The impact of working capital investment on the value of a company

RMA Journal, The,  April, 2003  by Dev Strischek

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Green processes vegetable, flower, and grass seed for sale to wholesalers and retailers, so it falls into the 0181 SIC (Standard Industrial Classification) code. The CFO survey does not cover this particular industry segment, but comparison with the RMA statistics for SIC 0181 (Figure 3) yields some preliminary observations about Green's working capital management: (3)

* First, Green maintains about the same level of cash that the industry does, 6.5% versus 5.8% at FYE 2001, a level that may mean its cash management is now a little better than its peers'.

* However, its receivables levels are higher and its turnover slower than the industry averages. The slowness could reflect more aggressive marketing to less creditworthy customers or less effective credit collections.

* The offset to the lackluster receivables performance is a lower level of inventory investment and a faster turnover. Of course, the lower inventory investment may reflect fewer products, which may also contribute to stock-outs, back orders, and customer dissatisfaction.

* On the other side of the balance sheet, Green relies a little less on trade debt and a little more on bank debt to finance its current assets. The result is that Green's Sls/NWC is a little higher than the industry's. A traditional rule of thumb is that when this ratio is above 10. liquidity may be tight. Both the industry and Green are over the lox mark. Yet Green generates a little more sales per dollar of working capital than its industry counterparts. Another way of describing Green's working capital management is that it has a little less cash tied up in its receivables and inventory working capital assets relative to its industry peers, so its cash balances are slightly higher than average.

Bankers find cash balances interesting because of their implications for loan repayment. Lenders take receivables and inventory for collateral, but the borrower is typically better positioned than its lenders to generate more cash out of the conversion of inventory to receivables to cash. In fact, one irony of expanding working capital is its absorption of cash. The difference in the yield from a revolution of this cash conversion cycle is the gap between a borrower realizing market value from its working assets and its lenders squeezing out liquidation value from the same assets.

The result is that lenders really prefer to stay out of the day-to-day operations and concentrate on the long-term prospects of the borrower. This emphasis on long-term perspective means that bankers and investors share a similar view of the importance of operating cash flows, financing flows, and investing flows.

Cash Flows: Dollars and Sense

Before FAS 95. Before the implementation of Financing Accounting Standard (FAS) No. 95 in 1987, bankers and analysts used traditional cash flow (TCF) as a proxy for cash flow to gauge debt repayment capacity. TCF worked well enough for firms that had relatively slow, stable rates of sales growth generating enough cash flow to support working capital expansion. As the economy accelerated in the postwar period, however, TCF tended to overestimate cash flow