Understanding Financial Statements : Working Capital and Why It Is Important in Investing

Why You Need to Focus on Ensuring Positive Cash Flow in Your Business

I have started a series of posts on understanding financial statements. This is because I have received questions from readers asking whether there is a need to have a financial background in order to analyse annual reports/financial reports.

I did not receive any formal finance or accountancy training. The only course I took was a Accountancy 101 module during my university days. The only advantage I have over those with zero knowledge is understanding terms like “account receivables” and “cost of goods sold”. This can be learnt using Google. So that means that you do not have to be an accountant to do the same research that I’m doing. In this post, I will be going through the concept of “Working Capital”.

Definition

If you just look up “working capital” online, you will probably not be able to interpret it in terms of valuation. This is because the definition is from an accounting perspective.

Working capital is required to run the day to day operations of a business.  It is as essential to running a business as the employees and physical assets.  

While some businesses can operate on negative working capital (current liabilities greater than current assets), such as subscription-based media companies or other firms that require large up-front payments from their customers, most firms have positive working capital requirements that grow along with the business.

Defining The Formula for Working Capital

Now, if you refer to Investopedia or any other sources. Working capital is defined as the difference between current assets and current liabilities.

Current assets (CA) is an accounting term that refers to assets that can easily be turned into cash. For example, cash is a current asset, but so are most accounts receivable.

Current liabilities (CL) is the amount of liabilities that are expected to be settled in cash within a year.

However, I feel that we should also exclude cash and debt from the formula. This is because they are not operational line items.

Taken from Venture Corp’s 2019 Annual Report

In this post, I will be using Venture Corp (SGX: V03)’s numbers as an example.

Looking at Venture Corp’s Cash Flow Statement, you will not see cash or debt listed under the working capital changes. This is because debt is a financing activity so it belongs in the “cash flow from financing activities” section. Cash will be included at the end of the cash flow statement so it will not appear in this section.

Hence, instead of thinking about working capital in terms of current assets and liabilities, a better way would be to think about it in terms of the individual items that comprises of operating assets and liabilities.

I prefer to define Working Capital as :

Current Assets Excl Cash less Current Liabilities Excl Debt

Referring to the cash flow statement above, what this means is that you have to look at the assets and liabilities that are crucial to the company’s day to day running of the business. From the above, we can see that Venture Corp, as a manufacturing business, has trade receivables, other receivables, prepayments, inventories etc etc.

Most common current operating assets

Accounts Receivables, Inventory, prepaid expenses.

The more current operating assets you have, the more cash it will cost you. This is because items like inventory and prepaid expenses are usually paid upfront or in advance and account receivables are payment that you are waiting on.

Most common current operating liablities

Deferred Revenue, Accounts payables and accrued liabilities.

Conversely, the more current operating liabilities most likely means that you have more cash on hand. This is because items like deferred revenue means that you have received payment before you provide the service (like beauty salons selling 10 treatment packages). Account payables means that you are paying for something later on.

Hence, by finding the “change” in working capital, you will be able to see which group of items increases by a higher amount.

Change In Working Capital

What the concept of working capital comes down to, is to find out

  1. Difference between your Current Assets excl Cash and Current Liabilities excl Debt.
  2. Find out how it changes every year

This is what this really means. It is really the change in working capital that matters when evaluating a company and not so much on the working capital number itself. For example, when evaluating Venture Corp, I will be looking at how the working capital goes up or down every year. As it will ultimately affect your cash flow. Just looking at the working capital value itself is not very helpful in gaining an insight into the company’s business model.

If this change is Negative, then Current Assets are increasing by a higher amount compared to Current Liabilities. The interpretation is that the company might be spending alot on inventory, longer credit terms with customers and shorter credit terms with their suppliers.

If this change is Positive, then Current Liabilities are increasing more than Current Assets. This could mean that the company is collecting more upfront payment or they might be delaying their payment to suppliers.

Example

So let’s take a look at Venture Corp’s numbers.

Values extracted from https://www.sgx.com/securities/equities/V03

Notice how Changes in Working Capital (Item 6) is on a decreasing trend. If we take a look at a standalone year by itself say, 2019, the value -218.83 will not be of any significance.

Looking at its 5 year record, it is evident that their Account Receivables (AR) is increasing while Accounts Payables (AP) is decreasing which results in a negative working capital.

Interpretation

It seems like Venture is paying upfront for the manufacturing costs like inventory before they can actually sell products and collect payment from their customers.

From this, we can also imply that they may be waiting too long for customers to pay them or they are too lenient with their collection policies. The issue could also be more on the supplier side where they are facing shorter credit terms.

The change in working capital has a negative effect on their cash flow as they are not able to increase their cash balance for the past 2 years (notice the net change in cash is stagnant for 2018-2019).

Even if Venture improves it earnings, having an decreasing working capital is bad for the company’s valuation in a DCF analysis. Therefore, it might not cause a rerate in the share price even if it beats expectations.

Recap

It is really the CHANGE in Working Capital that matters for valuation and stock analysis purposes.

Working Capital, by itself, does not tell you a terrible amount and could mean many different things.

When trying to define Working Capital, cash and debt should be excluded from Current Assets and Liabilities. This is because they are not operational line items and therefore won’t factor in when calculating a company’s Free Cash Flow or in any other type of valuation. Also, it’s easier to think of this in terms of the individual items that comprise these Current Operating Assets and Liabilities.

Change in Working Capital affects the cash flow used in a DCF analysis. It also makes a difference for how much funding the business needs to grow or whether it can sustain its growth plans based on their free cash flow generation.

If you enjoyed this article and would like to see more similar posts, you can refer to the link below,

Value Investing

Cheers

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