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The impact of working capital investment on the value of a company
RMA Journal, The, April, 2003 by Dev Strischek
In this article, Dev Strischek describes how to use a popular shareholder valuation tool to quantify the impact of working capital management for use in both credit decisioning and in the financial advisory role. Lenders will be able to show their customers how receivables, inventory; and payables management can increase or decrease their companies' net worth and share value.
Four hundred years ago, English philosopher Francis Bacon observed, "And money is like muck, not good except it be spread." Bacon has described the principal property of working capital, the ubiquitous yet ambiguous financial term for the balance sheet's collection of current assets and liabilities that aggregately fertilize and nurture a company's growth.
Working capital management plays a critical role in a company's quest to maximize its shareholder value. A key component of shareholder value is the cost of capital, and credit risk is its driver. Did you ever stop to think that how you judge a borrower's working capital management skills may impact its cost of capital? What if you judge the firm to be too easygoing in collecting its receivables, too overstocked in inventory, too slow in paying its trade suppliers, and too thin in its cash reserves? Is the customer then too risky to bank even with extra risk premium added to the rate? Of course, these mental adjustments would boost your borrower's cost of debt and ultimately decrease the firm's shareholder value. However, if your borrower pays a little more attention now to managing its working capital, the future boost to cash flow could pay off in more cash flow later that increases shareholder value and improves your customer's creditworthiness.
Working Capital Fundamentals
A company's working assets and the liabilities that fund them are collectively referred to as working capital. Ideally, current assets are partly funded by current liabilities and the remainder by the owners. A banker's shorthand way of quantifying the excess or net investment in current assets over current liabilities is to subtract current liabilities (CL) from current assets (CA) to arrive at net working capital (NWC), as demonstrated for Green Company over the past two fiscal years (FYE) 2000 and 2001. (See Figure 1.)
Green's NWC increased by $74 million from 2000 to 2001 because of more receivables and inventory. Trade credit also increased, but only by $55 million, not enough to fund all of the $136 million expansion in inventory and the $54 million more in receivables. From a banker's perspective, NWC represents the owner's equity in these working assets, and up to a point, that is a good thing. Bank debt and trade credit should not pay for all the earning assets; the company should have some of its own money at risk for these operating assets--but how much? After all, NWG expansion absorbs cash that might otherwise be available to repay creditors and, after debt service, be used for capital expenditures, dividends, or just equity accumulation.
NWC and sales growth. One way to gauge the appropriateness of NWC is to relate it to sales (Sls). After all, working capital investment is a prerequisite to growing sales. Increasing the inventory depth and breadth creates more customer appeal. Extending more liberal credit terms helps the company sell to more customers. Thus, sales growth usually requires more working capital, as illustrated in Figure 2, in which Green's figures for fiscal years (FY) 2000 and 2001 indicate sales up 48%, NWC up 72% for the fiscal year, and net working capital to sales up from 9.3% to 10.7% over the two fiscal years.
All things being equal, working capital should remain proportional to sales, so the increase from 9.3% to 10.7% of sales suggests that a bigger investment of inventory and receivables was needed in 2003 to gain more revenues. Although sales rose 48%, it took 72% more NWC to support the sales growth--part of the NWC maintained base sales of $1,113 and the $74 remaining of the NWC fueled the $535 increase in sales.
Another way to look at the NWC/Sls relationship is to compare the changes in each component, because this view shifts the focus from financial statement year-end numbers to an incremental approach. How much NWC is needed to support another dollar of sales? Incrementally, the gain in NWC to the gain in sales was 13.8%, so it took 13.8 cents of new NWC for every new dollar of sales. Whether looking at the incremental or the total picture, both the borrower and the banker need some reference point to determine the right amount of working capital to support sales.
Industry comparisons. Many bankers measure the appropriateness of working capital investment by comparing the company's working capital ratios with RMA (Risk Management Association) industry statistics. One advantage of RMA data is that most of the companies represented by the financial statements are privately owned, thus mirroring the borrowers in the portfolios of bank statement contributors. (1) Bankers looking for working capital data on large, publicly traded companies find CFO's annual working capital survey useful. The survey compiles data on working capital efficiency at public companies. Although lacking RMA's decades of data, the CFO survey does provide some turnover information on receivables, inventory, and cash by broad industry segments for large, publicly traded firms. (2)
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