An important metric when investing during a recession

Posted by Dan Hung

April 27, 2009

Over the last year, “cash is king” has become the modus operandi for companies everywhere. In an environment where revenues are declining and credit markets are difficult to access, the conservation of cash is an important aspect of maintaining the business and living through the recession.

To gain a better view of the cash flow generation ability of a business, a lot of focus has been put on free cash flow and, in many instances, EBITDA in various valuations as price-to-earnings has become less and less meaningful in a market where earnings visibility is at a minimum and valuation multiples are volatile.

One aspect that many investors overlook, however, is working capital. Most retail investors view working capital as strictly current assets – current liabilities and view it as a glorified quick ratio. Working capital analysis, however, is much more useful than simply a measure of solvency.

If one defines working capital as current assets ex cash minus current liabilities, then the resulting “working capital” determines an important characteristic of the business and its ability to generate liquidity through its operations.

Positive working capital (ex-cash) businesses maintain current assets in excess of their current liabilities. This implies that, in order to maintain operations, a business must invest siginificantly in inventory or pre-paid expenses before being able to receive cash from its customers. An example might include a rapidly growing retailer like Urban Outfitters (URBN). As of January 31, 2009, the Company had $167 million in working capital (ex-cash) which would represent more than 50% of its cash balance. This build up of assets requires some form of funding either by consuming the Company’s cash on hand or forcing the issuance of long term liabilities (debt). The assumption is that, by investing in these assets, the Company will be able to drive increased sales (and consequently increased cash flows).

Negative net working capital businesses are able either maintain current liabilities in excess of current assets. An example of this might be a computer manufacturer which is able to book sales and receive cash from customers before actually buying materials to make their computers (i.e. Dell). Thus, instead of having fund increasingly larger investments in parts inventory or other expenses, the company can simply sell and collect payments from customers and use these to buy the parts necessary to complete orders (thus creating significant current liabilities).

Working capital analysis is important in understanding just how a business operates and creates value. Further, in a recessionary market, it gives an idea of the cash need or cash generation ability of a business’ operations when under stress. Positive net working capital businesses require significant funding through cash on hand or through credit markets in order to continue growing, but will not be as seriously affected by declining revenues as they can liquidate current assets on hand to meet operating obligations. Negative net working capital businesses can scale without consuming cash or forcing the company to access external financing. They are more dangerous in downturns, however, and require the business to have sufficient capital to plug potential working capital needs. For example, in the case that a Company like Dell finds that customers stop purchasing computers altogether, they will no longer be able to use cash from purchases to fund continue to fund new production. Instead, it will have to use cash on hand to purchase the necessary parts and services to complete orders. This is why in my analysis of Apple and Dell, I subtract negative net working capital from the company’s cash and short term investments to determine how much “excess” cash the companies are truly carrying.

Full Disclosure: Author is long shares of AAPL at the time of writing. No positions in other stocks mentioned.