As highlighted in traditional financial analysis, creating value invariably necessitates investment. In financial terms, investment typically involves either the establishment of new fixed assets or the allocation of resources towards working capital.

1. NATURE OF WORKING CAPITAL

Analysts often relate a company’s working capital to its annual sales. The ratio of operating working capital to annual sales indicates the funds tied up in inventories, customer receivables, and accounts payable. For instance, a 25% ratio means 25% of annual sales is tied up in inventories and receivables not financed by suppliers, requiring the company to have funds equal to a quarter of its annual sales for operations. This ratio can also be expressed in days of sales, where a 25% ratio translates to around 90 days.

Steady business requires permanent working capital. Calculated from the balance sheet, a company’s working capital balances accounts directly related to the operating cycle. Traditional financial theory suggests these amounts are very liquid, collected or paid within a short time. However, working capital also reflects a permanent requirement. Regardless of the closing date, the balance sheet always shows working capital, though the amount varies. The only exceptions are rare companies whose operating cycle generates cash rather than absorbing it. This creates a contradiction between the liquid nature of working capital and its permanence. Working capital is liquid because every element of it disappears during business operations: raw materials and inventories are used in manufacturing, work in progress becomes finished products, products are sold, receivables are collected, and payables are paid. If the production cycle is less than a year, all components of working capital at the statement date will disappear within the following year, but will be replaced by new ones. Thus, working capital is a permanent requirement because it is continuously replenished. Despite each component’s short lifespan, the operating cycles keep the working capital accounts at a constant level if business activity remains steady. Therefore, while a company’s working capital is liquid at any given moment, it represents a permanent capital requirement similar to fixed assets from a going-concern perspective.

In seasonal businesses, working capital varies throughout the year, expanding and contracting with the business cycle. However, it never falls to zero as a minimum level of inventories is always needed for the next production cycle. Companies in seasonal industries often focus too much on the seasonal aspect of working capital, overlooking the permanent portion. In highly seasonal businesses like toys, peak working capital is only twice the minimum, indicating that half is permanent and half is seasonal.

An external analyst might confuse the working capital on the balance sheet with permanent working capital. Many companies close their books at a date other than December 31 to show the lowest working capital requirement, which can be misleading. A troubled company might maximize trade credit, requiring adjustments to normalize working capital levels. Similarly, unusually high year-end inventory levels due to speculative raw material purchases should be adjusted. Companies might also pay suppliers early to avoid appearing too cash-rich, which is more about managing cash balances than working capital.

It’s risky to assume that year-end working capital represents the permanent requirement. However, year-to-year changes in working capital can be informative, as they eliminate seasonal impacts and reflect operational improvements or deteriorations. If the company publishes quarterly financial statements, permanent working capital can be taken as the lowest quarterly balance, with average
working capital being the average of the quarterly figures. If only year-end statements are available, analysis must focus on year-to-year trends and comparisons with competitors.

2. WORKING CAPITAL TURNOVER RATIOS

Financial analysis uncovers hidden realities. To understand the analytical tools, let’s simulate reality.

Working capital accounts reflect business activities just before the statement date:

• If customers pay in 15 days, receivables represent the last 15 days of sales
• If suppliers are paid in 30 days, accounts payable represent the last 30 days of purchases
• If raw materials are stored for three weeks, the inventory represents the last three weeks of purchases

These principles have complexities:

• Payment periods can vary
• Seasonal business affects year-end balance sheets
• Payment terms differ among suppliers and customers
• Manufacturing processes vary

Despite these complexities, working capital turnover ratios based on accounting balances attempt to reveal the reality behind the figures.

Days’ sales outstanding (DSO)

The days’ sales outstanding (or days/receivables) ratio measures the average payment terms granted to customers. It’s calculated by dividing the receivables balance by the company’s average daily sales:

Since receivables on the balance sheet include VAT, sales must also include VAT for consistency. The sales in the profit and loss statement are shown without VAT, so they need to be adjusted by the applicable VAT rate or an average rate if products are taxed differently.

Days’ payables outstanding (DPO)

The days/payables ratio measures the average payment terms granted to the company by its suppliers. It’s calculated by dividing accounts payable by average daily purchases:

Days’ inventory outstanding (DIO)

The significance of inventory turnover ratios hinges on the quality of available accounting data. Detailed information allows for accurate turnover ratio calculations, while less detailed data necessitates approximate comparisons.

