• JUNE 27, 2022

A Critical Metric to Look At Before You Buy Stocks in this Dip

What does a good business look like?

If you are in the shoes of the owner, a good business would look like something that does not need much working capital as it earns revenues, and is able to sell very fast the product and services it is dealing in.

As an investor too, you should be looking for these qualities in the companies you own.

Here's a quick indicator of short term financial health and liquidity in the business.

Hello Viewers

In this video, I'm going to talk about a business aspect where less could be more.

To understand this concept and use this to get better investment results, we first need to understand the concept of working capital and Cash conversion cycle.

Working capital, is a part of the capital that is used to run the daily operations of the company. Depending on how well the business is managed, two companies can earn same amount of sales in a year with different amounts of working capital. In an ideal scenario, the less amount you need in the working capital, the more operationally efficient a business is likely to be.

The operating efficiency of a business can be assessed through cash conversion cycle. It's the addition of inventory and receivable days less the Days payable outstanding. As an investor, you should be looking for a lower number of days.

To understand the reasons, let's go through each of these components that go into this equation.

First is Receivable Days. Which means how quickly you can convert sales into cash. i.e how fast you can collect cash for the products and services you deliver. If you are in the business of selling prepaid cards, or doing business online where you charge a customer first before delivering the product, you are likely to have low, nil or even negative receivable days. In a different scenario, especially in B2B segment, the cash collection happens much after making the sales, stretching the receivable days. For example, auto ancillary companies with low bargaining power, or bulk and commodity chemical companies.

  • Second component of this cycle is Inventory Days: It measures how long the final product or raw material is in storage before you can sell it to customer. For service companies, where the inventory is not involved, the inventory days could be nil. For product companies, a business that operates on build to order model, such as Dell, is likely to block a lot less cash in inventory as compared to another player, let's say Compaq, that just makes the products in bulk, with the hope to sell them. Managing inventory well requires very strong business acumen, the ability to predict demand trend, predict raw material availability and prices and so on.
  • Payable Days or Days Payable outstanding reflects how long the company takes to pay its bills from its suppliers, vendors, or financiers.

    Now, if you think about these components, as a business owner, you would ideally like to own a business where can collect cash as soon as possible, or even in advance before you make the sales. That is, you would prefer to own a business with lower receivable days.

    Similarly, you would not like to block too much cash in buying the raw material, but just enough to meet the demand. Also, once the product is ready, you would like to sell it as fast as possible. In other words, you would want a business with low inventory days.

And while it's not a good idea to keep your suppliers waiting, as long as you can ensure business continuity with them, it would be best for you to pay them later rather than sooner. Now why would your suppliers wait to get paid? Well, it could be because you are a big client for them you enjoy the huge bargaining power. And because they have the confidence that your business is growing and even though with a delay, they will eventually get their money. However, if you are keeping your bills pending because you don't have enough liquidity or cash to meet these obligations, you are likely to be in trouble soon.

Now from an investment perspective, to put things simplistically, for 2 companies that are earning same revenue, a company with low receivable days and low inventory days, and with better bargaining ability with its suppliers i.e high payable days , is likely to be run more efficiently and is likely to be a better investment bet. That's because such a business will not need to borrow money for its day to day operations, and will saves on interest cost. Also, in crisis times such as Covid, it can avert a crisis for the longer period as it will enjoy more liquidity as compared to its counterpart.

However, just like any other quantitative parameter, it needs to be used with some wisdom.

For instance, airline companies, which sell tickets and collect cash well before the passenger takes their flight could be working on very low receivable days. However, this is an industry which is highly competitive and often requires huge upfront investment and debt in the business. Another examples where you should be cautious of falling for low receivable days is multiplexes and hotels where business economics could be shaky.

Similarly, if the payable days are high because company is unable to pay and facing liquidity crunch, it's not good for the business. Because it would not take long for vendors to lose confidence and stop doing business with it, leading to its downfall.

While we are on the topic of working capital management, it is worth mentioning the case of Starbucks here. Starbucks have created a giant empire using the goodwill or loyalty programs with their customers. Through Starbucks Reward Prepaid Card it collects money in advance and also offers the user loyalty benefits such as free drinks when certain number of points are collected, based on the transactions. This way, it get access to interest free credit. Not only it has lowered the working capital requirement, but has also allowed the company to expand its business and earn free interest on this deposit.

Now, when you are analyzing businesses, it won't make sense to compare the cycle for an auto ancillary with that of an FMCG firm. You should assess these parameters over the years in the business itself, and limit comparison to its peers in the same industry.

So don't just go by the numbers. Try to assess the qualitative factors that are leading to low cash conversion cycle. If it is not backed by qualitative factors, goodwill in the market, liquidity in the business, low debt on the balance sheet and healthy returns on capital, the chances are you are going in the wrong direction.

If you like the video, do let me know through comments and press the like button. For more such investment insights, subscribe to Equitymaster channel.

Thankyou for watching. Goodbye.

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