How do you incorporate working capital into your investment thesis?

1 Why is working capital important?

Working capital is important for several reasons. First, it indicates the liquidity and efficiency of a company. A positive working capital means that a company has enough cash and other current assets to cover its current liabilities. A negative working capital means that a company relies on external financing or delayed payments to run its business. Second, working capital affects the cash flow and profitability of a company. A high working capital means that a company has more cash available to invest in growth opportunities, pay dividends, or reduce debt. A low working capital means that a company has less cash to spare and may face cash flow problems or higher interest costs. Third, working capital reflects the operational and financial risks of a company. A stable and predictable working capital means that a company has a smooth and efficient business cycle. A volatile and unpredictable working capital means that a company faces challenges in managing its inventory, receivables, payables, or debt.

2 How do you assess working capital?

To assess working capital, you need to analyze its components and drivers. The main components are inventory, accounts receivable, accounts payable, and cash, while the main drivers are sales, cost of goods sold, payment terms, and collection policies. You can measure the level, trend, and performance of working capital with various ratios and metrics such as the working capital ratio (current assets / current liabilities), the working capital turnover (sales / working capital), the cash conversion cycle (days inventory outstanding + days sales outstanding - days payable outstanding), and the working capital days (working capital / (sales / 365)). Comparing these ratios and metrics across different companies, industries, and time periods can help you benchmark and evaluate the working capital performance of your portfolio companies.

3 How do you improve working capital?

To improve working capital, you must identify and implement operational and financial initiatives that can optimize the components and drivers of working capital. These initiatives include reducing inventory levels through better inventory management, forecasting, and planning; increasing accounts receivable collections with improved invoicing, credit control, and collection policies; decreasing accounts payable payments through better payment terms, discounts, and incentives with suppliers; and increasing cash balances with improved cash flow forecasting, budgeting, and management. Additionally, you can quantify the impact of these initiatives on the working capital performance and cash flow generation of your portfolio companies by using scenario analysis, sensitivity analysis, and cash flow modeling.

5 How do you monitor working capital?

To monitor working capital, you need to establish and track working capital reporting and monitoring systems that can provide timely, accurate, and relevant information on the working capital performance and cash flow generation of your portfolio companies. You can use dashboards, scorecards, and KPIs to measure and compare the working capital ratios, metrics, and initiatives across different companies, segments, and periods. You can also use variance analysis, trend analysis, and benchmarking to identify and explain the drivers and deviations of working capital performance and cash flow generation. You can use these systems to communicate and collaborate with the management teams of your portfolio companies to review and improve the working capital performance and cash flow generation of your portfolio companies.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?