The surprising factors that influence profitability – working capital.
In the last article, I introduced a model that implicated five rarely considered variables in the profitability of commercial organisations. While strategies to increase profitability usually include tactics such as increasing prices and productivity or reducing costs and waste, the model shows that working capital, number of employees, share capital, share funds and total fixed assets explain a significant amount of the variability in the profitability of companies regardless of sector, monopolisation or market conditions.
The widely held idea that operational managers hold more tools to improve profit may lead to a bias that they have the responsibility. However, the model suggests that executive decisions could impede operational efforts to increase profits. On the other hand, carefully considered strategies to manage the variables implicated by the model could enhance operational efforts.
In this article, we’re going to look at the first of these variables: working capital.
The model we have developed as a whole explains 73.1% of the variability in the pre-tax profits of the companies in the data set. Working capital as just one of the five variables in the model accounts for 41% of the total difference in pre-tax profits between the most profitable and least profitable companies in the data set. That is massive. While some of this difference could be associated with the working capital requirements of different sectors, the model also illustrates why the relationship between working capital and profitability is rarely considered. That’s because the model indicates that a £1 increase in working capital correlates with a 3.3 pence decrease in in pre-tax profit. That is miniscule. And therein lies the problem, it can seem like managing working capital to improve profitability is unproductive, but as we can see the effect becomes clear on a cross-company, cross-sector comparison. Fortunately, there are good reasons to manage working capital besides profit, reasons associated with cashflow management – arguably much more important than profitability.
Working capital management is usually considered to be an operational activity. A significant aspect of working capital is the difference between receivables plus inventory and payables. It is not often perceived that carefully managing these can affect profits as well as cashflow. The most obvious way this may happen is through inventory. Over-stocking can lead to waste or having to discount to reduce stock levels or unload obsolete products. Allowing debtors to get out of control can also affect profitability. Time spent chasing debt, debt collection agencies, solicitor involvement or factoring are all clear mechanisms to profit margin reduction. Other mechanisms include having debtors under control which can make borrowing cheaper and help the purchasing department get better terms. So much so, it may be worth offering discounts to customers that pay early.
The opposite logic holds true for creditors. Extending payment terms will reduce working capital, increasing profitability according to the model. However, this is to the detriment of the supplier. It is clear from the discussion about debtors, that it is in the suppliers’ interests to get paid early. If they offer you a small discount for early payment, it could help their profitability as well as helping yours. If discounting for early payment became common practice through supply chains it would set up a virtuous cycle of increased profitability with a net positive effect on cashflow.
Although largely operational, aspects of working capital can be affected by corporate decisions. In particular, the amount of cash retained in the business and the amount of debt held by the business are executive decisions. The model suggests that having too much cash in the business or having too little current debt can reduce profitability. This is somewhat counter-intuitive. However, too much cash and or too little debt could be a sign of a risk-averse executive team resulting in low profit growth. A drive to reduce cash should not be an excuse to withdraw large dividends – we will see later that this has a negative association with profitability. We will also see how too much debt is not ideal either. There is therefore a fine balance to be achieved. Achieving this balance is the role of executive decision making and needs to be done in lock-step with operational decisions to avoid conflicts in profit goals.
Besides working capital, the other largely operational variable in the model is the number of employees. In the next article we will look at how this impacts profitability.