How to assess the working capital efficiency of a company?

Working capital is like the Swiss Army knife for a business - a trusted tool to ensure businesses run smoothly daily. Need to pay suppliers? Check. Need to cover unexpected expenses? Check. Need to fund operations? Check.

In fact, if working capital were a religion, businesses would swear by it. Which is why assessing a company's working capital efficiency is important, as it reveals more about a business than it hides.

So, let's look at the important ratios that can help investors understand how a company is utilising its working capital.

Current ratio

This classic and the most basic ratio measures whether the company has enough resources to cover short-term obligations. It is calculated by dividing current assets by current liabilities. (Current assets can be converted into cash within a year or an operating cycle; current liabilities are a business's obligations due within a year.)

A ratio of two or more is typically ideal, meaning current assets should be at least double the current liabilities.

However, this ratio has its limitations; it doesn't reveal the true nature of current assets. Current assets can be of two types: cash or trade receivables. Cash is good because it is readily available, but receivables are not.

Inventory turnover

This ratio indicates how frequently a company replaces its inventory. It is calculated by dividing the sales by average inventory.

A higher ratio is ideal as it may suggest the company sold more goods due to higher demand. Conversely, a low ratio may signal fewer goods sold due to weak demand. However, a high ratio can also imply sub-optimal inventory levels relative to demand. It's crucial to consider inventory turnover in the context of the industry in which a company operates.

This ratio primarily applies to manufacturing companies and excludes sectors like BFSI, services, real estate, and others. The ratio also differs from sector to sector. For instance, Britannia has a five-year median inventory turnover of 15, one of the best in the FMCG sector. In contrast, it is 7.5 for Sun Pharmaceuticals during the same period. Although Sun Pharma's performance appears lower than Britannia's, it still ranks well within its industry. Evaluating inventory turnover relative to the industry and business model can offer insights into a company's inventory management efficacy.

Receivables turnover

Selling goods on credit is common in business. How often a business collects payments from its customers is reflected through receivables turnover. It can be calculated by dividing sales by average receivables or debtors.

A higher ratio is desirable as it indicates fewer debtors or frequent collections from customers. However, it may also suggest stringent credit policies. In highly competitive markets with no product differentiation, companies might lose customers to rivals offering better credit terms.

It's also crucial to consider receivables turnover in the context of the company's industry. Generally, B2C companies report higher ratios compared to B2B companies. For example, Nestle's five-year median receivable turnover is 97, while GMM Pfaudler's is 8. Avenue Supermarts exceeds both at 649. However, this does not mean the ratios of the other two are poor. Each company has achieved some of the highest ratios in their respective industries.

Payables turnover

Similar to selling on credit, companies often buy raw materials and other necessary goods on credit. Payables turnover measures the frequency of payments to creditors. It can be calculated by dividing purchases by average payables or creditors. Purchases can include raw materials, any other purchases and changes in inventory.

A higher payables turnover ratio suggests prompt payments and sufficient cash availability. However, a payables turnover ratio lower than receivables turnover is preferable. Additionally, a continuously falling ratio could be a bad sign and might indicate increasing creditors or delayed payments to creditors.

It's also crucial to consider payables turnover in the context of the company's industry. Neither a lower nor higher ratio is universally better. It varies depending on the company's industry and working capital during a period.

Cash conversion cycle

As mentioned, the above ratios alone don't provide the full picture. They must be viewed together to understand the complete scenario. This is where the cash conversion cycle comes into play.

By dividing 365 by the respective ratios, we get the number of days for each ratio. For instance, receivable days show how long a company takes to collect from debtors, while payable days show how long it takes to pay its creditors.

To calculate the cash conversion cycle, add receivable days to inventory days and subtract payable days.

This cycle measures how long it takes a company to convert its inventory investments into cash. The shorter the cycle, the better it is. In fact, a cash conversion cycle can be negative. For instance, Britannia has maintained a negative cycle for the past ten years due to shorter receivable and inventory days than payable days.

Again, it is crucial to consider this number in the context of the industry and business model. For example, the average cash conversion days for companies in capital goods and FMCG are 82 and 11, respectively.

Also read: Negative working capital is not always negative