Working capital
This is the first in a series of posts about the elements that go into working capital.
An analysis of working capital can quickly produce important insights into the state of a company’s business. So it’s an extremely important topic for any securities analyst. Yet it’s my feeling that working capital analysis is often skipped over, even by professionals, although it doesn’t take much time to become proficient at reading what this part of the balance sheet has to tell you.
What it is
What is working capital? It’s total current assets minus total current liabilities. “Current” here means balance sheet items that record and trace the progress of the cash conversion cycle. For most companies, this cycle covers a period of a few months. For such companies, simply as a convention, “current” is defined as items that will be used, or used up, in a twelve-month period. For companies with a longer cash conversion cycle, say, a distiller who specializes in making ten year-old scotch, current means however many years it takes from the purchase of raw materials to the sale of the finished product.
‘Current” is also as opposed to “long term,” the latter meaning permanent or semi-permanent assets (like real estate, factories, trademarks) and liabilities (like a twenty-year debenture or preferred stock or common equity).
Cash conversion
The cash conversion cycle? That’s the sequence of events that starts with cash being used to purchase raw materials, sometimes on credit, which are then turned into work-in-process and then finished goods. The finished goods are sold on to customers, who are perhaps extended credit but who will at some point pay for the merchandise. This allows the company to pay for the raw materials and have its original cash plus profits back in its hands. In the cycle, then, you start with cash and end with cash.
One of the original rules formulated by Benjamin Graham (1894-1976), who is thought of as the father of modern securities analysis, was to buy stock in a company when it was trading at 50% of net working capital (meaning current assets minus current liabilities minus long-term debt) or below and sell it when it rose to 100% of net working capital. The idea was that if the company just stopped making anything, sell its remaining inventories and collect the accounts receivable (trade credit given to customers), the cash on the balance sheet would be enough to pay off all the company’s debt and have 2x the stock price per share in cash + all the factories, machinery, real estate, etc. left over.
Stocks that meet this strict criterion may have been plentiful during the great depression of the Thirties, but other than at moments of extreme panic at market lows, they’ve been few and far between over the past thirty years. Still, the general idea is a good one–and I’m confident, though I haven’t looked, that one could have found firms trading at 100% of net working capital just this past March.
Working capital isn’t always good
Everything I’ve written so far makes the tacit assumption that having working capital is a good thing. That’s not always the case, though. For example:
1. When I first looked at Mizuno (Japan) as a stock, I was struck by the fact that the stock was trading at a discount to its working capital, even in a buoyant (second half of the Eighties) stock market. On Ben Graham principles, the stock looked like a bargain. But it wasn’t. How so? In order to get retailers to stock its sports merchandise, Mizuno had to offer financing of what looked to me to be about two years! Most of its working capital was money tied up in trade receivables. In this case, the fact of huge working capital was a real sign of weakness. And it had to be financed through large dollops of long-term debt.
2. There are very valuable businesses, like restaurants, hotels, magazine publishers (in a better age) or public utilities, that typically have negative working capital. In all these cases, customers either pay for services in advance–magazine subscriptions and public utilities, or they pay as the services are delivered–restaurants and hotels–but the company pays for food, rent, labor at the end of the month, i.e. on average two weeks after it collects its money.
So long as these businesses are growing, they generate increasing amounts of cash that’s not needed to pay bills. In the public utility case, this extra cash may amount to three months’ sales; in the restaurant case, it’s more like two weeks’ sales.
That’s it for now. Succeeding posts will deal with the key individual elements of working capital, like receivables, inventories, payables, and how to analyze them.