Guest post by Sandesh Trivedi of http://sandeshtrivedi2.blogspot.com/ This article is especially good for someone who is brand new to investing, but also useful to a more advanced investor who might need to brush up on some accounting 101!
Working capital analysis
Investors don’t need to become a professional accountant but only need have a basic understanding of accounting in order to read financial statements and evaluate the working of a business. One of the key issues in understanding the functioning of a business is the flow of funds or working capital. Businesses vary in size, structure and products & services but they all need to manage cash flows and funding requirements for day to day operations. A business may need funding to pay its bill, or financing the conversion of raw materials into finished goods, obtain credit from suppliers and extend credit to its customers in its everyday operations. Cash is the lifeline of a company and working capital is the cash which enables the company to fund its daily operations. In other words Working capital is the money needed to fund the normal, day to day operations of your business Understanding the cash flow of funds or working capital is very important to make investment decisions. It basically tells the investor how the manages its cash, the better a company manages its working capital the less is strain on balance sheet. To illustrate how a typical company manages its working capital lets consider the a Peanut butter manufacturer uses $100 worth of inventory which consists of basic ingredients required to prepare the butter. The initial investment is out of its own pocket or if the company was short of cash it could sign an IOU with a supplier and promise to pay for the inventory within a time mutually agreed upon by the manufacturer and the supplier. This is followed by the production of the peanut butter which is sold to the customers either on a cash basis or on credit. The amount which is sold on credit accumulates in the accounts receivables account of the company and upon collection from the customers it becomes cash. The company uses the accumulated cash to replenish its inventory or to pay off the IOU so that the supplier would extend credit for the next cycle. The quicker the company is able to sell the peanut butter and collect cash, the sooner it can go out and buy new inventory and produce more peanut butter. If the company is not able to sell its products then inventory is piled up and as a result the cash is tied up and cannot be used to grow the business. Cash is also tied up when customers do not pay in time or the company gives credit on very easy terms. The better a company manages its working capital, the less the company needs to borrow and the less is the strain on the balance sheet of the company. Studying the working capital position of a company reveals more about the financial condition of a business than any other performance metric. Looking at the working capital position of a business enables one to foresee any financial difficulties that may arise. Poor management of working capital affects the cash generating capacity of the company and leads to financial pressure on the company.
Working capital Calculation
Current Assets minus Current Liabilities = Working Capital
It’s the best way to judge how much a company has in liquid assets to build its business, fund its growth, and produce shareholder value. If a company has a positive working capital then that means its in good financial health with plenty of cash and short term resources to pay off its short term liabilities. however some companies can generate cash so quickly they actually have a negative working capital. This happens because customers pay upfront and so rapidly, the business has no problems raising cash. In these companies, products are delivered and sold to the customer before the company ever pays for them.A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis).
Accounts Receivable turnover in days
Measures the average number of days from the sale of goods to collection of resulting receivables. It is obtained by the following formula: ( Accounts Receivable / Sales X 365). Rising accounts receivable is a sign of trouble because it shows that a company is taking longer to collect its payments. It suggests that the company is not going to have enough cash to fund short-term obligations because the cash cycle is lengthening. If Accounts receivable is handled poorly, it means that the company is having difficulty collecting payment from customers. This is because accounts receivable is essentially a loan to the customer, so the company loses out whenever customers delay payment. The longer a company has to wait to be paid, the longer that money is unavailable for investment elsewhere
Measures the length of time on average between acquisition and sale of merchandise. For a manufacturer it covers the amount of time between purchase of raw material and sale of the completed product. It is obtained by the following formula: (Inventory / COGS X 365).
A high inventory turnover is good for business and is an indication of good demand for the company’s products.
Analyzing a company’s working capital management provides one with good insights about the business and enables a investor to foresee any financial difficulties that may arise in the near future.