WORKING capital adds punch to CASH FLOW ANALYSIS

Adding working capital to cash flow analysis frequently reveals problems that may not be apparent from observing the trend of EBITDA or net- income-plus-depreciation.

Consider, for example, an apparel manufacturer that must produce its garments before knowing which new styles will catch the fancy of shoppers in the season ahead. Suppose that management guesses wrong about the fashion trend. The company now holds inventory that can be sold, if at all, only at knockdown prices. Instead of selling the unfashionable garments, which would force the manufacturer to recognize the loss in value, manage­ment may decide to retain the goods in its finished goods inventory. Ac­counting theory states that the company should nevertheless recognize the loss by writing down the merchandise. In practice, though, management may persuade its auditors that no loss of value has occurred. After all, judg­ing what is fashionable is a subjective process. Moreover, management can always argue that the goods remain in its warehouse only because of a tem­porary slowdown in orders. If the auditors buy the story, it will not alter the fact that the company has suffered an economic loss. Analysts focusing ex­clusively on EBITDA will have no inkling that earnings are down or that the company’ cash resources may be starting to strain.

In contrast, analysts will recognize that something is amiss if they mon­itor a cash flow measure that includes working capital as well as net income and depreciation.

Working Capital

Requirements

= Accounts Receivable + Inventory - Accounts Payable

Inventory increases, causing working capital requirements to increase. Ac­cording to the FASB definition, a rise in working capital requirements re­duces operating cash flow. Analysts receive a danger signal, even though net-income-plus-depreciation advances steadily.

A surge in accounts receivable, similarly, would reduce operating cash flow. The buildup in receivables could signal either of two types of underly­ing problems. On the one hand, management may be trying to prop up sales by liberalizing credit terms to its existing customers. Specifically, the com­pany may be “carrying” financially strained businesses by giving them more time to pay up their accounts. If so, average accounts receivable will be higher than in the past. That will soak up more cash and force the company to absorb financing costs formerly borne by its customers. Alternatively, a buildup in receivables may result from extension of credit to new, less cred­itworthy customers that pay their bills comparatively slowly. To reflect the greater propensity of such customers to fail on their obligations, the com­pany ought to increase its reserve for bad debts. Current-period reported income would then decline. Unfortunately, companies do not invariably do what they ought to do, according to good accounting practice. If they do not, a cash flow measure that includes working capital requirements will re­veal a weakness not detected by net-income-plus-depreciation or EBITDA.

To be sure, management may attempt to mask problems related to in­ventory or receivables by pumping up the third component of working cap­ital requirements, accounts payable.

In any case, analysts should use operating cash flow as one of many di­agnostic tools. They should not rely on it exclusively, any more than they should limit their surveillance solely to tracking EBITDA. If a company re­sorts to stretching out its payables, other ratios detailed in Chapter 13 (re­ceivables to sales and inventories to cost of goods sold) will nevertheless send out warning signals. Note, as well, that if the company does not fi­nance the bulge in inventories and receivables by extending its payables or drawing down cash, it must add to its borrowings. Accordingly, a rising debt-to-capital ratio (see Chapter 13) can confirm an adverse credit trend revealed by operating cash flow.