How many times have you heard businessman or entrepreneurs telling you “Cash is king!“?
How many times have you heard value investors telling you “Cash is king!”?
As Warren Buffett says, “Investment is most intelligent when it is most businesslike” and vice versa. No wonder businessman and investors speak alike.
So why is cash so important? And what affects the amount of cash that a business generates?
If you are running a business or startup, or if you have a friend who does so, you would probably have experienced/ heard of a situation where the business is generating a lot of profits (as shown in the income statement), but for whatever reason, there are just not enough cash. And the financial or treasury team is shouting “We don’t have enough cash to pay our employees payroll, or the suppliers are chasing for payments!” Sounds real? It is – in the business world.
And one of the main reasons for this is poor working capital management, or bad working capital dynamics. And many new investors miss this out in analysing the companies they own, and could end up overpaying for a business, or missing out great opportunities!
Which is why we are going to talk about working capital today – as it has a huge impact on businesses and investments!
What is Working Capital?
Working capital is basically the “capital” that you need in your business to make it “working” on an ongoing basis.
When a business trades, it has a working capital requirement – It buys goods from suppliers, holds them as inventory, and then sells them to customers.
There are various methods for calculating net working capital (NWC) – depending on what’s your purpose, or what you want to include or exclude in the calculations.
Some of the formulae used include:
NWC = Current Assets – Current Liabilities;
NWC = Current Assets (less Cash) – Current Liabilities (less Debt); or
NWC = Accounts Receivable + Inventory – Accounts Payable.
The first formula above is the broadest (as it includes all accounts), the second formula is more narrow, and the last formula is the most narrow (as it only includes three accounts).
At MoneyWiseSmart, we prefer to not stick to any single formula but evaluate NWC case-by-case for each company. However, we usually could be ending up using something closer to the third formula, i.e. NWC = Accounts Receivable + Inventory – Accounts Payable, so we will focus on that today.
How to Think About NWC?
Generally, accountants prefer a positive net working capital, i.e. the sum of accounts receivable and inventory is greater than the accounts payables. This means that the business can collect or realise more cash than it needs to pay to its suppliers in the short term. As this indicates good liquidity, with the business having no trouble in having enough cash to settle its obligations.
However, for (value) investors, this is one area where the thinking could differ vastly. Liquidity is important for a business to survive, but having a positive net working capital dynamics is not necessarily needed (as it depends on how much cash the business is holding, what are the types of short term obligations that the business has, or how can they be settled, etc). Nor is it ideal.
In fact, as investors who look for high growth high quality companies, as long as the balance sheet or financial/cash standing of the business is good, most of the time, we would actually prefer negative net working capital (which the accountants chastise).
Think about this carefully – Let’s imagine two scenarios. As a business owner, assuming the inventory amount is the same for now, and that you have enough cash to pay off any short term liabilities as they fall due and you are in a high growth phase when you are expanding fast, which of the following two scenarios would you prefer?
You owe people more than what people owe you in the short term, i.e. your account payable is greater than your account receivable, e.g. you owe your supplier $2 million and your customers owe you $1 million; or
You owe people less than what people owe you in the short term, i.e. your account payable is less than your account receivable, e.g. you owe your supplier $1 million and your customers owe you $2 million.
If we are confident that we can manage our cash flows well, we would go for the first one, i.e. owe our supplier $2 million and have our customers owe us $1 million. This is because this means that we are effectively borrowing $1 million of capital/cash from our suppliers in the short term (maybe for a few months) interest-free for us to grow our business, instead of having to go to the bank to borrow $1 million and having to pay interests on that to do so.
Examples of Positive NWC Businesses
Let’s look at some examples to illustrate this better.
First, let’s start with a business with accounts receivables greater than accounts payables.
Maybe let’s imagine you are a small construction company owner. You work on construction projects, procuring raw materials at $1 million to do so at the start of the 1st month. Then, upon completing the project, you deliver the buildings to your customers and invoice them for payments of $2 million (which is your revenue) in the 2nd month. So you record revenue of $1 million, and accounts receivables and payables of $2 million and $1 million respectively, assuming the payments terms are the same at 3 months.
However, in terms of cash, you need to fork out $1 million at the end of the 3rd month, while you can only collect that revenue in cash at the end of the 5th month. So you need to find cash of $1 million to pay your suppliers in the mean time, on top of other cash you need to pay your employees’ payrolls, etc.
So on accounting terms, it seems like your short term liquidity is good, in the sense that you owe people less than what people owe you. However, in terms of timing of cash, you are doing pretty bad and need to have access to or borrow cash from somewhere. And cash/capital does not come free/cheap.
And we have only talked about maintaining the business. If you want to expand and grow your business, say to 2 times the size now, by doing double the projects, that means you have to have $2 million now (instead of $1 million) to pay for the raw materials to your suppliers, as the cash from your revenue only comes in later, even though that revenue amount is doubled. So you are on a constant treadmill on looking out for cash capital, to either maintain or grow your business, making running and expanding the business difficult.
In our next article (Part 2 of 3), we will look at an actual example of a great business that has compounded its revenue and profit by a compounded annual growth rate (CAGR) of 22%-26% during the period 2009 to 2019. However, its operating cash flows (OCF) are much lower than its profits, at around 36%-50% of profits (with free cash flows (FCF) being even lower), due to its bad working capital dynamics. Therefore, an investor valuing the company based on its profits, instead of FCF, could be overpaying more than double the amount for the company. Read on here!
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