For investors, the strength of a company's balance sheet can be evaluated by examining three broad categories of investment quality: working capital adequacy, asset performance and capitalization structure. In this article, we'll start with a comprehensive look at how best to evaluate the investment quality of a company's working capital position. In simple terms, this entails measuring the liquidity and managerial efficiency related to a company's current position. The analytical tool employed to accomplish this task will be a company's cash conversion cycle.

Don't Be Misled by Faulty Analysis

To start this discussion, let's first correct some commonly held, but erroneous, views on a company's current position, which simply consists of the relationship between its current assets and its current liabilities. Working capital is the difference between these two broad categories of financial figures and is expressed as an absolute dollar amount.

Despite conventional wisdom, as a stand-alone number, a company's current position has little or no relevance to an assessment of its liquidity. Nevertheless, this number is prominently reported in corporate financial communications such as the annual report and also by investment research services. Whatever its size, the amount of working capital sheds very little light on the quality of a company's liquidity position.

Another piece of conventional wisdom that needs correcting is the use of the current ratio and, its close relative, the acid test or quick ratio. Contrary to popular perception, these analytical tools don't convey the evaluative information about a company's liquidity that an investor needs to know. The ubiquitous current ratio, as an indicator of liquidity, is seriously flawed because it's conceptually based on a company's liquidation of all its current assets to meet all of its current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going concern. It's the time it takes to convert a company's working capital assets into cash to pay its current obligations that is the key to its liquidity. In a word, the current ratio is misleading.

A simplistic, but accurate, comparison of two companies' current positions will illustrate the weakness in relying on the current ratio and a working capital number as liquidity indicators:

Liquidity Measures Company ABC Company XYZ
Current Assets $600 $300
Current Liabilities $300 $300
Working Capital $300 $0
Current Ratio 2:1 1:1

At first glance, company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over current liabilities, a seemingly good current ratio and a working capital of $300. Company XYZ has no current asset/liability margin of safety, a weak current ratio and no working capital.

However, what if both companies' current liabilities have an average payment period of 30 days? Company ABC needs six months (180 days) to collect its account receivables, and its inventory turns over just once a year (365 days). Company XYZ's customers pay in cash, and its inventory turns over 24 times a year (every 15 days). In this contrived example, company ABC is very illiquid and would not be able to operate under the conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with working capital; you pay bills with cash! Company XYZ's seemingly tight current position is much more liquid because of its quicker cash conversion.

Measuring a Company's Liquidity the Right Way

The cash conversion cycle (also referred to as CCC or the operating cycle) is the analytical tool of choice for determining the investment quality of two critical assets – inventory and accounts receivable. The CCC tells us the time (number of days) it takes to convert these two important assets into cash. A fast turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and the efficient management of inventory and receivables. By tracking the historical record (five to 10 years) of a company's CCC and comparing it to competitor companies in the same industry (CCCs will vary according to the type of product and customer base), we are provided with an insightful indicator of a balance sheet's investment quality.

Briefly stated, the cash conversion cycle is comprised of three standards: the so-called activity ratios relating to the turnover of inventory, trade receivables and trade payables. These components of the CCC can be expressed as a number of times per year or as a number of days. Using the latter indicator provides a more literal and coherent time measurement that is easily understood. The cash conversion cycle formula looks like this:

Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO) = CCC

Here's how the components are calculated:

• Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO).

• Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO).

• Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO).

Liquidity Is King

One collateral observation is worth mentioning here. Investors should be alert to spotting liquidity enhancers in a company's financial information. For example, for a company that has non-current investment securities, there is typically a secondary market for the relatively quick conversion of all or a high portion of these items to cash. Also, unused committed lines of credit – usually mentioned in a note to the financials on debt or in the management discussion and analysis section of a company's annual report – can provide quick access to cash.

The Bottom Line

The old adage that "cash is king" is as important for investors evaluating a company's investment qualities as it is for the managers running the business. A liquidity squeeze is worse than a profit squeeze. A key management function is to make sure that a company's receivables and inventory positions are managed efficiently. This means ensuring an adequate level of product availability and providing appropriate payment terms, while at the same time making sure that working capital assets don't tie up undue amounts of cash. This is a balancing act for managers, but an important one. It is important because with high liquidity, a company can take advantage of price discounts on cash purchases, reduce short-term borrowings, benefit from a top commercial credit rating and take advantage of market opportunities.

The cash conversion cycle and its component parts are useful indicators of a company's true liquidity. In addition, the performance of DIO and DSO is a good indicator of management's ability to handle the important inventory and receivable assets.

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