Working Capital: cash and short-term investments

Many observers have remarked that accounting techniques can give favorable shadings to almost every balance sheet or income statement entry–but they can’t do anything about cash.  Therefore, they conclude, analyze the changes in cash and you can most accurately assess the strategy a company is taking and the profits a company is making.

Analyzing cash as a component of working capital

I think this is right, but analyzing cash–which means looking at the sources and uses of funds–is a little more complex than just looking at the “cash” item in Current Assets.  For working capital purposes, though, there are only a few things to look for to make sure you get an accurate picture of the changes, + or -, in the cash a company is holding:

Three rules

1.  Count all the cash.  Cash in a checking account (cash) and T-bills (short-term investments) will certainly appear in Current Assets.  But if the company has cash it knows it won’t need for a while, it may also buy Treasury securities that mature in more than twelve months.  They’ll be in the long-term section of the balance sheet, as Long-Term Investments.  Count them, too (you may have to check the footnotes to the balance sheet to make sure the company hasn’t mixed in equity holdings in joint venture projects, or other “real” investments that shouldn’t be counted as cash.).

2.  Look for a buildup in financial liabilities and subtract it, if there is one.  Check for increases in payables and short-term debt and long-term debt.  Also make sure there hasn’t been an equity issue.  All of these items will generate cash, but adding liquidity from new debt or new equity isn’t the same as adding it from operations.  It’s highly unusual for a company to issue a special cash dividend to use up extra cash (WYNN is the only firm I’m aware of to do so recently), but you might look for that and add it back in.  Personally, I wouldn’t add back in stock repurchases, although firms present these as a “return” of cash to shareholders, since they typically only offset (as well as disguise) the company’s issuance of stock to top management.

3.  Think twice about negative working capital companies.  When negative working capital companies have increasing sales, they generate excess cash, just due to the fact that customers pay for the product/service either in advance or before the company has to pay its suppliers.  Often, these companies will use the excess cash to fund capital expenditures, believing that they will continue to grow and generate larger amounts of cash.  That’s the highest probability case.  But there’s always the risk that revenues will stagnate, or even begin to decline–in which case the business will begin to absorb cash rather than throw it off.  One adjustment for the cash position of negative working capital companies would be to calculate payables minus receivables and subtract the difference from cash.

5 responses

  1. Hi,

    Love your blog. I work in equity research and really like your simple analysis of stocks..hope to get there sometime soon myself, but as I have realized there is little substitute for experience in this industry.

    Had a quick question for you about negative working capital and terminal values of DCF. If you project negative working capital for a firm like amazon, it can add 15/20% of the value of the firm. This just does not feel right, but I am having a hard time figuring out how to adjust for this. Do I just ignore the negative working cap in the terminal year ?

    Any comments welcome..


    • Thanks for your comment. Sorry about the late reply, but I’m just getting settled back in after my older son’s wedding.

      You’re right in your characterization of the industry as very experience intensive. In a way, it’s like being a baseball player or a housebuilder–they’re all craft skills that you learn by apprenticing yourself to someone who knows what he’s doing and is willing to teach.

      As to negative working capital, I don’t have any good suggestions about what to do. Now that you make me think of it, I’m not sure I’ve ever done a DCF with a negative working capital company. That’s not so surprising, though. As a growth investor, virtually all the DCF work I’ve done has been in M&A. I do have two observations, however:

      –as you know, negative working capital arises from a timing difference between when you get paid and when you have to pay your suppliers. It only keeps increasing as long as sales are rising; if sales begin to fall, negative working capital quickly begins to shrink, as payments to suppliers start to exceed new cash coming in from operations. So the cash doesn’t belong to the company once and for all, in the way that profits do. This means it’s worth less than other forms of cash generation.

      –in my experience, companies differ greatly in the way they treat the cash generated from negative working capital. For example, some hotel companies aggressively invest the NWC cash in new long-term projects, seemingly without a worry about possibly having to pay the money to suppliers. On the other hand, DELL (in its heyday–I don’t know what they do now) used all the cash operations generated to buy back its own stock. But the company wouldn’t touch the NWC cash, which it simply kept in money market investments in case it was needed.

      These are the polar extremes. I don’t know what the typical company does. It seems to me that the value of the NWC cash varies with the characteristics of the business (e.g., how cyclical, regular repeat purchase?) and the risk tolerances of managements.

      What do you think?

  2. I also believe that it is very important that we count our cash so that we can identify whether it’s generating profits or not. Thanks for sharing this article. This is really useful for business owners like me.

  3. I totally agree with what you said.I think that it is very important to always count our cash so that we can see to it that the business is generating cash. Thanks for sharing this article.

Leave a Reply