Fundamental Analysis: Working Capital
Fundamental analysis is a lot more qualitative than technical analysis. As we all know from the Enron scandal, financial statement in and of themselves are subject to the manipulations and approximations of the accountants and auditors who create them. That being said, assuming that the numbers reported are generally correct, it is possible to delve in deeper than just the face value of those numbers reported. As we continue the Fundamental Analysis series, we’re going to see how financial statements can be broken down and used to create new sets of data that we can use to judge a company’s financial health and value it absolutely or relative to peers.
One way to check on the near-term financial health of a company is to calculate working capital. This is defined as current assets minus current liabilities. Simple enough and all the information is available on the balance sheet. Basically, we are trying to answer the question: Does a company have enough in its current assets (things it can turn to cash quickly) – cash, accounts receivables, inventory – to pay its bills?
You may notice that current assets is not made up of things that are immediately useful to the company. After all, receivables and inventory are not guaranteed money. Actually, if allowed to sit too long, they can end up not being worth much at all. You may sometimes see company’s take one-time write downs for inventory that it does not anticipate being able to sell anymore. So, if a company a lot of its current assets tied up in either receivables or inventory or both, it is necessary to ascertain that a company is capable of turning current assets into cash quickly.
This is done by calculating inventory turn or receivables turn. Each one is a rather intuitive calculation. For inventory turn, you divide the cost of revenue found on the income statement by the average of the inventories reported on the balance sheet from the year in question and the year prior to it. This will give you how many times in one year a company can turn its inventory around in a year. Similarly, for receivables turn you divide credit sales or, if this is not reported as is the case on Yahoo! Finance income statements, total revenues by the average of the receivables reported over the most recent two years. This will tell you roughly how many times the company can turn receivables into revenues every year. If you take 365 and divide it by either inventory turn or receivables turn, you’ll be able to find how quickly a company should be able to turn its inventory or receivables into cash for use. This is important for companies with high amounts of their current assets locked up in these two categories and should be something to look out for especially if they have minimally positive or worse yet negative working capital.
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