Ask Art: How Do Improvements to Your Balance Sheet Drive Earnings?

Because most traditional managers consider the balance sheet to be, well, just a balance sheet, they will consider this question a nutty concept. They believe the balance sheet is simply what it is, and there is nothing you can do about it. Most would further argue that because competitors have similar-looking balance sheets, this merely reflects the type of industry you are in. Shareholders rarely—if ever—ask questions about the balance sheet. Instead, they focus on how earnings growth impacts the value of their shares. So if neither management nor shareholders focus on the balance sheet, it is no surprise that not much effort goes into changing it. 

What if you can increase inventory turns, generate cash, and improve customer service simultaneously?

That’s why traditionally run companies pay more attention to how they will secure the debt needed to finance their working capital needs than on fixing the balance sheet as they grow. When I first became CEO of The Wiremold Company, and we presented our initial growth plans to the board of directors, the first thing they did was suggest that we line up the banks to finance our working capital needs as we grew. This advice made no sense to my lean perspective: lean companies generate cash as they grow. They don’t use it. So what were they talking about? I slowly realized that they believed that balance sheet measures for items like inventory turns and working capital ratios would remain the same as we grew, thus requiring outside financing.

I’m sure this thinking was bolstered by the fact that Wiremold management had attempted to implement just-in-time manufacturing a couple of years before my arrival. The board members followed the thinking that if you lowered the inventory level, you would expose the rocks (i.e., waste) that you could then eliminate to get better and better. Unfortunately, by lowering the inventory without fixing any of the processes first, they uncovered not rocks but boulders. Inventory turns improved marginally, from 3.0x to 3.4x, but the resulting customer service problems nearly bankrupted the company.

As you might expect, they beat a hasty retreat and went back to building even bigger batches than before. In my experience, this is not uncommon. But what if it is all wrong? What if you can increase inventory turns, generate cash, and improve customer service simultaneously? Numerous successful efforts to do this have taught me that it’s possible. But you can’t achieve this if you stick with your traditional functional organization and batch manufacturing approach.

My response to the Wiremold board was, “What do you mean by ‘line up the banks,’ we are only turning inventory 3x? So that means that we have a tremendous amount of sleeping money just lying around on the shop floor waiting for us to come along and pick it up.”

So what happened? I joined Wiremold at the end of 1991 and, by the end of 1993, this is what we had done:

                 1993 inventory at 1990 turn rate            $16.7 million
                 Less Actual 1993 Inventory                        5.6 million
                 ———————————————————————-
                 Cash Freed Up                                       $11.1 million

We made five small acquisitions in 1993 with the cash we had freed up. These five acquisitions cost $10 million and contributed $24 million in annual sales, producing a 10% pretax profit. Instead of saddling us with $1.1 in inventory carrying costs, we realized $2.4 million in pretax profit. By putting our “sleeping money” to work, we realized a net gain of $3.5 million without investing any money. 

Accounting for the Benefits of Lean

Why can a lean company do this while the traditionally run, functionally organized company can’t? The critical difference is that the traditional company makes things in batches, and the lean company is organized for flow. The lean company follows the ideal of “sell-one, make-one,” while the batch company focuses on something like “sell-one, make-10,000.” The functional organizational structure of the batch company, in fact, prevents it from “sell-one, make-one.” The closest it can come is “sell one, take one out of inventory,” which might work if your forecasting system is always right (they never are). Still, even with perfect forecasting, “sell one, take one out of inventory would be very expensive, as it would require a great deal of inventory, excess storage space, too many people to move it around, and extra financing costs.

For the lean company, inventory is the root of all evil, the number one waste in a system that focuses on removing waste in order to deliver value to your customers. As a result, the lean company’s extreme focus on boosting inventory turns leads to significant changes in other areas. In fact, you could run your company successfully by using just two measurements: 1) 100% on-time customer service and 2) inventory turns. For both these metrics to be rising simultaneously, everything else has to fall into place. To improve inventory turns, you adopt a value-stream approach instead of a functional approach. You also have to reduce all your setup times so you can achieve flow. (At Wiremold, we were able to average a 90% reduction in setup times on all types of equipment after a one-week kaizen.)

