Why Working Capital Works
In many cases, great businesses tend to be asset-light. They have significant bargaining power with customers and suppliers that allow the business to command attractive payment terms, which translates into limited working capital intensity and attractive free cash flow. We screen for low levels of working capital, along with our other factors, to find high attractive investment opportunities.
Summary
Working capital is mainly a function of accounts receivable, inventory, and accounts payable
Low working-capital businesses usually have superior bargaining power with customers or suppliers
Strong leverage with customer and/or suppliers can create attractive cash flow that can be deployed to maximize shareholder value
A low working capital business can grow rapidly without raising outside capital and diluting shareholders
Low working capital businesses have less risk associated with inventory write downs or accounts receivable defaults
Elements of Working Capital
Working Capital = Current Assets - Current Liabilities. When analyzing working capital, the key accounts to review are inventory, accounts receivable, and accounts payable. Preferably, you will see low inventory, low accounts receivable, and high accounts payable.
Easier to Grow
In order grow, companies need to build up inventories and to extend payment terms to customers. This requires cash. Companies can raise cash by issuing equity, which causes dilution, or taking on debt, which results in higher interest charges. Companies with asset-light, low working capital business models do not have these problems. They may not need to invest in inventories or to extend payment terms to customers. They can grow without raising external capital. This means no interest costs and no share dilution, which results in higher earnings. It also results in reduced risk of inventory write-downs or customer defaults on accounts receivable.
Supplier Bargaining Power
When a company has superior bargaining power with suppliers, it can demand favorable payment terms. That results in high levels of accounts payable, which reduces working capital. In this situation, suppliers are providing free financing for the business. Dell exemplified this principle in the late 1990s and early 2000s. During this time, the company was growing rapidly, but there was no need for additional working capital. Dell would hold about a day’s worth of inventory, which it paid for on average 45 day after receiving. At the same time, Dell sold computers and collected from the customer’s immediately. As a result, working capital was negative. In other words, its business was completely funded by suppliers while shareholders reaped the benefits.
Customer Bargaining Power
Low accounts receivable indicates customer bargaining power. Customers pay their bills in a timely manner, and days sales outstanding (DSOs) are less than 30. Business that have leverage with customers typically have some kind of competitive advantage. It isn’t usually to find businesses with debt-free returns on equity of over 15%, gross margins over 60%, operating margins over 10%. As you would expect, companies in this category often have great brands, differentiated offerings, or benefit from regular buying patterns.
Heavy Working Capital
Typically, less attractive businesses requires heavier working capital cycles relative to their industry. This demonstrates that company has less freedom to dictate payment terms with customers and suppliers. In order to grow and stay competitive, the company must expand inventories, pay suppliers in advance, and finance customer purchases with receivables. For these types of businesses, it is difficult to pay dividends or buyback shares without taking on debt. Shareholders are also subject to the risks of the company’s balance sheet. Large write-downs in receivables or inventory will sink share prices.
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Quantitative Traits of High Quality Businesses
Small and micro-cap stocks encompass a large universe with volatile prices. This creates numerous opportunities for patient investors that are willing to purchase underfollowed, misunderstood, and cheap businesses. The challenge is sorting through the thousands of potential investments. To assist in screening, we have listed some of the quantitative characteristics we look for in small companies. Keep in mind these are rough guidelines, not hard-and-fast rules, for finding high-quality business.
Summary
Most investors pay too much attention to a “story stock.” Too few investors focus on the quantifiable traits of the underlying business.
Return on Invested Capital (ROIC) is probably the best measure business quality, and we like to see at least 15%
In terms of profitability, we like gross margin of 50% and EBIT margin of 10%
In terms of asset efficiency, we like days sales outstanding (DSO) and cash conversion cycle (CCC) of less than 30 days. We prefer days of payables to be equal to or greater than days of inventory
ROIC of at least 15%
The easiest way to spot a high quality business is to look for a high return on invested capital (ROIC), or equivalently a high return on equity (ROE) without debt. ROIC measures both how much money a firm earns and the assets required to earn it. The more a firm earns relative to its assets, the better. The main components of ROIC are profitability and asset efficiency. Profitability is the difference between revenues and costs. It is the amount of income generated for each dollar of sales, and it can be measured with numerous ratios. Net margin (net income divided by sales) is probably the most popular. We also look at gross margins and EBIT margins. Asset efficiency is a measures the quantity of sales that can be generated for each dollar of assets. The high-level metric is asset turnover (revenue divided by average assets). We use days sales outstanding (DSOs), days payable outstanding (DPOs), inventory turnover, fixed asset turnover, and cash conversion cycle (CCC).
Gross Margin of at least 50%
Gross margin equals gross profit divided by sales. Gross profit is revenue less cost of goods sold (COGS). COGS represents the direct costs associated with the products, such as raw materials and direct labor costs. It does not include overhead expenses, marketing and sales costs, etc. The level of gross margin will vary depending on the business model. Retailers and manufacturers will probably have lower gross margins than software, pharmaceutical or media companies. As a starting point, we look for companies with at least 50% gross margins.
EBIT Margin of at least 10%
Earning before interest and tax (EBIT) is a good measure of a company’s operating profit. It includes COGS, overhead, sales and marketing and all other operating costs. It does not include non-operating costs, such as taxes and interest. EBIT is not affected by the type of financing a company has, and, therefore, it useful for comparing companies with different capital structures. We typically prefer at least 10% EBIT margins.
DSO of less than 30 days
Days sales outstanding (DSO) equals accounts receivable (AR) divided by sales multiplied by days in the period. This is an easy way to estimate how long it takes to collect cash after a sale has been made. The faster a company collects cash, the less working capital is needed. Timely payments also indicate some degree of bargaining power with the customers. We prefer DSO of less than 30 days.
DPO greater than or equal to DSI
Days payable outstanding (DPO) is accounts payable (AP) divided by COGS multiplied by days in the period. This is an easy way to estimate how long on average you can delay paying suppliers. We prefer companies that have leverage with their suppliers and higher DPS. This creates minimal working capital needs. When a company can match its DPO to its days sales in inventory (DSI), essentially its suppliers are financing its inventory carrying costs for free.
DSI less than or equal to DPO
Days sales in inventory (DSI) is inventory divided by COGS multiplied by days in the period. This provides an estimate of how long it takes the company to convert inventory into sales. In this case, faster is better. If a company converts inventory to sales faster, it will receive cash from customers sooner and less cash will be tied up in working capital. Great businesses tend to have minimal inventory, or they have enough leverage with suppliers to finance inventory with payables.
CCC of less than 30 days
Cash conversion cycle (CCC) is equals DSO plus DSI less DPO. This measures how quickly a company can convert inputs into cash. The faster a company converts, the less working capital will be tied up in the business. We prefer companies that can convert cash in 30 days or less.
Fixed Asset Turnover
Fixed asset turnover equals revenue divided by fixed assets, also called property, plant and equipment (PPE). While CCC mainly focuses on the company’s management of working capital, this ratio measures how efficiently a company is using its fixed assets.
Additional Quantitative Traits
We have outlined some of the quantifiable traits related to a businesses operation. However, that is only part of the exercise. A high quality business will generate free cash flow. Does management reinvests cash into the business to drive additional shareholder value? If the stock is beaten down, a buyback might be in order. In other articles, we explore these concepts and how to grade management’s reallocation of cash to drive shareholder value.