Why does working capital matter?
Aside from being a measure of a company’s liquidity and financial health, working capital is a window into the efficiency of a company and may also serve as a signal of competitive advantages. It is useful to think of working capital as a support mechanism for revenue; for every dollar of revenue, a certain amount of capital is needed for support. It is analogous to the pillars supporting a bridge, the more pillars are needed the higher the load of the bridge. As investors, we care about the cash flows a business generates, and understanding working capital helps us better forecast those cash flows.
Joel Greenblatt explains how working capital affects a company’s future cash flows below:
“Let us say Coke is growing at 12% per year and Moody is growing at 12% and they both are earning $1 per share. For Coke to continue to grow at 12% it has to take 20 cents for every dollar and plow it back into its business for working capital, etc. Coke uses the 20 cents of the dollar they earn to continue to grow at 12% so the remainder is 80 cents for other uses. Moody’s meanwhile needs $0 to grow 12%. So what we said was that a $1 from Coke is worth 80 cents compared to $1 for Moody’s. Moody’s earnings are worth 25% more”
What exactly is working capital?
Working capital is generally used to describe the liquidity of a company or the capital it has to meet short-term obligations: supplier payments, inventory needs etc. The accounting definition is:
Working Capital = Current Assets – Non-Interest-Bearing Liabilities
The above definition only paints a picture of the short-term financial health of the company and is only one facet of working capital. When examining working capital, one should strip out non-operating current assets and liabilities such as cash and deferred taxes. Because our goal is to gain insight into the core business, working capital should be compared to revenue and the relationship between the two should be analyzed. Low working capital needs means a company enjoys operational advantages such as rapid inventory turnover or the company has “power” with customers via deferred revenue or with suppliers via lengthy supplier financing. High working capital needs can be a signal of inefficiency or lack of “power” in its ecosystem. Along with looking at working capital as a percentage of revenue, investors should also look at industry peers, providing both an absolute and relative measure of working capital needs.
The effect of working capital on intrinsic value
Now that we have dealt with the why and what of working capital, the next question is when: When should an investor care? It is prudent to care when the company in question has high working capital needs. These companies are typically retailers, distributors, and manufacturers. Working capital dynamics can significantly alter FCF conversion; by FCF conversion we mean how much of earnings translates into free cash flow from operations. With low working capital companies such as SAAS-based ones, working capital is not the right lens to examine operating efficiency. Instead, income statement line items such as SG&A would be more useful to examine along with non-GAAP ratios such as LTV:CAC.
We have listed two scenarios where working capital has a marked effect on cash flows. It is important to highlight that in both these scenarios, it is the change in working capital that affects cash flows and not the level of working capital itself.
- A rapidly growing business with high working capital needs
- A business whose working capital needs changed
Case 1: A rapidly growing business
If a business with high working capital needs is growing, then working capital can significantly impact future cash flows. For every incremental dollar of revenue, capital is required to support that growth. This is not to be confused with growth capex—growth capex drives revenue growth but working capital “maintains” it. This leads to:
Reinvestment rate = growth capex + Δ working capital
A simple example helps illustrate the concept. Pretend you want to start a bookstore (we will assume in the remainder of this example that the cost of real estate is zero dollars). You only need to purchase books to stock your store. You go to various publishers, however, none of them are willing to extend supplier terms and you must come up with $200k to purchase the books. Your bookshop is very popular, and you sell your entire inventory and generate a net income of $100k in Year 1. The initial cash outlays to start the business was $200k and the FCF per year the business generates is $100k, amounting to a 2-year payback period. (We are assuming the $200k was funded by cash, if it is debt then interest payments would eat at profits, lengthening the payback period.)
What happens if you want to open another one of these stores in Year 2? Let’s call it Store B. You need $200k to buy the inventory for Store B. Let us assume you can finance it with 70% debt and 30% equity. The 30% equity will cost $60k or 60% of the annual cash flow from Store A. Store B working capital will hoover up most of the cash flows Store A is generating, and you will also incur interest payments of $7k per year assuming the cost of debt is 5%. Cash flow from operations from both stores will be $40k in Year 2 (as Store B is not generating any revenue yet). After interest payments, FCF will be $33k, significantly lower than the net income of $100k Store A is generating. The more stores you want to open, the more working capital will be needed, acting as a siphon on the cash flows of your existing stores.
However, what if you have significant clout with textbook publishers and can match payment terms with inventory and you only need to pay publishers once the books are sold. You immediately free up $200k per store and your return on capital has gone from 50% to infinity. This is the benefit of low working capital- you can grow with minimal capital needs. For example, companies that have these characteristics are Walmart, Dell, McDonalds, and O’Reilly Auto Parts.
A business that is working capital intensive and growing will find that FCF conversion is low and earnings overstate cash flows. This is because earnings exclude the incremental investments needed in working capital to support future growth. Only until the business stops growing are these earnings fully realized.
Case 2: A company is not growing but its working capital needs have changed
When a business is operating in a steady state environment, working capital needs are constant and there is no impact on FCF. However, when dynamics change, this may represent a sea change in working capital and subsequently cash flows. By dynamics, we mean anything from COGS beginning to increase due to inflation or higher inventory needed to support the same revenue base. When fundamentals change, the FCF conversion will also change.
For example, take the below statement:
“… net working capital has declined for companies in the U.S. over the last fifty years, going from nearly 30 percent of assets in the 1970s to under 10 percent of assets today. Reduction in inventory is the largest single contributor to this decline” Michael Mauboussin
This has been profitable for companies as all that money was released as cash and FCF outpaced earnings. What if the reverse happens? Geo-political tensions rise causing supply chains to become more fragile, and companies need to have larger inventories to build buffer capacity. This will impact future cash flows by the magnitude of the change in working capital. If working capital for a company increases from $100mm to $1B, then it will be a $900mm drag on future cash flows. Only until working capital from quarter to quarter becomes constant do cash flows wholly reflect the earnings power of the business.
Understanding working capital provides insight into the efficiency of a business and helps better forecast future cash flows. Investors should be discerning of working capital if there is an expected rate of change either due to the growth of the business or industry dynamics.
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