Acknowledging the importance of working capital analysis (in private equity valuation) is only the first minor step. Understanding the drivers of working capital and how they influence value is the second and most important step. By understanding each driver, you’ll gain an appreciation for how movements in working capital can create untold value, but also unprecedented destruction.
We run into problems when a particular movement can indicate both an improvement and a critical problem. So we have to look deeper. For example, an increase in working capital may refer to revenue growth, stubborn debtors, stricter creditors, slower inventory, assets sales, or even debt reduction.
The primary drivers of working capital are as follows (see the diagram for more detailed conceptual drivers of working capital):
- Debtors (accounts receivable) – this refers to accrued revenue/sales placed on credit and awaiting to be settled by cash. An increase in debtors may refer to a growth in revenue, a change in debtor terms or difficulty in collecting cash from debtors.
- Inventory (stock) – all materials used to create products (or support services) are considered inventory. Good management of inventory is all about efficiency; how little has to be held, how quickly can we use it, how best can we store it, and what’s the cheapest way to manage it? An increase in inventory can refer to revenue growth, slower moving stock, revaluations, increased obsolescence, or preparations for volatility.
- Creditors (accounts payable) – simply the opposite to debtors; any accrued expenses for payment in the current period but as yet unsettled for cash. An increase in creditors may refer to increased creditor terms, an inability to pay, revenue growth (therefore, increased COGS), increased short-term debt, or higher unearned revenue (prepayments by customers).
- Cash – as discussed in the Working Capital Series: References and calculations, we exclude cash from our analysis because it is the cash requirement itself that we’re attempting to determine. Just think of cash as the plug. If we estimate that worst case conditions show a shortfall of $1m in cash, then we must arrange to have that cash on standby or at least have contingencies to deal with the shortfall (such as renegotiated creditor terms).
- Other - There are other minor drivers of working capital, which include any current account (on the assets or liabilities side) that isn’t included above. If the business has a large debt burden, the current portion of debt may be a major working capital driver. Prepayments, unearned revenue, taxes, provisions, etc. should certainly be considered and included in your analysis if they seem to be volatile and influential.
The typical strategy with working capital drivers is to decrease debtors terms, decrease inventory requirements and increase creditors terms in order to manipulate the working capital profile of the business. If optimised (debtors pay much earlier than you have to pay creditors), you’ll find a cash flow surplus opposed to a shortfall.
However, if most accountants saw creditors ballooning and debtors shrinking, their last thought will be of your credit term negotiating skills. Most likely, they’ll warn you of insolvency. In actual fact, what may look like an increasing need for cash could really be a surplus of cash created by your improved working capital profile.
So as you can see, it is critical to understand working capital drivers in understanding how a business operates from a financial perspective. In the next post of the series, I’ll show working capital profiles in illustration and you’ll see why Buffett was first drawn to insurance companies many years ago.