Ask Art: Why Should I Focus on My Balance Sheet to Grow Earnings?

This advice might sound a little goofy — and won’t make any sense — to the traditional business leader who runs a batch company. Conventional business leaders believe the balance sheet has nothing to do with earnings, is based on the nature of your business or industry, and cannot be materially changed. They believe that you will grow earnings by growing sales and lowering costs and that, by successfully doing this, the balance sheet will take care of itself.

The lean-thinking leader sees this (like so many other things) from a completely different perspective. While they acknowledge that growing sales and lowering costs lead to higher earnings, they understand that the best way to achieve this is by focusing on the balance sheet. 

This logic comes from the lean principle that removing waste from all processes delivers more value to the customer. While waste can and does occur in every process, the accumulated total shows up most clearly on the balance sheet, which is where waste goes to die. Once you understand this formula, you will focus on the balance sheet to grow earnings. 

Two key measurements can drive most strategies derived from lean thinking:

1. Customer service
2. Inventory turns

Both measures support the idea of growing sales and lowering costs to drive earnings. However, over time, the company with 100% on-time customer service will always take market share from the company that scores 95% to 96% customer service. Achieving this critical goal will also prod everyone to deliver more value to customers, which is the primary consideration of every decision made by a  lean practitioner. 

Similarly, a company with higher inventory turns will offer better customer service at a lower cost than a competitor with lower inventory turns, enabling it to grab market share. So, while inventory is a balance sheet item, the lean-thinking leader recognizes it as a key to earnings growth. Why? The traditional business leader sees inventory as a necessary evil, enabling the company to provide better customer service, thinking, “You can’t sell from an empty wagon.” In contrast, lean-thinking leaders see inventory as “the root of all evil,” the No. 1 item in Taiichi Ohno’s list of seven wastes. They understand that excess inventory hides all the other types of waste and is created “just in case,” the opposite of “just in time.”

Managing Inventory

Let’s explore this by comparing inventory turns at two companies. Company A turns inventory 3x, and Company B turns inventory 20x. Which one has lower costs? Shorter lead times? Better quality? Customer service? While these are not trick questions, traditional managers might struggle with the correct answer. That’s because they might be happy with 3x inventory turns and would consider the idea of 20x inventory turns so impossible that they would dismiss it out of hand.

The correct answer becomes apparent when you understand everything that must change to reduce inventory from 3x to 20x turns. You cannot make this happen overnight. You must remove quite a lot of waste from every process to get to 20x turns. To do so, start with setup reduction: tackle the two- to three-hour setup times on most of the equipment that forces you to produce in big batches, driving up inventory. If you reduce your setup times to the single digit (less than 10 minutes), your batch sizes will decrease, and your inventory will drop. 

Moving from batch to flow will also reduce inventory as you approach the lean ideal of “sell one, make one.” Along with setup reduction, flow production will reduce your lead times from six to eight weeks to one to two days, dramatically improving your ability to deliver value to your customers, gain market share, and boost your sales growth. Every time your competitor with a six-to eight-week lead time stumbles, your two-day lead time will allow you to gain market share at book price.

Creating flow and a value-stream-focused organization will not only lower your inventory but will also lower your costs and improve your quality. In my experience, it is common to see a 10x improvement in quality by moving away from batch production to flow production. When you have all the production steps in line with a short lead time, every time a quality problem occurs, you will understand all the reasons it happened and develop a permanent solution. Moving to flow from batch production will also lower your costs. It is common to see a reduction in the number of required operators by more than 50%.

Removing excess inventory will force you to figure out how to live without this crutch and reduce even more waste, further improving production and customer service. You will no longer live with unplanned machine downtime. You will need to develop close relationships with your suppliers to ensure they can keep up with your daily deliveries. You will no longer tolerate defects. And, as you remove inventory, you will free up space. The lean company with 20x inventory turns will typically require 50% less space than the competitor who turns it 3x — another significant cost reduction that will occur by focusing on inventory turns, i.e., your balance sheet.

Financing Growth

Traditional business leaders somehow believe that reducing costs requires spending money — that it is capital-intensive. With lean, however, the opposite is true. Moving to lean will generate significant cash while reducing costs simultaneously.

The balance sheet can finance a lot of growth.

Consider a company with $100 million in inventory that turns at 3x. Look what happens as it reduces inventory:

Inventory Needed at Various Inventory-Turn Levels

You can reinvest all this freed-up cash in new products or acquisitions that grow earnings. So, the balance sheet can finance a lot of growth.

Managing Accounts Receivable

Accounts receivable is another part of the balance sheet that is a potential source of growth capital. Unfortunately, traditional business leaders often overlook using accounts receivable for growth because they assume, “Gee, we can’t do anything about that.” But that’s not true: here’s the evidence. 

At Wiremold, we started with sales terms that almost everyone in the electrical industry used. Technically this was “2% ten, twenty-fifth prox.”: If a distributor orders by the 25th of the month, they could get a 2% discount if they paid by the 10th day of the following month. But, these terms forced the majority of shipments into the last days of the month, causing problems for us and our distributors.

It also resulted in 45-day sales terms that often stretched to 60 days. Trying to ship 50% in the last week of the month made it impossible for us to level-load our plants and achieve flow. And it prevented us from delivering more value to our customers. 

Our solution was to offer a higher discount of 5% if they paid us every 15 days and allow our distributors to choose either the 2% or the 5% rate. No surprise that they all picked the 5% (which we could offset with a one-time 5% price increase) and paid us in 15 days. This change cut our receivable days in half and freed up cash for acquisitions and new products. The more significant contribution, however, was that it enabled us to level-load our factories, lower our costs, and deliver more value to our customers with shorter lead times and better customer service.

Unlike the traditional company, the lean company focuses on improving its balance sheet to drive costs down, provide better quality, reduce lead times, and improve customer service. Try it. You’ll like it!