How Best to Evaluate the Investment Quality of a Company's Working Capital Position?

Topics: Asset, Inventory, Generally Accepted Accounting Principles Pages: 14 (4814 words) Published: October 2, 2010
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 Capital Structure. Let us consider Working Capital Adequacy, to evaluate the investment quality of a business organization. WORKING CAPITAL;

Working capital may be regarded as lifeline of a business. It provides the ability to fund business operations, reinvest and meet capital requirements and payments. Understanding a business’s working capital health is essential to make investment decisions. A good way to judge a company’s working capital prospects is to look at its Working Capital Management. The concept of ‘working Capital’ was first evolved by Karl Marx, though in a different form-‘Variable Capital’. According to Marx, Variable Capital means outlays for payrolls advanced to workers before the goods they worked-on were complete. He contrasted this with ‘Constant Capital’ or ‘Dead Labour’, meaning outlays for raw-materials and other instruments of production produced by labour in earlier stages, which are now needed for live labour to work with the present stage. [Luxemburg, Rosa; The Accumulation of Capital; Monthly Review Press, New York, 1968]. This Variable Capital is nothing but, wage fund which remains locked in work-in-process along with other operating expenses, until it is realized` through sale of finished goods. Although, Karl Marx didn’t mention that workers also gave credit to the firm by accepting periodical payment of wages which funded a portion of work-in-process, the concept of Working Capital, as we understood today, was embedded in his ‘Variable Capital’.

Today, Working Capital is regarded as the fund needed to carry on operations during the Cash Conversion Cycle (CCC) or Operating Cycle. Working Capital refers to the cash or fund, 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.

Cash Conversion Cycle (CCC) or Operating Cycle is the time duration required to convert cash into resources, resources into final products, the final products into receivables and receivables back into cash. The length of the operating cycle is the function of the nature of a business. The following exhibit shows a typical operating cycle;

Raw-materials and operating supplies must be bought and stored to ensure uninterrupted production. Wages, salaries, utility charges and other incidentals must be paid for converting the materials into finished products. Customers must be allowed a credit period that is standard in the present day business. Only at the end of this cycle does cash flows-in again. This affects cash flows which, most of the time, are neither synchronized nor certain. Cash outflows are relatively certain in the sense that, the firm needs to maintain cash to purchase raw-materials, pay expenses and there is hardly a match between cash inflows and cash outflows. Funds are also held to meet future contingencies. Stocks of raw-materials and work-in-process are kept to ensure smooth production process and to guard against non-availability of raw-materials and other components. The business holds stock of finished goods to meet the demands of customers on continuous basis and sudden demand from some customers. Accounts Receivables are created because goods are sold on credit for marketing and competitive reasons. Thus, for financing all these, a firm makes adequate investment in inventories, debtors, bills receivables, cash etc., which is known as WORKING CAPITAL. Take a simple example: A garment manufacturing company uses Rs. 1 lakh to build up its inventory of cloth materials, to pay wages and other day-to-day expenses. A week later, the company assembles the raw-materials into ready-to-wear clothes and ships them out for sale. One week after that, customer enquiries are...
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