You are on page 1of 2

What are the challenges and trade-offs for supply chain management in balancing the objectives of

profitability, liquidity and asset utilisation?

Profitability and asset utilisation are covered by ROCE. Return on capital employed (ROCE) is
measured as profit before interest and tax as a percentage of capital employed. ROCE is an important
measure for assessing shareholder value and is underpinned by two main drivers:

● increased profitability;

● increased asset utilisation.

These two supporting drivers are the key determinants for increasing ROCE and hence
shareholder value. An understanding of the financial ratios that affect these two drivers is essential
when formulating a focal firm’s supply chain strategy.

The challenge for the supply chain is to develop a combination of initiatives that will lead to an
increase in the supply chain ratio. Reductions in working capital have a beneficial effect on an
organisation’s supply chain ratio (and its ROCE). For example, inventory reductions increase both
profitability and asset utilisation, as well as reducing cash to cash cycle times (or liquidity). The supply
chain ratio emphasises the importance of reducing working capital, such as inventory, on cash-to-cash
cycle times to improve liquidity. Liquidity is the ability of an organisation to meet its obligations as and
when they fall due. The use of time-related financial ratios is key to monitoring the cash-to-cash cycle
and liquidity. Key ratios, which reflect the three key levers of liquidity, are:

● average inventory turnover: the number of times inventory is turned over in relation to

the cost of goods sold;

● average settlement period for accounts receivable: the time taken for an organisation to be paid by
its customers;

● average settlement period for accounts payable: the time taken for an organisation to pay its
suppliers.

The traditional view to improving liquidity is to take the single company’s perspective. Here liquidity can
be improved by reducing days of accounts receivable from customers and increasing days of accounts
payable to suppliers. However, it is not difficult to see how this could place adverse pressure on these
relationships and lead to both dissatisfied suppliers and customers. Therefore, from the perspective of
the ‘vertical’ approach, reducing inventory levels and increasing inventory turns is the main supply
chain lever for improving liquidity, as discussed earlier in this section. In any case, a supply chain
manager does not have control over accounts receivable (as this is typically within the sales function),
however they can have influence of accounts payable, in relation to procurement.

Liquidity, as accounts payable and receivable suggest, is related to supply chain relationships and both
the causes and effects of liquidity are related to the wider supply chain. It follows that a supply chain
perspective (sometimes termed the ‘horizontal’ approach) is more appropriate, where each company in
the chain considers the impact their accounts payable terms (days to pay suppliers) has on their
suppliers’ cash-to-cash cycle times. After all, one company’s accounts payable is the next company’s
accounts receivable. Further, days of accounts receivable may well be factored into prices, as there is a
cost of borrowing cash to support days of accounts receivable.

The supply chain ratio allows the trade-offs across profitability, liquidity and asset utilisation to
be managed. This is important for maintaining liquidity, as it can suffer as a result of pursuing either
profitability or asset utilisation improvements. For example, chasing profitability by extending payment
terms to customers may increase sales revenue, but can cause liquidity problems by increasing cash-to-
cash cycle times. Alternatively, seeking higher utilisation levels of manufacturing assets can lead to
lower costs per unit but also can result in excessive finished stock. This results in cash being tied up for
longer and higher inventory management costs (e.g. storage, insurance, obsolescence).