MELISSA A. CRAIG - PRACTICAL TURNAROUND THINKING

To improve their companies’ performance, managers focus on activities that increase net income. This study finds that marginal reductions in working capital are as effective at improving performance as are significant increases to NOPAT.*

PWC just published its latest European Working Capital study. The researchers looked at ten industries and calculated the median working capital ratio* and that of firms in the top quartile (25%), for each industry. It then determined the % by which industry firms can increase their Return on Net Assets when they move from the median to the top quartile of working capital as a % of assets. For example, technology companies’ RONA* increased by almost 12%, and manufacturing firms’ increased by almost 4%, simply by reducing their working capital as a % of net assets. This is a key finding: firms did not have to sell fixed assets or increase sales (cash and A/R) to improve RONA – all they had to do was be more judicious in their decisions to employ cash.

But a more compelling argument is made when the researchers estimate the NOPAT equivalent of the improvements in RONA. Tech firms would have to increase NOPAT by 26% and manufacturing firms would have to improve it by 18% to achieve results similar to the RONA improvements described above. This is another key finding: firms did not have to increase revenue or cut costs – all they had to do was be more judicious in their decisions to employ cash.

To improve firm performance in 2010, which of these activities seem more achievable: 1) increase revenue and reduce costs, 2) sell fixed assets at a price at or near fair market value, or 3) reduce the amount of cash tied up in working capital? Management teams have undoubtedly already done all they can to achieve the first and maybe even the second options.

Here’s the Practical Turnaround Thinking: a significant reduction in working capital is a reliable path for management to increase firm value. Each additional dollar of cash permanently eliminated from working capital increases firm value by            [1_t  / (1+WACC)^t ]. That’s a good investment.

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* Definitions:

NOPAT = Net operating profit after taxes.
Net Working Capital = Current assets less current liabilities.
Net Assets = Fixed assets plus net working capital.
Working Capital Ratio = Net working capital as a % of net assets.
Return on Net Assets = Net Income as a % of net assets.