QUALIPORT
Working Capital -- Part II

By Maynard Paton (TMFMayn)
July 23, 2001

Carburton Street, London -- On Thursday, I started to tackle the subject of working capital. To recap, the feature covered the importance of a company's working capital performance and provided a quick and easy way for investors to determine whether all was well within the accounts.

Today's feature will conclude the working capital review. It will highlight some further balance sheet pointers and a few other factors to consider when investigating a company's apparently poor working capital characteristics.

Alongside perusing the reconciliation of operating profits to cash generated from operating activities, further working capital investigation can be sought be comparing a company's stocks, debtors and creditors to its turnover and cost of sales.

(With this analysis, for debtors and creditors, an accounting note is provided within a company's annual report to break down the type of payments involved. The entries to concentrate on are Trade Debtors and Trade Creditors. Other debtors and creditors (e.g. the Inland Revenue) usually have no bearing on a company's trading fortunes.) 

Stock days

Let's start with stock. Given the risk of obsolescence, rising stockpiles are a signal of potential trading trouble. To determine any ominous stock mountain, the level of stock should be compared with the company's cost of sales. Why use costs of sales and not turnover? Simply, the calculation of cost of sales uses the book value of any stock sold, while turnover bears no direct relation to what the stock was worth in the accounts.

This is the recent record for Carpetright (LSE: CPR), and by using this formula...

    Stock

------------- x 365 days

Cost of Sales

...shareholders can derive the time it takes for a company to shift its stock (otherwise known as "stock turn" or "stock days").

(to April 30th)        1998      1999      2000      2001

Cost of sales (Łk)  131,726   137,242   140,610   138,275

Stock (Łk)           22,953    22,939    22,268    28,453

Stock turn      
period (days)            64        61        58        75

Note the sudden end-of-year build-up of stock for 2001. Is that a sign of stock building for further expansion, or customers not interested in carpet?

Debtor days

Now let's look at trade debtors and revisit Latchways (LSE: LTC), the company having previously given concern in this area. Here, we'll use the trade debtor collection period calculation (or "debtor days"):

Trade debtors

------------- x 365 days

   Turnover

Note that the calculation uses turnover as the denominator, as trade debtors (i.e. customers who have yet to pay) directly correlate with a company's sales.

(to March 31st)        1998      1999      2000      2001

Turnover (Łk)         4,571     6,671     8,656     9,401
Trade debtors (Łk)    1,292     2,238     2,876     4,577

Debtor collection
period (days)           103       122       121       178

With Latchways, we can see that the time taken for its customers to settle up has risen from just over three months to nearly six months. On the face of it, not a very good performance. Are Latchways relaxing trading terms to generate business?

Creditor days

Finally, trade creditors, and a return to Carpetright.

(to April 30th)        1998      1999      2000      2001

Cost of sales (Łk)  131,726   137,242   140,610   138,275
Trade creditors (Łk) 37,529    39,502    38,399    42,962

Creditor payment
period (days)           104       105       100       113

The trade creditor payment period (or "creditor days") is defined as

Trade creditors

--------------- x 365 days

  Cost of Sales

Again, a company's cost of sales is used in this formula as that accounting figure, unlike turnover, incorporates creditor (i.e. payments to suppliers) values in its calculation.

With Carpetright then, there's nothing much to worry about. The time taken to pay suppliers has remained both relatively stable and consistently greater than the time taken to clear the supplied stock.

(Indeed, after taking delivery, if it then takes 75 to days to sell the carpet but 113 days to pay the supplier, Carpetright therefore has the benefit of 38 days' worth of interest on the money owed to the supplier!)

Timing

Any accounting analysis must bear in mind that balance sheets are "snapshots in time" and the timing of sales close to the year-end can distort the overall picture. Also, there is the possibility of seasonal distortions. For instance, the December stock levels of a toy retailer will be completely different to those seen during June.

Rather than use any balance sheet ratio in isolation, further company clues can help gauge the true working capital performance.

Reviewing the earlier examples, we noted that Carpetright's "stock days" for 2001 had risen quite sharply -- a sign that customers were not buying carpet?

It's worth noting that both Carpetright's "stock days" and "trade creditor days" had increased during 2001 to diverge from a previously consistent record. This indicates the company could have bought an unusually large amount stock around the end-of-year, a move that would increase both year-end stock and trade creditor levels.

What's more, Carpetright's reported like-for-like sales growth performance for the current year -- 9.7% -- also underpins why the extra stock may have been purposely built up. Thus, alongside the creditor and like-for-like information, Carpetright's rising stock position is put into some reassuring context.

But what about the trade debtors of Latchways? The company's trading profile has to be considered. Latchways is increasingly dealing with blue chip "volume" customers, whereby the timing and "lumpiness" of their contracts can distort year-end figures. What's more, the Latchways management has said in the past that the run-up to their year-end is generally the busiest period for sales anyway. Unfortunately, no real conclusion on Latchways' outstanding invoices can be drawn. However, there is a certain reliance on the company's record, market-leading industry position and the nature of its clientele.

Summary

Alongside highlighting general management inefficiency, the main working capital shareholder dangers are:

* Rising stocks: Is the company having trouble shifting its goods?

* Rising debtors: Is the company relaxing terms to improve trade?

* Falling Creditors: Are the company's suppliers flexing their trading muscles?

And when using the formulae outlined in this feature, investors should also consider:

* Sales timing issues: Year-end figures can be distorted. Other company information can help add perspective to a worrying working capital trend.

* The company's trading profile: Are "lumpy" contracts involved? Is that stock at risk from obsolescence? Are those debtors reliable blue chips or cash-strapped one-man bands?

Deteriorating working capital movements are an early warning signal for trading problems down the line. But unfortunately, there's no strict formula for determining whether trouble looms. Ideally, investors should seek consistency in a company's working capital performance.

Although a company's latest earnings figure may not be affected, any sudden weakening in working capital should prompt further shareholder investigation. Remember, the actions of customers and suppliers often speak louder than the words of the company itself.

More: Analysing Company Reports discussion board

Disclosure: The author owns shares in Carpetright and Latchways