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The importance of working capital

Jan 24 2019 10:58
Simon Brown

There is a saying that cash is king. 

Businesses operate for profit, and that profit is best illustrated with positive cash flow. 

For investors, this ultimately boils down to dividends. 

Numbers can be smudged or massaged, but a dividend cannot – the company needs the money in order to pay the dividend. 

It then arrives in your account as money you can spend.

An exception here is where a company uses debt to pay a dividend. 

That is a massive red flag that would see me exiting an investment.

But there is a lot of other cash floating around in a business, which is needed in order to continue the day-to-day operations of the business. 

Keeping an eye on that cash can help warn investors of an impending cash crunch.

Internal cash usage is called working capital and is calculated as current assets less current liabilities. 

Remember, current assets or liabilities can be liquidated within the next year. So short-term debt, cash and inventories are usually top of the list here.

As a company expands, this working capital will also increase, and it is well worth keeping an eye on that rate of expansion. 

Does that mean working capital expanding equals growth? 

In an ideal situation one would see operational leverage, whereby working capital is growing at a slower pace than profits are growing, indicating that the business has synergies within its operations.

Very volatile working capital is also a concern. Sure, some businesses are seasonal. 

Retailers will, for example, hold more inventory towards the end of the year for the holiday season, while farmers may have costs in one reporting period and revenue in another. 

This will smooth itself out when looking at full-year results – and it is important to remember this seasonality when looking at half-year results.Other than the above, volatile working capital could mean weak management in terms of managing inventory levels relative to expected sales.

It could perhaps also mean fluctuating short-term debt, such as an overdraft.

One aspect of working capital that I always pay extra attention to is inventories. 

Here a spike could mean that inventory did not sell, and that the business may not be able to sell it at normal margins. 

This could hurt overall profitability.I also like to check inventory turnover and how it compares over time. 

Inventory turnover is really just inventories divided into revenue. 

An inventory turnover ratio of say 12 over a year means that the business pretty much sells all inventory every month. 

By comparing this figure against peers and previous years, you will get a sense of how the business is doing. 

A sudden drop in inventory turnover can also serve to alert you. 

Is the business holding more stock? Or could it be that sales are dwindling?Another asset within working capital is biological assets. 

If you are a timber farmer, for example, this would be your trees, while chickens would be the biological assets of a chicken farmer. 

Here, you have to trust the board on how it values these assets – and for some industries it will be easier than for others. 

Chickens, for example, have a very short lifespan of some 40 days, so the values provided are relatively short-term and should hold for the duration.

However longer-term assets such as trees have a lifespan measuring in years, maybe even decades, and as such the eventual price for that asset may be vastly different when it is finally time to sell to market.By digging into working capital, investors can try to get a sense of future cash flow and, ultimately, dividends. 

It is not a perfect science, but it certainly can alert you to potential problems that may crop up in the next year or three.

This article originally appeared in the 24 January edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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