During these times of high short-term interest rates and inverted yield curves, companies with low or even better negative working capital (ex-cash) and cash conversion cycle are worth their weight in gold provided they are not in a liquidity trap, that is, they generate good, free cash-flow and are not highly leveraged.

After all, most of the short-term borrowing of companies is used to fund the working capital that is tied up in the form of inventory, receivables and payables.

For the unaware, ‘cash conversion cycle’ is the time between a company spending cash and receiving cash per unit of output. To put it simply, it is a measure of how long cash is tied up in working capital. Based on past data, it is evident that sectors with better working-capital metrics have outperformed the market especially during recessionary times.

While the common perception may be that P&L metrics such as revenues and earnings drive valuation, the secret to long-term performance lies in the balance-sheet and cash flows. Understanding working capital and cash conversion cycle as well as their impact on company performance and stock returns is critical to identifying good businesses.

Sector influence

While individual companies may display differential prowess in managing working capital, it is still largely a function of the sector in which the company operates. In general, companies that deal in consumer products and staples have shorter cash conversion cycles compared to industrials, cement and utilities. In sectors such as retail, given the typically large inventory levels and wafer-thin margins, cash conversion cycle can make or break a firm.

A recent study done by Forbes indicates the link between cash conversion cycle and stock returns of large retailers in the US (Table).

Free Float

Negative working capital is one of the least understood, yet most powerful, weapons that not many healthy companies possess. It is virtually a source of free capital or, in Buffett terminology, “float” that can potentially boost return on capital employed (ROCE) in the business. Bajaj Auto and HUL are a couple of noteworthy companies that benefit from such a float derived through negative working capital.

Cash sales, trade credit, advances and deposits from customers are all ways in which companies manage to secure this float. Sanjay Bakshi, a popular professor at the Management Development Institute, Gurgaon, and a value investor, has written some insightful articles on the virtues of negative working capital in his blog (fundooprofessor.wordpress.com) which provide a deeper understanding of this phenomenon.

Companies that have a consistent negative working capital (coupled with healthy, free cash flows) typically have the bargaining power to demand longer credit periods from their suppliers (usually fragmented). They are also able to make sales in cash or collect payments from their customers within a few days of the sale. Both these require strong franchise value that is not easily replaceable. The two aspects coupled together provide free, short-term funds for the company to finance its operations.

Lead indicator

Deterioration in inventory-receivable days tends to ‘lead’ sales and can be a good indicator to predict turn in business cycles. Many sectors such as industrials and cement witnessed the bloating of receivables and inventory days by 30 per cent or more, which in turn led to an elongation of cash conversion cycle prior to their recent slowdowns.

Investors can thus track the efficiency of managing working capital and reasonably predict future performance using the cash conversion cycle, keeping in mind that “less is more”.

(The author is a business consultant. Feedback can be sent to perspective@thehindu.co.in)

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