Working capital status

For investors, you can evaluate the strength of the company’s balance sheet by examining three financial indicators: working capital adequacy ratio, asset performance, and capital structure. In this article, we will first fully understand how to best assess the company’s working capital situation. Simply put, this requires measuring the liquidity and management efficiency related to the company’s current situation. The analytical tool used to accomplish this task will be the company’s cash conversion cycle.

Don’t be misled by the wrong analysis

To begin the discussion, let us first correct some commonly held but false views about the current state of the company, which include only the relationship between its current assets and current liabilities. Working capital is the difference between these two types of financial data, expressed in absolute U.S. dollars.

Although the traditional view is that, as an independent number, the company’s current situation has little or no correlation with the assessment of its liquidity. Nonetheless, this number has been prominently reported in corporate financial communications (such as annual reports) and investment research services. Regardless of scale, the amount of working capital has little effect on the quality of a company’s liquidity status.

Use working capital

Another traditional view that needs to be corrected is to use the current ratio and its closely related acid test or quick ratio. Contrary to popular belief, these analytical tools do not convey the assessment information that investors need to know about the company’s liquidity. The commonly used current ratio as an indicator of liquidity has serious flaws because it is conceptually based on clearing all current assets of a company to repay all its current liabilities. In fact, this is unlikely to happen. Investors must treat a company as a going concern business. The time required to convert a company’s working capital assets into cash to pay its current debt is the key to its liquidity. In short, the current ratio is misleading.

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A simple but accurate comparison of the current positions of the two companies will illustrate the weakness of relying on current ratios and working capital figures as liquidity indicators:

Liquidity measures Company ABC XYZ Company
Current assets 600 USD 300 USD
Current liabilities 300 USD 300 USD
Working capital 300 USD 0 USD
Current ratio 2:1 1:1

At first glance, ABC Company seems to have easily won the liquidity race. It has sufficient current assets to exceed the profit margin of current liabilities, a seemingly good current ratio, and $300 in working capital. Company XYZ has no safety margin for current assets/liabilities, a weak current ratio, and no working capital.

But what if the average repayment period of the current liabilities of the two companies is 30 days? It takes six months (180 days) for ABC Company to collect the receivables, and its inventory is only turned over once a year (365 days). Customers of XYZ Company pay in cash, and their inventory turns 24 times a year (every 15 days). In this artificial example, ABC Company has very low liquidity and cannot operate under the conditions described. Its bills are due faster than it generates cash. You cannot pay bills with working capital; you pay bills with cash! Due to the faster cash conversion rate, XYZ’s current seemingly tight positions are more liquid.

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Measure the company’s liquidity in the right way

The cash conversion cycle (also known as the CCC or operating cycle) is the preferred analytical tool to determine the investment quality of two key assets-inventory and accounts receivable. CCC tells us the time (number of days) required to convert these two important assets into cash. The rapid turnover rate of these assets creates real liquidity and is a positive indicator of the quality and efficiency of inventory and accounts receivable management. By tracking the company’s CCC history (5 to 10 years) and comparing it with competitors in the same industry (CCC will vary according to product type and customer base), we provide an insightful balance indicator Table of investment quality.

In short, the cash conversion cycle consists of three criteria: the so-called activity ratios related to inventory turnover, trade receivables and trade payables. These components of CCC can be expressed as the number of times per year or the number of days. Using the latter indicator can provide a more direct and coherent time measurement, and is easy to understand. The CCC formula is as follows:

DIO + DSO − DPO = CCC where: DIO = open inventory days DSO = open sales days DPO = open days payable begin{aligned} &text{DIO + DSO}-text{DPO} = text{ CCC} &textbf{where:}\ &text{DIO = open inventory days}\ &text{DSO = open sales days}\ &text{DPO = open due days} \ end{aligned}

DIO + DSODPO=CCCWhere:DIO = number of days of outstanding inventoryDSO = days of outstanding salesDPO = number of unpaid days due

Here is how to calculate the components:

• Average inventory divided by daily cost of sales (cost of sales/365) = number of days of outstanding inventory (DIO).

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• Average accounts receivable divided by daily net sales (net sales/365) = open sales (DSO).

• Divide the average accounts payable by the daily cost of sales (cost of sales/365) = the number of days the accounts payable are outstanding (DPO).

Liquidity is king

What is worth mentioning here is an incidental observation. Investors should be wary of discovering liquidity-enhancing factors in the company’s financial information. For example, for companies with non-current investment securities, there is usually a secondary market that can convert all or most of these projects into cash relatively quickly. In addition, unused committed credit lines—usually mentioned in the management discussion and analysis section of the debt financial report or company’s annual report—can provide quick access to cash.

Bottom line

The old adage “cash is king” is equally important for investors who assess the quality of a company’s investment and managers who run a company. The liquidity crunch is worse than the profit crunch. A key management function is to ensure that the company’s accounts receivable and inventory status are effectively managed. This means ensuring that there are enough available products and appropriate payment terms, while ensuring that working capital assets do not take up too much cash. This is an important balancing act for managers, because under high liquidity conditions, companies can use cash purchase price discounts to reduce short-term borrowing, benefit from the highest commercial credit rating, and take advantage of market opportunities.

CCC and its components are useful indicators of a company’s true liquidity. In addition, the performance of DIO and DSO is a good indicator of management’s ability to handle important inventory and assets receivable.


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