In our previous articles (Part 1 of 3 here) and (Part 2 of 3 here), we looked at what is net working capital (NWC), how to think about it, and fictional example and actual example (Pax Global) of a business with positive NWC dynamics, to see how that positive NWC dynamics make running and expanding the business difficult.
Today, we will switch gear and look at companies with negative NWC dynamics (e.g. companies with accounts payables greater than account receivables (and inventories)) to see how they contrast.
Businesses with Negative NWC
First, let’s use an actual example – China Maple Leaf Educational Systems Ltd (CML), which is a leading international school operator mainly based in China and increasingly going global.
CML provides private bilingual education to its students, from pre-schools (i.e. kindergartens) to high schools. It collects tuition fee revenues from its students at the start of the two semesters every year, resulting in large amounts of up-front tuition fee collections. As the (teaching) service has not been delivered as at the start of the financial year, these collections are recorded as contract liabilities (or deferred revenues), as part of current liabilities. As of 31 August 2019, it had RMB 1.4 billion of contract liabilities, much higher than its receivables of RMB 0.1 billion (and it had minimal inventories as a school operator).
This means that, as of 31 August 2019, CML had collected a net RMB 1.3 billion of cash upfront (considering the tuition fees it collected upfront, less off the amounts its customers were owing it). This means that CML had RMB 1.3 billion of cash that it could use, not only to pay its teachers and employees in the next 12 months, but it also had lots of capital to expand the business – either by building new schools, acquiring new schools, etc. As shown in the chart below, CML has been collecting around 90%-100% of its revenue upfront every year, therefore having access to lots of interest-free capital that it could use.
Therefore, CML did not really need to go to the bank to take up a loan, or a working capital loan, just to fund its operations or expansions, unless it’s a really huge investment (which it did in 2020 when it acquired 2 large schools in Singapore and Malaysia). In fact, even when expanding, in building new schools, CML generally partners with the local government, where the government contributes, or pays for, the land and the buildings (so as to make the area more attractive for economic development). While CML just contributes its management and educational systems in running the schools, therefore requiring minimal capital for expansions.
This makes CML an amazing business to own, as it is able to expand without having to worry much about capital constraints, and is able to compound the wealth for shareholders for the long term, in our opinion. The chart below shows its good growth in revenue and profits over the years from FY2014 to FY2019, before the COVID-19 pandemic hit its business in FY2020.
Next, let’s look at another example with negative NWC – Insperity.
Insperity is a leading professional employer organisation (PEO) firm in the United States. It targets the small and medium businesses (SMBs), where the SMB clients outsource their entire human resources (HR) function to Insperity as a strategic partner.
Under the co-employment model, Insperity works with the SMBs to hire employees who work for the SMBs, known as the worksite employees (WSEEs). Insperity takes care of all the associated HR and compliance work (which can be very burdensome in the U.S.), reducing the workload for the SMBs which are generally small and might not have a dedicated HR team or experiences to handle the work well.
As shown in the picture below, Insperity offers a wide range of services to its > 100k SMB clients, including recruitment, payroll administration, compliance, employer liability management, and benefits plan sponsorhip.
As Insperity collects upfront various employees costs (e.g. payroll costs, payroll taxes, health insurance, workers’ compensations, etc) from the SMBs first, before paying them to the relevant parties (e.g. the employees, tax authorities, and insurance firms), it runs a negative net working capital. This is because those upfront collections (recorded as current liabilities) greatly exceed the accounts receivables (as a service business, Insperity has no inventory).
As shown in the chart below, just the accrued payroll taxes & deductions (the yellow bars) plus the accrued payroll costs (the dark blue bars) greatly exceed the accounts receivables (the light blue bars). This results in a highly negative NWC for Insperity, as indicated by the green line. As of end 2018, it had negative USD 350m of NWC, which was around 9% of its total revenue.
This highly negative NWC dynamics provide Insperity with lots of cash for it to deploy into whatever opportunities it has in mind, e.g. organic growth by expanding into new states in the U.S. or share buybacks, to drive shareholder value. Coupled with its minimal capital expenditure requirements, this makes Insperity having high FCF conversion and return on equity (ROE), helping it to grow well rapidly for the past decade, with a CAGR for revenue of 15% and profit of 20% in the past 2+ decades from 1996-2008. The high FCF conversion also resulted in Insperity having so much cash, which it has been using to buy back its shares, reducing its book equity value to even negative recently in 2020 Q1 (again, something that accountants probably would chastise, but not necessarily so for investors).
How good it is to be using other people’s capital (for free) to grow your business, as long as you are careful with your cash flow management, and has the ability to fulfil the short term liability obligations when they come due. (However, do take note that, when the growth of a business with negative NWC slows down to become negative, the benefit of negative NWC could reverse, leading to a cash outflow from the business.)
If you are keen to understand Insperity’s business model more and why it is an amazing business in our opinion, do watch our summary video analysis below.
Do also check out our article on its moats here, or our full detailed analysis of the company at our Multibagger Research Series here.
So What Have We Learned from All These?
So what have we learned about working capital – the topic of today (and the past 2 articles)?
Let us recap some key points for you:
Cash is king, for both businessmen and investors. Understand why and appreciate it;
Businesses could be “earning” lots of profits, but actually generate little cash. One of the reasons is due to bad working capital management or dynamics;
There are various formulae to calculate net working capital (NWC) – We prefer to not stick to any single formula, and evaluate NWC case-by-case based on the circumstances of the business. However, generally, it could be close to: NWC = Accounts Receivable + Inventory – Accounts Payable;
Businesses could have positive or negative NWC dynamics – Understand the difference, and think about what type of dynamics you prefer for the companies that you own;
Companies with positive (and worsening) NWC are on a constant treadmill on looking out for cash capital, to either maintain or grow the business, making running and expanding the business more difficult;
Companies with negative (or improving) NWC, if managed well, get to utilise interest-free cash provided by others for whatever purposes good for the company or shareholders, and therefore have an easier journey maintaining and expanding the business, and have high FCF generation and ROE (due to capital lightness);
Growing accounting profit is good, but be careful that it does not necessarily translate into growing FCF, which is the factor ultimately driving the value of a company. So please examine NWC (including whether it is improving or worsening) and FCF carefully, and look at FCF to estimate the value of the business;
Be careful that you might overpay for a business, if you value it based on its accounting profits, but its FCF is actually much lower – this is something that new investors could commonly miss out, but could have been easily avoided with the right knowledge and discipline.
So is working capital a hidden timebomb or a hidden goldmine?
We think that, just like what Albert Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t, pays it.“
Finally, let us remember that businesses with negative NWC are not uncommon – If you spot them, do consider them to see if they are good investment opportunities, as generally they have an inherent advantage over other businesses. We have provided you a few examples in this article – China Maple Leaf Educational Systems, and Insperity.
And we cover more of such great businesses in our Multibagger Research Series, which we would recommend you checking out (at the link below) if you don’t want to miss out knowing and owning companies that could potentially compound your investment amount by many times over a long period. In addition, you would be able to learn about in-depth investment analysis or concepts similar to those covered in this article, through out detailed and easy-to-understand videos and reports provided under that program.
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