negative working capital

Working capital is all about the inventory cycle–meaning the journey from cash in the bank to production materials to finished goods to sales and back to cash.  For pharma distributors the cycle may take two weeks, for a scotch distillery six years.  Conventionally, however, working capital is defined as assets and liabilities being used over a 12-month period.

Manufacturers typically have lots of working capital, much of it tied up in inventory.  Retailers of consumer durables and jewelry do, too.

There’s another class of companies, however, like utilities, restaurants, hotels…that typically have negative working capital, meaning the company doesn’t need to feed cash into the production process to keep it going.  Instead, operations generate cash, at least for a time.   And the amount of cash grows as the business expands.

Why is this?

–A restaurant is an easy example.  In the US, sales happen either in cash or by credit card, where the funds are available for use almost immediately.  So it has no receivables on the asset side of the balance sheet and it has an inventory of maybe a couple of days’ food.  On the liabilities side, rent, utilities, salaries and food ingredients are paid for an average of, say, two weeks after their inputs are used.  So once it gets going, the restaurant has many more current liabilities than current assets and it has the use of the upfront payments for about 14 days.  If the restaurant prospers, the gap between liabilities and assets may expand in percentage terms, but even if not the cash “float” will grow in the absolute.

–An online service charging a monthly or yearly subscription fee–music, books, news, Adobe Cloud–works the same way.  People pay in advance for services provided bit by bit over the term of the subscription.

–hotels, cruise ships and public utilities, too.

There’s a temptation for negative working capital companies, seeing apparently idle cash of $100,000, then $125,000, then $175,000 (much bigger figures for publicly-traded companies) just lying on the balance sheet for years, to use this money to, say, open a second restaurant that would potentially double the size of the firm, create economies of scale…  In fact, the only company I can think of that steadfastly refused to touch any portion of its cash buildup was Dell in its heyday as a PC manufacturer.

The problem:  suppose a negative working capital company takes a risk with its “float” money and stumbles.   In our restaurant example, let’s say the company takes $50,000 out of its cash balance, uses it to set up a second location and the second restaurant flops.  All of a sudden, salaries, utilities, rent, food bills come due and there isn’t enough money.  Whoops.

Suppose the business begins to shrink.  If so, so too does the cash pile.  But at least initially the liabilities remain the same.  Potential trouble, unless the company adjusts very quickly.

More relevant today, suppose there’s a quarantine and incoming cash dries up completely.  In the restaurant case, in less than a month, the cash is all gone!   And the owner has to decide whether to inject more capital into the business, close its doors, or not pay the bills and see what happens.


A case in point is cruise line Carnival (CCL), which raised about $6 billion last week in a stock/bond sale, shortly after drawing down much, if not all, of its $3 billion bank credit lines.  Three entries on the balance sheet explain these moves to me.  As of last November CCL had $518 million in cash on the asset side:  liabilities:  $4.7 billion in customer deposits + $1.8 billion in accrued liabilities (= other stuff).

















Looking at Inventory (I): general

Two posts

I’m going to cover this topic in two posts.  This one will be about what inventories are:  the sub-categories of the inventory entry on the balance sheet, and three main ways companies choose to account for inventories.  Tomorrow’s post will cover what kinds of information you can get about a company from comparing the inventory entries from different time periods.

Here goes:

There are three sub-categories of inventory on a company’s balance sheet:

raw materials.  This is pretty straightforward.  Raw materials are inputs to production that the company owns but has not yet begun to process.  They might be a pile of iron ore outside a steel mill or a bunch of windshield wipers stacked in a warehouse next to an auto assembly plant.

This entry records what the company owns, which may be something very different from what’s at the production site.  The idea of “just in time” manufacturing is that the component suppliers have warehouses full of their wares that they deliver on the day they’re needed.

In today’s world, financing cost aren’t the big issue.  Instead, it’s who takes the risk that the stuff in the warehouse falls in price while it’s just sitting there.  The answer is whichever party has less market power, typically the component supplier.

work in process (which a lot of people incorrectly call “work in progress”).  This is stuff that has entered production and is in the process of being turned into finished goods.  The increase in value of the raw materials will be a mix of direct costs involved in making the item, like salaries of assembly workers, and indirect, or period costs, like the cost of renting/leasing the production site, utilities (heating, lighting), and salaries of foremen and the plant manager.

The amount of work in process varies widely from industry to industry.  Assembly of a PC or a cellphone may take a day.  A semiconductor may take several months.  Wine or whiskey may ferment for years.

finished goods.  This one is also straightforward.  It’s the final products a company makes that are waiting in storage for a buyer to pick them up–or in some cases, to materialize in the first place.

How finished goods move from the balance sheet to the income statement Continue reading

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.

Working Capital: inventory


Inventories are either a very complex topic or a very simple one.  I’m taking the simple route here.

One ratio:  inventory/sales (or sales/inventory)

There’s only one ratio that securities analysts are interested in:  inventory/sales. As with other working capital items, one could also calculate inventories/cost of goods, but I don’t think that using this less common ration gets materially different results.

What the ratio means

The significance of the ratio is what one would expect–it’s bad if the ratio of inventory/sales starts to go up vs. historical experience.

Two cases

In looking at inventories, it’s important to distinguish two cases:  manufacturing companies, which create products or services, and distribution companies, which add their value by selecting among products of manufacturers and making them available either to other distributors or to end-user customers.

