How a Company Manages Money Is Key to Its Profitability and Stock Valuation.
As exciting as it might be to see endless rows of pallets of product in the warehouse or scads of new orders flying in, inventory and accounts receivable still won’t guarantee the firm has healthy cash flow. They’re close to being liquid assets, but inventory can pile up without ready buyers and the company’s customers could slow down payment. Executives watch the size of inventory they carry and how long it takes for the company to collect on sales because these two items — considered part of the firm’s working capital — will impact the most scrutinized financial ratios.
Working capital might not be as eye-catching as changes in profit margins, but firms with great profit margins can still go belly up. With that in mind, I’ll highlight some of the causes, effects and implications of changes in working capital.
Working capital is the amount of short-term assets the company carries on its balance sheet to conduct its business operations. But firms also have short-term liabilities, so most analysts look at net working capital, which is current assets minus current liabilities. Accountants define this as those assets and liabilities that will either be
consumed or converted into cash within a year. Firms can have a working capital surplus (current assets exceed current liabilities) or, if what they owe is more than what they own, they have a working capital deficit.
Breaking Down Working Capital
Current assets might include cash and cash equivalents, inventory and accounts receivable. Current liabilities will typically include accounts payable: rent, mortgage payments, bills coming due and payroll, for example. Firms also include any long-term debt and interest coming due within the year as a current liability, so working capital may take a dramatic hit if the bond principal is coming due and the company hasn’t accumulated the funds to pay it.
Some industries can survive perfectly fine with a working capital deficit simply because of the nature of their business. An expanding grocery chain, for example, may own or lease buildings and pay employees, but it stocks its shelves with inventory on 90-day terms. As long as that inventory continues to turn over before the bill for the product comes due, food manufacturers are financing the grocery chains’ businesses.
Is Cash King or Is Cash Trash?
Risk-averse executives like to hoard cash on the balance sheet, but that can draw the frustration of shareholders who would certainly prefer to spend it or invest it elsewhere. Some cash is always desirable to keep the business running smoothly and prepared to take advantage of unexpected opportunities, but too much cash is a drag on the business.
Unlike inventory and accounts receivable, cash and cash equivalents such as money market funds, Treasury bills and short-term certificates of deposit, might be safe but won’t earn much return. Ideally, excess cash is redeployed into a profitable project or distributed to shareholders through dividends or, as is popular these days, share buybacks.
Working Capital and Profitability Ratios
Any profitability ratio that relies on net assets will be negatively affected by high working capital. Return on assets, for example, is net income divided by average total assets. If a firm makes $1 million in net income from $20 million in net assets, then its return on assets is 5 percent.
Shareholders are usually most concerned with return on equity, which is affected by return on assets. Though companies can compensate for a low return on assets through more revenue, astute managers seek to maximize both.
The chief financial officer must always respect a fine line: that point where the level of working capital is so low that the firm might not be able to meet its obligations or take advantage of new opportunities. That additional risk would increase investors’ required return to buy the stock and, as we know, that would drive the stock price down.
The CFO will estimate and pursue an ideal level of working capital that maximizes both profitability and the stock’s price multiples, such as the price-earnings ratio. Sometimes, however, companies become so enamored of either safety or profitability that the stock price isn’t maximized. That makes the company subject to corporate raiders who would redeploy the firm’s excess capital or bolster its liquidity to increase safety.
Introducing the Cash Conversion Cycle
How long does it take for a company to convert cash on hand into profit? The cash conversion cycle formula might appear intimidating, but the concept is easy to grasp:
Days Inventory Outstanding
Plus Days Sales Outstanding
Minus Days Payables Outstanding
Which breaks down further into:
CCC = ________________
Cost of Goods Sold/Day
Average Accounts Receivable
Average Accounts Payable
The “average” numbers for inventory, accounts receivable and accounts payable are simply the beginning-of-period number plus the end-of-period number, divided by 2. COGS per day is the cost of goods sold divided by the number of days in the period; revenue per day is, of course, revenue divided by the number of days in the period. The resulting number is the number of days it takes for a company to convert cash to profit.
The shorter the cash conversion cycle, the more liquid the company. Companies can reduce their CCC by minimizing inventory levels, collecting cash for sales faster or paying its bills slower.
Again, the key here is to balance minimizing the cycle and maximizing sales. If the company doesn’t maintain enough inventory, it may lose sales. Likewise, if the firm bills too aggressively, its customers will find more flexible suppliers. Companies routinely slow-walk paying invoices, but hopefully not to the point of being unable to obtain raw material if they pay too slowly.
Analyzing Working Capital
Now that we understand the trade-offs involved in setting optimal inventories, credit and payables policy, we can see 1) why “just-in-time inventory” and supply chain management are so beneficial and 2) how companies can occasionally run into trouble. The goal is always to reduce time capital sits idle or at risk of not being collected.
We can also see the relative appeal of software firms that don’t need to maintain costly inventory and can collect on sales as they’re made, especially if we compare them with, say, consumer discretionary companies such as clothing retailers and automobile manufacturers.
The cash conversion cycle can be affected by poor products or a poor economy. If sales slow, inventory piles up and reduces efficiency. If inventory is perishable or runs the risk of becoming obsolete, the situation may become even worse. Inventory may even need to be written down in value.
The optimal scenario for receivables is for customers to wire cash whenever they place an order, but that would leave the door open to competitors with less stingy credit policies. Firms that don’t pay bills quickly might find it hard to find raw materials.
We can understand how a slowing economy might impact a firm’s liquidity. Lower revenue means less revenue per day, which impacts the CCC. Also, inventory might pile up and be written down.
Customers will have their own issues in a slow economy and might feel compelled to slow down payment or, worse, default or even go bankrupt. Meanwhile, growing demand
allows companies to increase prices and demand rapid payment while still paying bills only when they become overdue — again, not by too much.
Working capital might seem like one of those arcane accounting issues that only captivate accountants, but managing it properly is key to a company’s profitability, stock valuation and even survival. You don’t need to be a wizard on the topic to choose great stocks, but pay attention to working capital when the company is under stress or introducing key products.
This article was originally published in the November 2019 issue of BetterInvesting Magazine. Contributing editor to BetterInvesting Magazine Sam Levine, CFA, CMT, teaches securities analysis and portfolio management at Wayne State University.