offs. To buy in advance of your need adds to inventory, but if the supplier sufficiently lowers their price, it could be profitable enough to more than compensate for the cost of carrying the extra inventory. Or maybe a supplier is looking to push product in December to meet production quotas or earnings budgets. I've noticed the construction industry frequently gets paid deposits before work begins. If a customer procurement specialist seems to be only concerned about price, maybe concede some price in exchange for very quick payment terms or even deposits in advance. To make this work in practice, managers should consider their relationships with customers and suppliers to find opportunities for working capital improvement. In other situations, it’s better to employ a bit more capital to achieve higher profits. ![]() At times, it’s worth giving up a bit of profit to significantly reduce capital employed. Indeed, in a business world littered with companies obsessed with their profit and loss statement, almost without regard for their balance sheet, having the ability to make trade-offs between profits and working capital can be an advantage. So, there are times when having more working capital is better. As CFO Jana Croom explained this decision, “Customers are more than welcome to use our balance sheet, provided they are willing to pay for it.” Working Capital ![]() For example, to strengthen customer relationships during the pandemic, Kimball Electronics increased inventory to mitigate potential parts shortages. ![]() But interestingly, the best path was not always to drive lower net working capital. In addition, my colleague and I interviewed several EP company executives, and working capital management was frequently raised as an important driver of capital productivity. ![]()
0 Comments
Leave a Reply. |
AuthorWrite something about yourself. No need to be fancy, just an overview. ArchivesCategories |