QUALIPORT
Fool's Guide to Working Capital

By Maynard Paton (TMFMayn)
July 19, 2001

Carburton Street, London -- Within many Qualiport company evaluations, you'll often read something along the lines of "another good sign is the low working capital requirements of this business". Although many Qualiport features have touched upon working capital, there's never been too much explanation about its importance to investors.

So, just what is working capital, why are "low working capital requirements" a good sign and how can you actually tell if a company has low working capital requirements anyway?

Today's feature will cover the basics and the simplest way to answer those questions. Monday's Qualiport will conclude with some further investigative pointers.

Stocks, debtors and creditors

The importance of working capital to investors is simple -- it highlights the trading relationship between a company and its customers and suppliers. Both of these groups can cause trading difficulties at a company long before shareholders get to hear about it. Indeed, the actions of a company's customers and suppliers often speak louder than company's own words.

Working capital is made up of three accounting items.

* Stocks: Goods awaiting resale;
* Debtors: Payments owed to the company, and;
* Creditors: Payments owed by the company;

As we'll see on Monday, examining these balance sheet items on an ongoing basis can raise some trading questions. Is that rising stockpile a sign the company's goods are becoming obsolete? Do those rising debtors mean the company is relaxing customer payment terms to drum up business? Is that shrinking creditor figure an indication of suppliers flexing their muscles and demanding better terms?

So, what's the ideal working capital situation for a company? In a nutshell, "low" (i.e. good) working capital requirements mean having as little stock and debtors as possible, combined with as much money on trade credit as the company can muster.

Cash tied up in stocks and debtors, as well as not earning interest, runs the risk of never turning into cash at all (will that stock be sold? Will the debtors pay up?). On the other hand, creditors are effectively providing a cost-free loan, the interest on which the company can pocket for itself. Overall, investors should want to see a company's accounting profits, and its working capital assets, being converted into cash as quickly as possible. Remember, cash in the bank is the only shareholder certainty on any balance sheet.

Reconciliation

The easiest way of determining whether a company has low working capital requirements is to peruse probably the most important accounting note in any company's annual report. As we've seen in the past with Independent Insurance (LSE: IIG), the reconciliation between a company's reported operating profit, and the cash generated from its operating activities, can highlight worrying outflows of cash.

Here are the latest operating cash reconciliations for three very different companies.

                          Carpetright      Emap     Latchways
                             (£k)          (£m)        (£k)


Operating Profit            44,667          234       2,990

Change in stocks            (6,187)           0          13
Change in debtors             (745)          (2)     (1,780)
Change in creditors         12,940            3         159

Total working capital
movement                     6,008            1      (1,608)

To determine a good, or low, working capital situation, simply add up the changes in stocks, debtors and creditors to arrive at a "total change" figure. If the amount is positive, then all's well and good.

But when the total working capital movement figure is negative, then net cash is being tied up in those nasty stocks and debtors. In these circumstances, a comparison should be made to the reported operating profit. If the total change is a significant proportion of those reported profits, then some further investigation is required.

From the above table, you can see that there is nothing much to worry about at Carpetright (LSE: CPR) and Emap (LSE: EMA). (Carpetright has the advantage of its customer paying immediately for a carpet and the carpet supplier waiting a few months for its payment, while Emap has the benefit of some annual subscriptions paid in advance.)

Consistency

But at Latchways (LSE: LTC), half of the company's operating profits was accounted for in the debtor ledger. In other words, Latchways has yet to receive payment for a good proportion of its "profit". To put things into perspective, most companies fall somewhere between the performances of Emap and Latchways.

Of course, it makes sense to look at more than one year's operating profit to cash reconciliation. While companies can look good for twelve months, the true nature of the working capital characteristics will inevitably shine through over a few years.

Looking at Carpetright's past record, we can clearly see it has consistently exhibited great working capital management:

(to April 30th)               1998     1999     2000      2001                       

Operating Profit (£k)       28,793   23,152   36,853    44,677

Change in stocks (£k)       (2,378)      14      670    (6,187)
Change in debtors (£k)        (253)     419   (1,039)     (745)
Change in creditors (£k)    12,461    5,133    3,098    12,940

Total working capital
movement                     9,830    5,566    2,729     6,008

However, Latchways is a different matter, and some further investigation is necessary.

(to March 31st)                1998     1999     2000      2001                        

Operating Profit (£k)        1,688    2,265    2,842     2,990

Change in stocks (£k)         (190)    (626)     263        13
Change in debtors (£k)        (584)  (1,168)    (506)   (1,780)
Change in creditors (£k)        27      451      627       159

Total working capital
movement                      (747)  (1,343)     384    (1,608)

On Monday, I'll conclude this look at working capital. Specifically, I'll be looking at Latchways in more detail, outlining the benefit of comparing a company's stocks, debtors and creditors to its sales and profits, and highlighting the factors to bear in mind when investigating a company's apparently poor working capital characteristics.

Disclosure: The author owns shares in Carpetright and Latchways