What produces high returns on invested capital? – Part 2
In this article I expand on the factors that contribute to a high ROIC, focusing on what contributes to a high capital turnover.
5 minutes
This is part 2 of the series “What produces high returns on invested capital?”.
In my first article, I analyzed how firms generally derive their high returns on capital through either having an advantage on the consumer side (high-profit margins) or the production/efficiency side (high capital turnover), focusing on the latter.
This article will now touch on the factors that cause a company to have a high capital turnover.
Where High Capital Turnover Comes From
Like high margins, there are numerous reasons why companies are able to achieve high capital turnover.
High capital turnover means a company efficiently uses its assets to generate sales. Effectively reducing the need to tie up capital and shorten the cycle of turning working capital (inventory and receivables) into cash.
Some companies have distribution advantages that contribute to a high capital turnover.
Efficient distribution systems enhance a company’s ability to quickly move products from production to sale, reducing the capital tied up in inventory.
Walmart's distribution system is a good example, they centralize distribution and achieve economies of scale that reduce transportation and handling costs, which reduce inventory holding times.
Another strategy implemented by Walmart is cross-docking, a logistics practice where incoming goods are transferred directly from receiving docks to shipping docks, bypassing the need for long-term storage.
Some companies focus on services rather than physical products, they require less capital to be tied up in inventories and fixed assets, which can lead to higher turnover rates. Interestingly, software and media companies sell a product, but have the characteristics of service companies. Working capital needs are very small, as the cost to add new users is minimal.
Some companies operate with negative cash conversion cycles, a result of significant bargaining power, which allows them to receive inventory and sell it before they have to pay suppliers. Effectively, suppliers finance the inventory for the company. Classic examples are PepsiCo, Dell, and Walmart.
Vulnerabilities
Companies with a high ROIC derived from high capital turnover are not bulletproof.
A change in management can have a significant impact on the company’s operations, as they previously enforced practices of great efficiency. Banks and railworks are great examples of these businesses, where management can make or break a company’s profitability.
Summary
In summary, a business can achieve a high ROIC by having a high capital turnover.
Companies with a high capital turnover operate very efficiently, as working capital is quickly converted into sales.
In essence, to operate with a high capital turnover means that a lot of cash is produced, but little has to go back in–minimal capital is tied up in inventory or receivables.
Companies can reduce the capital that is tied up in working capital by improving the speed at which investments are turned into cash. This can include optimizing inventory turnover, reducing the time that it takes for clients to pay, and having suppliers finance inventory.