Corporate Finance, 6th Edition

Chapter 11WORKING CAPITAL AND CAPITAL EXPENDITURES

Building the future

As we saw in the standard financial analysis, all value creation requires investment. In finance, investment means creating either new fixed assets or working capital. The latter, often high in Continental Europe, deserves some explanation.

Section 11.1 THE NATURE OF WORKING CAPITAL

Every analyst intuitively tries to establish a percentage relationship between a company's working capital and one or more of the measures of the volume of its business activities. In most cases, the chosen measure is annual turnover or sales.

The ratio:

reflects the fact that the operating cycle generates an operating working capital that includes:

• capital “frozen” in the form of inventories, representing procurement and production costs that have not yet resulted in the sale of the company's products;
• funds “frozen” in customer receivables, representing sales that customers have not yet paid for;
• accounts payable that the company owes to suppliers.

The balance of these three items represents the net amount of money tied up in the operating cycle of the company. In other words, if the working capital turnover ratio is 25% (which is high), this means that 25% of the company's annual sales volume is “frozen” in inventories and customer receivables not financed by supplier credit. This also means that, at any moment, the ...