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OMG!’s wise Editors travel afar in seeking small cap value.Here is the first of a series of Reports from our Journey.
Finding Value (Part 1) Blood of Life or Working Capital
It can be hard to tell the difference between an Opportunistic Merchant Adventurer and a Corporate Kamikaze Pilot, although sometimes the red head-scarf gives it away! A company’s Working Capital is the cash flow, the money it needs to run the business, its life and death or the difference between Current Assets and Current Liabilities. By analysing it, a dreamer describing massive upside can be weeded out from the rational risk assessed business. Unlike in life, it all makes perfect sense expressed in Pounds and Pence.
This difference between Current Assets (CA= cash, stock, debtors) and Current Liabilities (CL= Creditors, Salaries, Interest payments, tax) is the Liquidity. This is the measure of a Companies ability to pay operating expenses and short-term or current liabilities. Not being able to pay staff because the sales director gave a customer ‘unfinanced’ extended credit is a serious problem.
If a company’s CA is £3m with CL of £1m (3/1) then the liquidity Ratio is 3x. A low Liquidity Ratio would indicate that the company is having financial difficulties or is poorly managed so a high ratio is better. As in life, though too much is not good either, as a high a ratio indicates that cash (capital) is not being used efficiently. Back in the day, Slater Walker would acquire and asset strip companies using capital inefficiently. What is too high and too low relates to the capital intensity of the business sector. A company laboriously producing specialist widgets would have a long manufacturing and sales cycle so needs a higher Liquidity Ratio than say a hairdresser.
Analysing a company’s working capital is a window to its soul or how much money it really needs to deliver on the, massive upside!