1. Manufacturing companies. For a manufacturer, inventory is classified into three categories:

–raw materials,

–work in process, and

–finished goods.

You’ll probably be able to get additional information from examining the percentage of total inventory contained in each category, but normally looking at the overall inventory total will be good enough.

A rise in the inventory/sales ratio usually represents an unanticipated slackening in demand for products contained in the finished goods inventory.  The falloff can be the result of a general economic slowdown, the emergence of new competition, or something wrong with the product itself.

(Note: while an unintended rise in inventories is a bad thing, a 15% rise in the dollar amount of finished goods doesn’t mean there are 20% more items in the company’s warehouses.  For example, assume the company has factory costs of $1 million a quarter that it allocates over full-capacity production of 1 million units.  That amounts to $1 per unit.  If the variable costs for each unit are $1, then the total cost per unit will be $2.  If nothing is sold during the quarter, the total dollar amount added to inventory will be $2 million.

If the beginning inventory is 5 million units and $10 million, then the ending inventory is 6 million units and $12 million.

Now suppose instead that the company responds to order cancellations by cutting current-quarter production in half.  That means it makes 500,000 items at a variable cost of $1 each.  It allocates $1 million of factory costs of those items at a rate of $2 each.  So total cost per unit is $ 3.  Ending inventory is 5.5 million units and $11.5 million in value.  In this case, the dollar value of inventory has gone up by 15%, but total units are only up by 10%.)

2. Distribution companies (think: Amazon, Advance Auto Parts or a supermarket).  Distributors are typically low-margin, high inventory turnover businesses.  They may have considerable value imbedded in their brand names, the know-how that produces their logistics computer systems and their physical store locations.  But these positive attributes do not often manifest themselves in high operating margins.  As a result, because they do not have the high margins of companies with significant legally-protected intellectual property, some growth investors tend to underestimate their earnings expansion potential.

Distributors’ claim to fame rests in their ability to turn inventories quickly.  For this reason, analysts usually place a lot of their analytic efforts on inventories, which they talk about in terms of “turns,” that is, annual sales divided by average (or some other measure to smooth out seasonal variations) inventories.

Since distribution companies usually don’t have exclusive rights to sell unique products, the sales/inventory ratio–how many times it can “turn” inventories in a year–is a good standard of comparison across competitor distribution companies, as well as for comparing a firm with its own history.

For a strong distribution company, sales should rise faster than inventory.  Therefore, inventory turns should rise over time.

Any deterioration of the pattern, either a flattering out of turns or a decrease in turns, is a cause for concern.  On the other hand, an increase on turns, or even better, an acceleration of turns, is a very bullish sign.

Working Capital: payables

Accounts payable

Accounts payable, or simply payables, are the trade credit that is extended to a company by its suppliers.  Payables are liabilities, things the company owes to others.  In almost all instances payables are current liabilities, and, as such, part of working capital.  There are rare instances, however, where they are long-term liabilities.  I gave an example of oilfield service company behavior after the mid-Eighties collapse in energy prices in my post on receivables.  The corresponding item to the long-term receivables on the oilfield service balance sheet would be the long-term payables on its customers’.

Two ratios

There are two payables ratios of primary interest to a securities analyst:  payables/sales and payables/receivables.  Both are calculated using the payables and receivables figures taken from the balance sheet of a certain date.  The sales figure used is for the twelve months ending on the balance sheet date.

The ratios are compared, first and foremost, with a company’s own history.  But since a supplier normally provides customers with more or less standard raw materials on more or less standard payment terms, it is also reasonable to compare the payables to sales ratios among different firms in a given industry.  The results will give a first approximation for the relative market strength and relative bargaining power of industry participants.

1.  receivables/payables. Receivables/payables is a way of quantifying the relative strength of a company vs. suppliers and customers in the universe it operates in. In a CEO’s ideal world, customers would be so eager for the company’s products that they would pay in cash–or even in advance (therefore, no receivables)–and suppliers vying for the privilege of supplying the company would provide unusually long payment terms (big payables).  In CEO hell, on the other hand, suppliers would be so worried about the financial viability of the company that they would demand payment up front (therefore, no payables) and customers would take the finished product only if they could obtain (a la Chrysler) unusually generous financing (big receivables).

As a general rule, the bigger the number, the weaker the position of the company in question.  It’s also important to examine the historical record.  Is this ratio constant over time, or has it recently begun to signal strength or weakness?

Look at the raw numbers, too

In addition to looking at the ratio, you should look at the raw numbers as well–and in two ways.  First, consider how much of the overall credit extended to customers by a company is in effect being financed by credit it is receiving from suppliers.  Then look at the increase in receivables over the previous, say, three years and compare that with the increase in payables.  Do the competitive dynamics of the company’s industry allow the company to keep any of the benefit of increased credit from suppliers?  or has the company been forced to simply pass this financing benefit on to customers?

2.  payables/sales Decline in this ratio can be a very important early warning sign of impending trouble for a company.  Suppliers are constantly analyzing the prospects of all their customers.  Because they deal with a wide variety of firms in their targeted industries, and because they see the pattern of their customers’ payments for supplies, they possess a very sophisticated picture of the industry and each company’s place in it.

Trade creditors are also at the bottom of the pile when it comes to recovery during liquidation.  So they have a lot to lose if they continue to send materials to a failing customer.  As a result, shrinkage in payables is a very reliable indicator of potential trouble.