For the lean company, inventory is the root of all evil, the number one waste in a system that focuses on removing waste in order to deliver value to your customers.

Improving inventory turns requires establishing one-piece flow throughout the organization, which, in turn, will dramatically lower costs and improve quality. My experience is that a simple switch from batch to a flow line can result in a ten-fold improvement in quality. While lower costs and improved quality are crucial, the real strategic gain from focusing on inventory turns comes from the reduction in lead times that flow creates. Going from six- to eight-week lead times to one- to two-day lead times is very common. This improvement delivers a tremendous strategic advantage that you can leverage to grow sales rapidly — and at your competitor’s expense. You can compete based on time, and you don’t have to cut prices to do so either. Every time a competitor is out of stock and looking at six- to eight-weeks to replenish, you can step right in and recoup the business at the total book price.

By focusing on your balance sheet, i.e., inventory turns, you will concentrate on the parts of the business that will give you a major strategic win. Increasing your inventory turns will lower your costs, improve your quality, and drastically shorten your lead times.

As you start to understand this, you must know that achieving these results requires setting stretch goals for inventory turns. If you are at 3x and set a goal of 5x, for example, not much will happen. At Wiremold, we were at 3x, and I established the initial goal at 20x, as that would require dramatically different thinking and actions. As a result, we got to 18x over 9-plus years. In fact, I recommend a 20x target for inventory turns for any manufacturing company. It will force change that, in the end, will drive your growth and your earnings. Competing on time is a powerful weapon.

Look for Improvements Everywhere on Your Balance Sheet

But don’t stop there. There are other items beyond inventory turns on your balance sheet that can drive your earnings. Accounts receivable (AR), for example. If your sales terms are net 30 days and your actual AR days outstanding are 55 to 60 days, you have another big pile of sleeping money waiting for you. Understanding why you have this big gap is a critical first step. What are you doing to cause this? Do you have billing errors that allow your customers to delay payment while they are sorted out? Do you have one or two customers dragging you out that need to be dealt with? Do you not enforce your own sales terms?

Having sorted out some of these issues, you should then learn what other problems your sales terms are causing. For example, when I first went to Wiremold, I asked, “How much of our shipments go in the last week of the month?” The answer was 50%. Wow! If we were going to become lean and level load the factory, we couldn’t continue to ship 50% in the last week. More importantly, doing this every month required us to staff enough people to handle the last week of the month, which caused us to overstaff the other three weeks — an expensive way to operate.

Dig deep to explore what types of problems your sales terms might be causing.

When we looked into why this was happening, we found the cause to be our own sales terms, which were “2%, 10, 25th prox.” These terms of art meant that if our distributors ordered by the 25th of the month, they could take a 2% discount if they then paid by the 10th of the following month. (So, place an order by the 25th of August and pay by the 10th of October). These sales terms incentivized our distributors to order in the last week of the month, preventing us from level-loading and achieving flow. So, instead, we offered a higher discount if they paid us on the 15th and 30th of every month. This change leveled out our incoming orders and allowed us to deliver more value to our distributors and customers.

Incentivizing distributors in ways that allowed us to level-load and achieve flow worked so well that we took it a step further to increase our earnings by improving our distributor’s balance sheets. Though we delivered to nearly all our distributors weekly, they carried about four months of our inventory. We asked them to stop batch ordering off their MRP systems and instead tell us daily what they sold every day. Then, we would replace that amount on next week’s truck. Those who made this change cut about three months of our products from their inventory, freeing up cash and space. We were delivering them more value. We then asked them to expand the number of our SKUs that they carried, which boosted sales of our products for them by about 10% and earnings on these products by 20%. Everybody won.

I think you get the picture. If you focus on your balance sheet and pick up the sleeping money, you will grow your sales and earnings much faster than if you follow the traditional path and take your balance sheet for granted.

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