Working Capital Position

The strength of a company’s balance sheet can be evaluated by examining three financial metrics: working capital adequacy, asset performance, and capital structure. Assessing a company’s working capital position involves measuring the liquidity and managerial efficiency related to its current position. A company’s cash conversion cycle is the analytical tool that’s used to accomplish this task.

Key Takeaways

• Assessing a company’s working capital position involves measuring the liquidity and managerial efficiency related to its current position.
• Working capital is the difference between a company’s current assets and its current liabilities.
• The asset test or quick ratio don’t provide the evaluative information about a company’s liquidity that an investor needs.
• The cash conversion cycle (CCC) is the analytical tool of choice.

Don’t Be Misled By Faulty Analysis

Some commonly held but erroneous views on a company’s current position consist of the relationship between its current assets and its current liabilities. Working capital is the difference between these two broad categories of financial figures. It’s expressed as an absolute dollar amount.

A company’s current position is a stand-alone number. It has little or no relevance to an assessment of its liquidity. This number is nonetheless prominently reported in corporate financial communications such as the annual report and also by investment research services. The amount of working capital sheds very little light on the quality of a company’s liquidity position.

Working With Working Capital

Another piece of conventional wisdom that isn’t entirely accurate involves the use of the current ratio and the acid test or quick ratio. These analytical tools don’t provide the evaluative information about a company’s liquidity that an investor needs. The current ratio is flawed as an indicator of liquidity because it’s conceptually based on the liquidation of all a company’s current assets to meet all its current liabilities.

This isn’t likely to occur in reality. Investors have to look at a company as a going concern. It’s the time it takes to convert a company’s working capital assets into cash to pay its current obligations that’s key to its liquidity.

A simple but accurate comparison of two companies’ current positions illustrates the problem with relying on the current ratio and a working capital number as liquidity indicators.

Company ABC looks like an easy winner in a liquidity contest at first glance. It has an ample margin of current assets over current liabilities, a seemingly good current ratio, and a working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio, and no working capital.

But what if both companies’ current liabilities have an average payment period of 30 days? Company ABC needs six months (180 days) to collect its account receivables and its inventory turns over just once a year (365 days). Company XYZ’s customers pay in cash and its inventory turns over 24 times a year (every 15 days).

Company ABC is very illiquid and wouldn’t be able to operate under the conditions described. Its bills are coming due faster than it generates cash. You can’t pay bills with working capital. Company XYZ’s seemingly tight current position is much more liquid because of its quicker cash conversion.

Measuring Liquidity the Right Way

The cash conversion cycle, also referred to as CCC or the operating cycle, is the analytical tool of choice for determining the investment quality of two critical assets: inventory and accounts receivable.

The CCC tells us the number of days it takes to convert these two important assets into cash. A fast turnover rate of these assets is what creates real liquidity and it’s a positive indication of the quality and efficient management of inventory and receivables. We’re provided with an indicator of a balance sheet’s investment quality by tracking the historical record of a company’s CCC and comparing it to competitor companies in the same industry.

The cash conversion cycle is made up of three standards: the activity ratios relating to the turnover of inventory, trade receivables, and trade payables. These components of the CCC can be expressed as a number of times per year or as a number of days. Using days provides a more literal and coherent measurement that’s easily understood. The CCC formula looks like this:

​DIO + DSO−DPO=CCCwhere:DIO = Days inventory outstandingDSO = Days sales outstandingDPO = Days payable outstanding​

Here’s how the components are calculated:

• Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO).

• Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO).

• Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO).

Important

CCCs will vary according to the type of product and the customer base.

Liquidity Is King

Investors should be alert to spotting liquidity enhancers in a company’s financial information. There’s typically a secondary market for the relatively quick conversion of all or a high portion of these items for a company that has non-current investment securities. Unused committed lines of credit are usually mentioned in a note to the financials on debt or in the management discussion and analysis section of a company’s annual report. They can provide quick access to cash.

What Is a Capital Structure?

The term capital structure describes how much debt a company incurs and how much equity it uses to fund and finance its operations.

When Are Assets and Liabilities Considered Current?

Both assets and liabilities are classified as current based on one year’s time. Current assets are those that can be turned into cash within a year. Current liabilities are those that are due to be paid within a year such as short-term loans and other accounts payable.

What Is a Secondary Market?

Investors buy and sell securities on the secondary market. The action takes place directly between them and other investors without the participation of the companies that have issued the securities. Secondary markets are national markets and include Nasdaq and the New York Stock Exchange.

The Bottom Line

The old adage that “cash is king” is as important for investors evaluating a company’s investment qualities as it is for the managers running the business. A liquidity squeeze is worse than a profit squeeze. A key management function is to make sure that a company’s receivables and inventory positions are managed efficiently.

This means making sure there’s an adequate level of product available and appropriate payment terms are in place while making sure that working capital assets don’t tie up undue amounts of cash. This is an important balancing act for managers because a company with high liquidity can take advantage of price discounts on cash purchases, reduce short-term borrowings, benefit from a top commercial credit rating, and take advantage of market opportunities.

The CCC and its component parts are useful indicators of a company’s true liquidity. The performance of DIO and DSO is also a good indicator of management’s ability to handle the important inventory and receivable assets.

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