Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund operations, reinvest, and meet capital requirements and payments. Understanding a company's 澳洲幸运5官方开奖结果体彩网:cash flow health is essential to making investment decisions. A good way to judge a company's cash flow prospects is to look at its 澳洲幸运5官方开奖结果体彩网:working capital management (WCM).

What Is Working Capital?

Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, for financing the conversion of 澳洲幸运5官方开奖结果体彩网:raw materials into finished goods, which the company sells for payment. It is the difference between a company's current assets and its current l𒁃iabilities, indicating its short-term financial health and liquidity.

Among the most important items of working capital are levels of 澳洲幸运5官方开奖结果体彩网:inventory, 澳洲幸运5官方开奖结果体彩网:accounts receivable, and 澳洲幸运5官方开奖结果体彩网:accounts payable. Analysts look at these items for signs of a🍰 company's effiꦑciency and financial strength.

Take a simplistic case: A small spaghetti sauce company uses $100 to build up its inventory of tomatoes, onions, garlic, spices, and so on. A week later, the company assembles the ingredients into sauce and ships it out. A week after that, the checks arrive from customers. That $100, which has been tied up for two weeks, is the 澳洲幸运5官方开奖结果体彩网:company's working capital.

The quicker the company sells the spaghetti sauce, the sooner the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. If the ingredients sit in inventory for a month, company cash is tied up and can't be used to grow the business. Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. 澳洲幸运5官方开奖结果体彩网:Working capital also gets trapped when customers do not pay their invoices on time or suppliers get paid to๊o quickly 🔯or not fast enough.

The better a company manages its working capital, the less it needs to borrow. Even companies with cash surpluses need to 澳洲幸运5官方开奖结果体彩网:manage working capital to ensu🐼re that those surpluses are invested in ways that will generate suitable returns for investors.

Not All Companies Are the Same

Some companies are inherently better placed than others. Insurance companies, for instance, receive premium payments upfront before having to m🤡ake any payments; however, insurance companies do have unpredictable cash outflows as claims come in.

Normally, a big retailer like Walmart (WMT) has little to worry about when it comes to accounts receivable: customers pay for goods on the spot. Inventories represent the biggest problem for retailers; as such, they must perform rigorous inventory 澳洲幸运5官方开奖结果体彩网:forecasting or 🥃they risk being out of business in a short time.

Timing aℱnd lumpiness of payments can pose serious t♉roubles. Manufacturing companies, for example, incur substantial upfront costs for materials and labor before receiving payment. Much of the time they eat more cash than they generate.

Evaluating Companies

Investors should favor companies that place emphasis on 澳洲幸运5官方开奖结果体彩网:supply chain management to ensure that trade terms are optimized. 澳洲幸运5官方开奖结果体彩网:Days sales outstanding, or DSO for short, is a good indication of working capital manage♏ment practices. DSO provides a rough guide to the number of days that a company takes to collect paymen𒁃t after making a sale. Here is the simple formula:

 $\begin{aligned}&\text{DSO} = \frac { \text{Accounts Receivable} }{ \text{Total Credit Sales } } \times \text{Number of Days} \\ \end{aligned}$​DSO=Total Credit Sales Accounts Receivable​×Number of Days​

Rising DSO is a sign of trouble because it shows that a company is taking longer to collect its payments. It suggests that the company is not going to have enough cash to fund short-term obligations because the cash cycle is lengthening. A spike in DSO is even more worrisome, especially for 🅰companies that are already low on cash.

The 澳洲幸运5官方开奖结果体彩网:inventory turnover ratio offers another good instrument for assessing the effectiveness of WCM. The inven🎃tory ratio s൩hows how fast/often companies are able to get their goods completely off the shelves. The inventory ratio looks like this:

 $\begin{aligned}&\text{Inventory Turnover} = \frac{ \text{Cost of Goods Sold} }{ \text{Average Inventory} } \\&\textbf{where:} \\&\text{Average Inventory} = \frac{ \text{Beginning} + \text{Ending Inventory} }{ 2 } \\\end{aligned}$​Inventory Turnover=Average InventoryCost of Goods Sold​where:Average Inventory=2Beginning+Ending Inventory​​

Broadly speaking, a high inventory 澳洲幸运5官方开奖结果体彩网:turnover ratio is good for business. Products thaꦯt sit on the shelf are not making money. Granted, an increase in the ratio can be a positive sign, indicat🍸ing that management, expecting sales to increase, is building up inventory ahead of time.

For investors, a company's inventory turnover ratio is best seen in light of its competitors. In a given sector where, for instance, it is normal for a company to completely sell out and restock six times a year, a company that achieves a turnover ratio of four is an underperformer.

Companies like computer giant Dell recognized early that a good way to bolster shareholder value was to notch up working capital management. The company's world-class supply-chain management system ensured that DSO stayed low. Improvements in inventory turnover increased cash flow, all but eliminating liquidity risk, leaving Dell with more cash 澳洲幸运5官方开奖结果体彩网:on the balance sheet to distribute to shareholders or💟 fund gr♔owth plans.

Dell's exceptional working capital management certainly exceeded those of the top executives who did not worry enough about the nitty-gritty of WCM. Some CEOs frequently see borrowing and raising equity as the only way to boost cash flow. Other times, when faced with a cash crunch, instead of setting straight inventory turnover levels and reducing DSO, these management teams pursue rampant 澳洲幸运5官方开奖结果体彩网:cost cutting and res🦋tructuring that may later aggravate pﷺroblems.

The Bottom Line

Cash is king; especially at times when fundraising can be difficult. Letting it slip away is an oversight that investors should not forgive. 澳洲幸运5官方开奖结果体彩网:Analyzing a companyꦗ's꧃ working capital can provide excellent insight into how well a company handles its cash, and whether it is likely to have any o🐼n hand to fund growth and contribute to shar🥃eholder value.