Everyone knows that running a business is difficult and there are many areas that deserve constant attention. If you ask the average person, they might say that generating profits is the key to operating a successful business. While generating net income is clearly important, it’s not the sole determination of success and too many businesses that appear profitable have suffered and failed due to a lack of focus on generating cash flow.
In reviewing a company’s financial statements, many business owners focus on the income statement and, to a lesser extent, the balance sheet. They often ignore the statement of cash flows. However, it’s the statement of cash flows that can provide significant insights into your company’s operations.
The statement of cash flows comprises three main components: operating, investing, and financing cash flows. We will focus on the cash flows from operating activities as this provides insight into your company’s ability to generate cash from running its business.
Asset turnover impacts operating cash flows and profits. It is calculated by dividing the company’s net sales by its total average assets. Asset turnover measures how efficiently the company is utilizing its assets to generate sales. The higher the company’s asset turnover, the more revenue for every dollar invested in assets. Conversely, a lower asset turnover may indicate that your company has overinvested in assets relative to its sales volume, resulting in unproductive assets. We often see this with companies that have excess inventory or large accounts receivable balances relative to their net sales. In essence, these companies may be asset rich, but cash poor.
Asset turnover can also positively or negatively impact operating profits. A company generating more sales with the same or fewer assets can earn higher profit margins as it spreads its fixed operating costs (depreciation and interest) over a larger sales base. With a lower asset turnover, the company may have to write down excess inventory or incur additional interest costs, thereby lowering profitability. Additionally, it may have difficulty meeting its financial obligations, including paying vendors, servicing debt, or covering operating expenses.
Increasing asset turnover is critical to improving your company’s profitability. Here are six strategies to improve asset turnover:
- Inventory management. Reduce excess inventory levels by implementing just-in-time inventory management in order to free up working capital. Implement lean principles to minimize waste and improve efficiencies. Too many companies have their profits tied up in excess inventory.
- Asset utilization and management. Extend operating hours and/or increase production shifts to increase utilization of assets. This may require regular maintenance and possibly an upgrade of the equipment to reduce breakdowns and extend useful lives. Perform scheduled maintenance during off-peak times. Consider disposing slow-moving, underutilized, or idle assets to generate cash that could be deployed more efficiently elsewhere in the business.
- Review pricing. Consider pricing strategies to increase revenues. Concentrate greater efforts on those customers providing the highest gross profit and consider increasing the pricing for those customers that are below acceptable levels relative to the demands on your company. Consider minimum order levels.
- Working capital management. Accelerate cash collections to convert accounts receivable into cash. Remember that the sales process isn’t completed until the cash is collected. Take advantage of favorable payment terms with vendors.
- Debt reduction. Reducing debt levels can lower interest expense and improve profitability.
- Automation. Invest in technology that can automate processes and increase production capacity and efficiency without a corresponding increase in assets (both tangible and human capital).
Improving asset turnover can have a dramatic impact on your company’s cash flow and profitability, especially in times of higher interest rates. Among the various key performance indicators that a business owner should regularly monitor, asset turnover should be among the top. If you have any questions or would like to discuss how your organization can improve asset turnover, please contact us.