Primer on Working Capital for New Investors from Non Accounting background
Why a company’s working capital matters for investors
Efficient management of working capital by a company is vital for maintaining its solvency and liquidity.
by Sameer Bhardwaj
Working capital is an impotant metric to evaluate a company’s health. This is because even profitable companies can turn bankrupt if they fail to manage their working capital properly. Working capital determines the resources that are needed for running day to day operations of a business. It is an accounting term that shows the short term liquidity position of a company at a point in time.
Working capital is defined as the difference between current assets and current liabilities and includes the receipts and payments that have a tenure of less than one year. Current assets includes the company’s unsold goods (inventory), amount due from customers who have purchased goods on credit (accounts receivable or debtors) and the amount of cash available with the company. On the other hand, current liabilities include short-term debt, amount of goods purchased by a company on credit (accounts payable or creditors), bank overdrafts and other short-term obligations.
The working capital of a company should be positive. Companies with negative working capital (current liabilities more than current assets) are prone to financial risk and should be thoroughly evaluated. Nature and size of business, seasonal variations in sales, change in input or raw material prices and length of production cycle are a few factors that influence the working capital requirements of a company.
Financial ratios like working capital turnover, current ratio and quick ratio prove very effective in judging the liquidity position of a company.
Working capital turnover is calculated by dividing sales by the working capital. Generally, higher the ratio, the better it is. It shows how much sales a company has made for every rupee of working capital employed. On the other hand, current ratio is simply the ratio between the current assets and current liabilities. Current ratio greater than one is desirable because it implies that the company has more current assets than its current liabilities.
Another modified version of current ratio is the quick ratio.
Also known as acid test ratio, it includes most liquid assets in the numerator. Such assets are cash, marketable securities and accounts receivables. Basically, quick ratio excludes inventory from the current assets as it is considered illiquid.
We tried to identify companies that have displayed working capital efficiency by considering consolidated data for the past five financial years, starting from the year 2013-14. Over 890 companies with market cap greater than ₹500 crore were picked. We filtered out companies that have the highest working capital turnover, current ratio and quick ratio in 2017-18 compared to the previous four financial years. Also, an additional filter is applied to identify companies with current ratio greater than one in the year 2017-18. Only 19 companies passed these comprehensive filters.
Let us look at the five companies out of the 19 shortlisted companies that have decent buy recommendations and highest one-year upside potential as per the Bloomberg consensus estimates:
A solution provider for air-conditioner original equipment manufacturer and design industry, engaged in room air-conditioners (RAC) and related components. According to a latest report by Sbicap Securities, low penetration in the RAC segment, higher wallet share for original design manufacturers and market share gain indicate strong growth prospects for the company in the medium term.
The company is engaged in personal and oral care business and offers products like soaps and cosmetics. JP Morgan is bullish on the stock due to expectations of volume growth revival, improving market share, healthy margin profile, free cash flow generation and improved dividend payout.
It is a manufacturer of graphite electrodes and carbon and graphite specialty products. Analysts believe that high prices for graphite electrodes and healthy operating environment will prove beneficial for the company. Moreover, growing demand for environment friendly electric arc furnace (EAF) due to stringent environmental norms in China are likely to create strong demand for electrodes.
The India Cements
A cement manufacturing company with market leadership in South India. Analysts expect demand revival in South India, cost rationalisation, improving plant efficiency and up-tick in realisation, which will all be significant growth drivers going forward. Moreover, cement demand is likely to grow on account of the government spending on low cost housing projects.
The company is engaged in goods and passenger transportation. Being one of the largest organised players in the industry, it has been a key beneficiary of GST. Analysts are closely monitoring the stock due to fuel related challenges that the company is witnessing. Revival in profitability will depend on the future fuel price trends and VRL’s ability to pass on the rising costs to consumers.
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