Granola for the banks
If you could choose a cereal for the CEOs and CFOs of your portfolio companies to be eating every morning, it would be the Working Capital Crunch. It won’t taste great (working capital pressures never do), but hopefully it reminds them every day to focus on the cash.
There’s a crunch under way that has nothing to do with the cereal. In company announcements locally and abroad, I’m seeing increasing signs of lengthening working capital cycles.
This is the time it takes to convert total net working capital into cash. Working capital gets tied up in inventory (stock waiting to be sold) and debtors (customers paying you). The pressure is relieved to some extent by having creditors (usually suppliers of inventory who give you terms of, say, 30 days).
Grocery retailers have lucrative working capital cycles as the stock in the stores is sold quickly and customers pay immediately. Suppliers must wait a couple of months for payment, so the retailer sits in a cash-flush position. Managed correctly, the business is effectively funded by suppliers rather than third-party debt providers like banks.
Most other business models aren’t so lucky. For example, heavy machinery manufacturers receive orders from customers and need to start manufacturing them with long lead times. There may be a deposit involved, but there’s still a long time between costs being incurred and all the cash being collected. These businesses need a strong balance sheet with the right funding lines to ensure they don’t run out of cash even when the order book is nice and full.
As a final comment on finance theory, the length of the working capital cycle can have a material affect on the valuation of a company. Investors look for cash conversion of earnings as a major driver of value. In a discounted cash flow approach, the change in working capital is explicitly forecast. In an earnings multiple approach, one might adjust the multiple higher or lower depending on how cash hungry the operating model is.
A deteriorating cycle means that more cash is tied up per unit of revenue than before. Put differently, the business needs to retain more cash from sales to meet working capital needs, so there is less available for other investment opportunities or to return to shareholders via share buybacks or dividends.
In a perfect world, a business wants the shortest possible working capital cycle. This is balanced against the risks of lost sales, usually from inventory shortages or from refusing to grant payment terms to customers.
These concepts are nothing new and any detailed analysis of a company has always required a look at the working capital cycle trends. Businesses have been dealing with these complexities for as long as capitalism has existed.
This is even more topical than usual because demand for goods has picked up sharply and supply chain backlogs don’t seem to be clearing.
As more companies release results, we can see the effect coming through in the numbers. Revenue is up (and in several cases ahead of pre-Covid numbers) and inventory is often up by an even higher percentage. If you read the prepared remarks overseas or the result overviews in local Sens announcements, you’ll usually find the management team talking about strategic
Working capital cycles seem to be lengthening; it’s bad news for companies, but good news for lenders
investment in inventory to respond to stock shortages in key items.
This is the joy of being a listed company — you usually have enough balance sheet strength to fill the warehouse for a year or two in response to longer lead times on stock. As usual, small businesses are not so lucky.
If you think a bit deeper, you may agree with me that banks are probably the ultimate winner in all of this. Corporate demand for debt has been subdued since the initial lockdowns, as companies were shocked into action to reduce debt on their balance sheets and cut expenses rather than invest in new areas.
Growth in loans and advances has primarily been driven by individual borrowers during a period of low interest rates.
With balance sheets under more pressure and companies seeking shorter-term funding solutions to enable strategic decisions around inventory, banks will be lining up to deploy deposits into loans to corporates and small and medium enterprises. In the next round of banking earnings announcements, we shall see if this trend is playing out the way I think it might.