One of the biggest benefits of using the Internet is that it's a great platform for exchanging information among trading partners, suppliers, and customers. So far, many companies have used it to improve the manufacturing process.

Unfortunately, the same types of improvement haven't been widely integrated into the financial process.

We use the Foolish Flow Ratio to evaluate how well companies are able to manage their working capital, or current assets and current liabilities. The main components of the Flow Ratio are accounts receivable and inventory. Accounts receivable can also be referred to as the financial component of working capital. Inventory represents physical working capital.

As I said, few companies have used the Internet to improve their management of financial working capital. The primary tool that can be used to measure progress in this area is the cash conversion cycle (CCC).

According to this article, since the end of 1980 the inventory turnover period has decreased to 48 days from 73 days -- 25 days in total. During the same period the amount of time it takes to collect outstanding receivables has only declined 11 days -- to 57 from 68. This means the physical component of working capital is now smaller than the financial component.

The improvement in the physical component of working capital can be attributed to the ability to exchange and process increasing volumes of information between manufacturers and suppliers. Companies are now willing to link their own internal management environments with those of their suppliers and customers.

Cisco (Nasdaq: CSCO) and Intel (Nasdaq: INTC) are two companies in our portfolio that improved inventory management with information flow. Both companies handle a significant amount of business directly over the Internet without the involvement of people in the order process. Cisco now processes more than 90% of its orders over the Internet and the vast majority of its manufacturing is outsourced to contract manufacturers.

Based on numbers from Intel's website, I found that its days sales inventory (DSI), on an annual basis, decreased to 45 days in 1999 from 75 days in 1992, an even better performance than the overall results cited above.

I also looked at the performance of Cisco, Intel, Pfizer (NYSE: PFE), Schering-Plough (NYSE: SGP), and Nokia (NYSE: NOK) since 1998. The one that's had the most improvement is Nokia, which cut its days sales inventory -- inventory/(cost of sales/90) -- to 44 days from 70 days over this period. That's impressive.

Pfizer's DSI has fallen to 205 days from 300 over this period; however, it's too soon to tell whether this represents improvement in its own processes or just the benefits from merging with super-efficient Warner-Lambert. Schering-Plough's DSI has actually increased 9 days over the last 11 quarters -- a disturbing trend.

What's hard to fathom is why companies failed to show the same level of improvement in collecting outstanding receivables, particularly when it should be much simpler to integrate the payable and receivable collection processes.

Here's a table showing the days sales outstanding (DSO) of the five companies mentioned above over the last 11 quarters: 

       Q1 98  Q2 98  Q3 98  Q4 98  Q1 99  Q2 99
CSCO   52     49     46     47     37     32
PFE    77     78     77     68     47     47
SGP    37     36     31     31     45     37
INTC   46     47     49     42     42     44
NOK    90     79     80     75     86     80


             
       Q3 99  Q4 99  Q1 00  Q2 00  Q3 00
CSCO   33     35     35     36     40
PFE    48     107    63     68     68
SGP    43     40     44     48     45
INTC   43     41     41     47     47
NOK    80     69     76     72     85
Note: References are to calendar quarters. Cisco's fiscal quarters are slightly different.

The failure to better integrate this process means companies have too much working capital tied up in their balance sheets and must turn to the corporate banking system to raise cash. Accounts receivable should be looked at in unison with accounts payable, which represents money owed to suppliers. The faster a company collects receivables, the more working capital it has at its disposal. If it can also delay payment of payables without upsetting suppliers, then it has even more working capital to play with. Companies that fail at either end must come up with other sources of cash. The best companies manage to maximize working capital. 

The problem is that it's easier to use the present systems to manage current cash positions than it is to improve working capital management, at least according to this article. As a general rule, companies often have more insight into their supply chains than into collections and payables. An August 2000 study by the Association for Financial Professionals revealed three primary reasons from the corporate perspective why companies have been slow to adopt electronic settlement of transactions:

  1. Electronic payment systems are not integrated with the accounting systems, which hold the relevant accounts receivable/accounts payable (AR/AP) information.
  2. Integrated payments and remittance information cannot be sent and received.
  3. Links between payment and financing and risk management providers are either cumbersome or nonexistent.

Fortunately, technology is coming online to streamline the AR/AP process. Companies should be making every effort to implement such technology into their operations as well as the operations of their customers and suppliers. If they do they will have the chance to do more business with less working capital, and they will save money and improve the quality of their balance sheets.

Currently, it takes about 57 days on average to collect accounts receivable. If invoices were moved online, the elimination of printing, mailing, and re-keying times alone could cut DSO by about 10%. There could also be additional savings as a result of a decline in disputes, fewer processing errors, and easier reconciliation. Finally, faster collection times would yield time-value-of-money savings.

Investors should keep an eye on working capital management. If you don't see improvement, you should question why. Is management unwilling to invest in technology to improve the process and ultimately save money? Companies with lower Flow Ratios and/or better cash conversion cycles are saving money and increasing the amount of cash available.

I'd also like to second Rich's nomination of Intel for this month's $500 investment. Intel's stock price has been unduly punished over the last few months, and it continues to look like a Rule Maker to me.

Have a great night.

Phil Weiss, TMF Grape on the Discussion Boards