For investors, the strength of a company’s balance sheet can be assessed by looking at three financial parameters: working capital adequacy, asset performance, and capitalization structure. In this article, we’ll start with a comprehensive review of how best to assess the working capital situation of the business. Simply put, it is about measuring the liquidity and managerial efficiency associated with the current situation of a company. The analytical tool used to accomplish this task will be the cash conversion cycle of a business.
Don’t be fooled by a flawed analysis
To begin this discussion, let’s first correct some commonly held, but mistaken, views about a company’s current position, which is simply the relationship between its current assets and current liabilities. Working capital is the difference between these two broad categories of financial figures and is expressed as an absolute dollar amount.
Despite conventional wisdom, as a stand-alone figure, a company’s current position has little or no relevance to an assessment of its liquidity. Nonetheless, this number is prominently reported in corporate financial communications such as the annual report and also by investment research departments. Regardless of its size, the amount of working capital does little to shed light on the quality of a company’s liquidity position.
Working with working capital
Another conventional wisdom that needs to be corrected is the use of the current report and, its close relative, the acid test or rapid report. Contrary to popular perception, these analytical tools do not convey the evaluative information about a company’s liquidity that an investor needs to know. The current ratio often used as an indicator of liquidity is seriously flawed because it is conceptually based on liquidating all of a company’s current assets to meet all of its current liabilities. In reality, this is unlikely to happen. Investors should think of a business as a going concern. It is the time it takes to convert a company’s working capital assets into cash to pay its ongoing obligations that is key to its liquidity. In short, the current ratio is misleading.
A simplistic but precise comparison of the current positions of two companies will illustrate the weakness of relying on the current ratio and a number of working capital as liquidity indicators:
|Liquidity measures||ABC Company||XYZ Company|
|Current assets||$ 600||$ 300|
|Current liabilities||$ 300||$ 300|
|Working capital||$ 300||$ 0|
|Current ratio||2: 1||1: 1|
At first glance, ABC Company looks like an easy winner in a liquidity contest. It has a large margin of short-term assets over short-term liabilities, a seemingly good current ratio, and working capital of $ 300. XYZ Company has no current asset / liability safety margin, low current ratio, and no working capital.
However, what if the current liabilities of both companies have an average payment term of 30 days? ABC Company needs six months (180 days) to collect its accounts receivable and its inventory only rotates once a year (365 days). XYZ Company’s customers pay cash and its inventory rotates 24 times a year (every 15 days). In this artificial example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills come due faster than it generates cash. You cannot pay your bills with working capital; you pay your bills in cash! XYZ Company’s seemingly tight current position is much more liquid due to its faster conversion to cash.
Correctly measure a company’s liquidity
The cash conversion cycle (also known as CCC or 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 how long (number of days) it takes to convert these two important assets to cash. A rapid turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and efficient management of inventory and receivables. By following the history (five to 10 years) of a company’s CCC and comparing it to competing companies in the same industry (CCCs will vary depending on product type and customer base), we get an insightful indicator of ‘a balance sheet investment quality.
In short, the cash conversion cycle is made up of three standards: so-called activity ratios relating to inventory turnover, 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 the latter indicator provides a more literal and consistent measure of time that is easily understood. The CCC formula looks like this:
DIO + DSO–DPD=CCCor:DIO = Outstanding Inventory DaysDSO = Pending sales daysDPO = Days payable in arrears
Here is how the components are calculated:
• Division average stocks through cost of sales per day (cost of sales / 365) = days of inventory pending (DIO).
• Division average claims through net sales per day (net sales / 365) = Days of incredible deals (DSO).
• Division average creditors through cost of sales per day (cost of sales / 365) = days of unpaid debts (DPO).
Liquidity is king
A collateral observation deserves to be mentioned here. Investors should be careful to spot liquidity boosters in a company’s financial information. For example, for a company that holds long-term investment securities, there is usually a secondary market for the relatively rapid conversion of all or a large portion of these items to cash. In addition, unused committed lines of credit, typically mentioned in a note to financial statements on debt or in the management discussion and analysis section of a company’s annual report, can provide quick access to cash. .
The bottom line
The old adage that “money is king” is as important to investors who assess a company’s investment qualities as it is to the managers who run the business. A squeeze in liquidity is worse than a squeeze in profits. A key management function is to ensure that a business’s receivables and inventory are managed efficiently. This means ensuring that there is an adequate level of product available and that appropriate payment terms are in place, while ensuring that working capital assets do not tie up undue amounts of cash. This is an important balancing act for executives because, with high liquidity, a business can enjoy discounts on cash purchases, reduce short-term borrowing, enjoy a commercial credit rating of foreground and take advantage of market opportunities.
The CCC and its constituent parts 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 manage large inventories and assets receivable.