Monday, May 18, 2009

Need Working Capital? Try Inventory Optimization.

What can inventory optimization actually do for you? How about financing more than half of your working capital?

Here is a simple exercise using the financial data easily available through the corporate annual reports. I selected the two largest retailers in the world and went through their annual reports from FY2000 through FY2006, comparing the cost of inventory and the amount of working capital. The results, though hypothetical, are eye popping.

Why select inventory above anything else? Two reasons: (1) inventories are reported on the balance sheets and therefore their values can be reliably found, and (2) one of the two companies have almost made it their religion to run their business with optimized inventories as the cornerstone strategy.

Here are the two companies considered for this analysis: Wal-mart (WMT), and The Home Depot (THD).


Step 1: For the purposes of the analysis, I needed the inventory turnover as the key data element. The basic data to work with was taken from these companies published annual reports from FY2000 through FY2006. This specific time period for analysis was selected because I wanted to leave out any disruptive effects of the recession that officially started in December 2007, but might have started impacting The Home Depot as the housing bubble broke earlier. A brief note on the fiscal year definitions for the two companies: both the companies use Feb-Jan as their fiscal year, however, their designation differs. For example, the period between Feb. 2000 through Jan. 2001 is FY2001 for The Home Depot, and FY2002 for Wal-mart. I made sure that the data used in comparisons refers to the same calendar period and have adopted The Home Depot's FY label for the exercise.

Here are data elements considered and the reasoning behind their selection.

  • Cost of Sales: Required as this is part of the Inventory Turnover calculation, obtained from the income statements
  • Inventories: Required for the Inventory Turnover calculation, obtained from the balance sheets
  • Inventory Turnover: Calculated as Cost of Sales divided by the Inventories

The core financial data for the two companies is presented below:


Step 2: Next, I recalculated the amount of inventories that The Home Depot would have carried in a hypothetical situation if it was able to achieve the same inventory turns as Wal-mart did in the same year. The following data elements were used for this exercise.

  • Cost of Sales: As above, obtained from the income statements of THD
  • Assumed Inventory Turnover: Assumed to be same as that of WMT in the same year, copied from the above table
  • Recomputed Inventories: Calculated as Cost of Sales divided by the Assumed Inventory Turnover
  • Actual Inventory: As above, obtained from the income statements of THD
  • Potential Dollars Available through Inventory Optimization: Calculated as Actual Inventory minus Recomputed Inventories

This data is presented in the table below:


Step 3: Finally, I collated the working capital numbers for THD from their annual reports. We will see how the working capital numbers compare with the (1) actual and the (2) recomputed inventories from the table above.

  • Working Capital: As reported in the annual reports for THD
  • Assumed Inventory Savings: Adopted from the above table, the Potential Dollars Available through Inventory Optimization row -- as it signifies the potential cash flow that the lower inventories would have infused into the THD working capital
  • Recomputed Working Capital Required: Calculated as the Working Capital minus Assumed Inventory Savings
  • Percent Savings in Working Capital: Calculated as (Working Capital minus Recomputed Working Capital Required as a percent of Working Capital)

This data is presented in the table below:


The numbers in the table above really say it all. The improvement in the inventory turns would have financed more than 70% of all the working capital requirements at the Depot for 5 out of the seven years considered!

Can the Depot Do It?

There is definitely a case to be made on the inventory turns based on the different categories of merchandise carried by the two retailers. After all, potential inventory turns depend on merchandise mix carried by the retailer. Grocers like Publix and Kroger typically operate with 10 or more inventory turns over the year. Therefore, let us review the merchandise mix for the two in the example.

Wal-mart has a much larger assortment, but the hard-lines comprise a big percentage of Wal-mart merchandise. In the 10K statement filed by Wal-mart on 4/1/2009, the company reported hard-lines being one of their strategic merchandise categories that accounted for 12% pf Wal-mart sales. In the same statement, Wal-mart reported annual sales of $401B, that would make their hard-lines to account for nearly $50B. This compares well with THD sales of $71B with their hard-line assortment.


Wal-mart does have a large grocery assortment which provides them with a natural advantage when it comes to inventory turns, but it is almost certain that THD can do much better on their inventory turnover than they are currently able to do.


The data overwhelmingly suggests that inventories make most part of the working capital requirements for the retailers and it can be substantially trimmed by adopting a good inventory optimization system. For learning more about what an inventory planning system does, what data does it require, and the underlying process, you can read this article here.