To calculate an overall turnover ratio, which isn’t meaningful in absolute terms but is useful for trend analysis:

Limits of ratio analysis

When calculating these ratios, adhere to two rules:

• Ensure consistency in comparison basis: whether sales price or production cost, inclusive or exclusive of VAT
• Compare balances in the balance sheet with their corresponding transactions
  Turnover ratios have inherent limitations:
• They can mislead when a company’s operations are highly seasonal, rendering the calculated figures irrelevant. For instance, a company making all its sales in a single month with a one-month payment term would show 365 days’ receivables at month-end
• They lack breakdowns of turnover components within asset or liability items related to the operating cycle, unless detailed information is available. For example, receivables may include varying collection periods for private sector customers, international customers, and government agencies known for delayed payments

Consider the level of precision needed for your analysis:

• For a general overview, average ratios suffice after confirming the business’s seasonality and data consistency across time points
• Express ratios as percentages (receivables/sales) for a broad perspective without direct ties to actual payment terms
• For detailed analysis, examine recent business volumes close to the statement date, adjusting daily sales calculations accordingly (e.g., last quarter’s sales divided by 90, last two months by 60)

3. WORKING CAPITAL PRECISION

Evaluating working capital is crucial for analysts in Continental Europe due to the economy’s reliance on intercompany financing, whereas Anglo-Saxon countries place less emphasis on this analysis due to lower working capital needs supported by prompt payment incentives. During periods of company growth, analysts expect the ratio of working capital to annual sales to remain stable. For example, if a company’s permanent working capital requirement is 25% of annual sales and sales increase from €100 million to €140 million, the working capital requirement should grow by €10 million (€40 million × 25%). This growth is reflected in the cash flow statement, either explicitly or implicitly.

However, growth often leads to a quicker-than-anticipated rise in working capital, sometimes outpacing sales growth. Factors contributing to this include management’s focus on strategic expansion rather than rigorous working capital management and vertical integration efforts that alter working capital structures. Effective companies manage working capital growth by closely aligning it with sales expansion to maintain financial stability. Conversely, during economic downturns, businesses struggle to adjust working capital to match reduced sales levels, underscoring the importance of proactive working capital management to avoid financial strain. In cases of negative working capital, such as in fast-moving consumer goods or specific service sectors, it can serve as a strategic advantage by funding growth without relying on external capital. However, it can also mask underlying profitability issues, particularly evident when sales growth slows and payment difficulties arise.

Understanding working capital dynamics provides insights into a company’s financial health and strategic positioning within its industry. It reflects the balance of power in business relationships, shaped by cultural, historical, and technical factors influencing intercompany credit practices across different regions. This knowledge informs decisions from operational management to strategic planning, significantly impacting the company’s overall financial performance.

4. CAPITAL EXPENDITURES (CAPEX)

Here are the key questions to direct your analysis of the company’s investments:

• What is the condition of the company’s plant and equipment?
• What is the company’s strategy regarding capital expenditure?
• How are these investments contributing to cash flow generation?

The assessment of a company’s current production capacity begins with a critical evaluation of its fixed assets, typically measured by the ratio of Net Fixed Assets to Gross Fixed Assets. A ratio below 30% signals that the company’s plant and equipment may be nearing obsolescence, potentially resulting in higher operational costs. In the short term, such companies might benefit from reduced depreciation expenses, leading to temporarily robust margins. However, this advantage is fleeting, as competitors with modernized facilities can leverage lower production costs over time, eventually eroding market share and profitability.

Conversely, if the Net Fixed Assets to Gross Fixed Assets ratio approaches 100%, it suggests that the company’s fixed assets are relatively new. This scenario implies that the company may not need significant capital expenditure in the near future to replace or upgrade its production capacity, potentially allowing it to allocate resources to other strategic initiatives.

Analyzing the company’s investment policy involves a nuanced examination of capital expenditure vis-à-vis depreciation charges. This comparison reveals whether the company is actively expanding its industrial base, merely maintaining it, or possibly underinvesting. Companies that invest more than the annual depreciation are likely expanding production capacity, indicating a growth-oriented strategy. On the other hand, those whose capital expenditure approximates depreciation are primarily replacing worn-out assets, aiming to sustain existing operations. Underinvestment, where capital expenditure falls below depreciation, poses risks to the company’s future competitiveness and operational efficiency unless justified by specific strategic goals like divestment or liquidity management.

Assessing the cash flows generated by these investments is crucial to understanding their impact on profitability and operational sustainability. While capital expenditures are essential for enhancing production capabilities, their ultimate success hinges on their ability to generate positive cash flows from operating activities. Companies must ensure that investments align with overall profitability objectives, avoiding scenarios where cash flow fails to grow commensurate with capital expenditures. This strategic alignment ensures a balanced financial approach, fostering a virtuous cycle of growth where increased operational cash flows fund future investments, thereby maintaining financial equilibrium and competitive advantage.

External growth through acquisitions presents additional complexities and risks. Companies expanding their fixed asset base through acquisitions must navigate integration challenges, potential shifts in group dynamics, and the risk of overpaying for acquired entities. The frequency of acquisitions within a sector provides insights into market concentration and competitive positioning. High acquisition frequency may indicate industry consolidation, which, while reducing competition, also necessitates careful scrutiny to ensure strategic fit and sustainable value creation.