One of my module lecturers happen to come from corporate banking background which involves a lot of credit and loan approvals for companies. She recently shared her take on working capital which I thought is worth sharing because it contradicts with conventional wisdom. It will be interesting to hear what others think of it.
What is working capital?
Working capital is a financial metric which represent operating liquidity available to a business. It is calculated as current assets minus current liabilities. Liquidity management is a vital aspect of a company – the conventional wisdom is that a positive working capital means sufficient liquid assets are able to be converted to cover short term funding requirements (current liabilities), serving as a positive indicator of strong liquidity.
While current assets and current liabilities include a wide range of accounts depending on the nature of the business, accounts receivable, inventory and accounts payable are the ones of special importance because of their universality. For the simplicity sake, we assume working capital to only constitute these 3 accounts for the remainder of this article.
Surprise #1 – Negative Working Capital is Good
In Security Analysis, Benjamin Graham mentioned that a current ratio of above 2 was one of his criteria for picking a stock. Many have abided by such a rule in their investments, us included. Some go a step further to argue that too high a current ratio implies inefficient capital allocation. I was familiar with both arguments and was expecting a similar rhetoric; imagine my surprise when she said that a negative working capital indicates a very strong company.
Singaporeans are familiar with the market strength of NTUC. She gave the example of NTUC, which based on her experience, insists on paying supplies 60 days after the delivery of goods. On the other hand, accounts receivable is very low as most transactions are done on cash-basis. A company such as NTUC has very favourable credit terms and consequently, ample liquidity, far from what its negative current ratio implies. One can argue that cash has been omitted hitherto and factoring in cash would lead to a very high current ratio. That may be true, but the point I wish to convey is that for a company like NTUC, they can afford to keep very little cash on hand, driving down their current ratios. Yet, it does not mean that NTUC has poor liquidity management and the reality could not be further from it.
In a similar vein, exceedingly high accounts receivables can be a sign of fraud activity through channel stuffing. At the very least, it indicates that a company has trouble collecting cash. Consider the case of Sino Grandness; it has a current ratio of 2.55x, but accounts receivable constitute a staggering 80.2% of net book value – definitely not a sign of a quality company.
Surprise #2 – Overestimation of Working Capital Requirements
Wikipedia has explained this perfectly and I’m going to be shameless here.
A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30 day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company’s profitability.
A company would require sufficient cash to tide through the 30 days before any cash is collected from its payables. This amount is often estimated by taking 30 days’ worth of sales from a full year, utilizing the account receivables turnover ratio in the process, and represents the level of funding required.
However, such basis of estimation tends to be inflated as sales amount include a portion to be earned as profits. To illustrate my point, consider a company with 50% gross margins; a product that costs $1 to produce (in terms of raw materials and processing) can be sold for $2 in revenue. Assuming it sells and produces only 1 unit of goods every 30 days, the company only needs to borrow $1 to sustain its production, not the full $2. The level of funding required to sustain 30 days of operations would therefore be a function of the cost of production, rather than the revenue it generates.
It is unlikely that both points raised will significantly impact your investment style. Nevertheless, we believe that this an interesting dimension that is worth sharing. We are always bullish on knowledge and perspectives.