The Art of Company Valuation and Financial Statement Analysis: A Value Investor's Guide with Real-life Case Studies

Chapter 4

Ratios for Working Capital Management

The long run is a misleading guide to current affairs. In the long run we are all dead.

John Maynard Keynes

 

Would it not be valuable to own a business that receives payment before the product has actually been delivered? And would it not be clever to pay for purchased goods months after they have been delivered? Large retailers such as Wal-Mart, Tesco and Home Depot raise their profitability using precisely these methods. As their suppliers are, to a large extent, dependent on them, they have to accept the giant retailers’ payment terms or entice them with generous cash discounts.

If Wal-Mart only pays its purchased goods after two months but sells them within a few weeks, the supplier essentially grants an interest-free loan. The computer manufacturer Dell, for example, uses this method very successfully towards its clients as they usually pay in advance. Its suppliers are largely dependent on Dell and therefore allow generous terms of payment, adding to Dell’s high cash flow generation.

The optimal amount of inventory, receivables and cash on hand, i.e. current assets, paired with an economically favourable amount of short-term liabilities, especially supplier credits, is called working capital management. Working capital management, if implemented correctly, reduces the amount of capital that is tied up within the business, releasing unused funds and ultimately increasing profitability.

This becomes clear considering that even ...