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 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 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 raw materials into finished goods, which the company sells for payment. Among the most important items of working capital are levels of inventory, accounts receivable and accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength. (Read more, in Free Cash Flow: Free, But Not Always Easy.)

Take a simplistic case: a spaghetti sauce company uses $100 to build up its inventory of tomatoes, onions, garlic, spices etc. 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 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 spaghetti business. Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. Working capital also gets trapped when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.

The better a company manages its working capital, the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that will generate suitable returns for investors. (Get some more background information, in The Working Capital Position.)

Not All Companies are the Same
Some companies are inherently better placed than others. Insurance companies, for instance, receive premium payments up front before having to make any payments; however, insurance companies do have unpredictable cash outflow as claims come in.

Normally, a big retailer like Wal-Mart (NYSE: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 forecasting or they risk being out of business in a short time.

Timing and lumpiness of payments can pose serious troubles. 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. (Find out how to do an analysis, in Evaluating A Company's Capital Structure.)

Evaluating Companies
Investors should favor companies that place emphasis on supply-chain management to ensure that trade terms are optimized. Days-sales outstanding, or DSO for short, is a good indication of working capital management practices. DSO provides a rough guide to the number of days that a company takes to collect payment after making a sale. Here is the simple formula:

Receivables/ Annual Sales/365 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 inventory turnover ratio offers another good instrument for assessing the effectiveness of WCM. The inventory ratio shows how fast/often companies are able to get their goods completely off the shelves. The inventory ratio looks like this:

Cost of Goods Sold (COGS)/Inventory

Broadly speaking, a high inventory turnover ratio is good for business. Products that sit on the shelf are not making money. Granted, an increase in the ratio can be a positive sign, indicating 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.

Computer giant and stock market champion, Dell (Nasdaq: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 ensures that DSO stays low. Improvements in inventory turnover increase cash flow, all but eliminating liquidity risk, leaving Dell with more cash on the balance sheet to distribute to shareholders or fund growth plans. (Read more, in Don't Get Burned By The Burn Rate.)

Dell's exceptional WCM certainly exceeds those of the top executives who do not worry enough about the nitty-gritty of working capital management. 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 cost cutting and restructuring that may later aggravate problems.

Conclusion
Cash is king - especially at a time when fundraising is harder than ever. Letting it slip away is an oversight that investors should not forgive. Analyzing a company's working capital can provide excellent insight into how well a company handles its cash, and whether it is likely to have any on hand to fund growth and contribute to shareholder value. (Read more, in Z Marks The End.)

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