Net Working Capital.

Analyzing Net Working Capital: Ghanaian Consumer Sector

Changes in networking capital are an important but often underappreciated component of enterprise free cash flows and thus company valuation. I discuss ways to assess net working capital management using companies in the Ghanaian consumer goods sector.

An analysis of the sector’s performance is especially interesting given the improvement of all companies in 2010 propelled by strong economic rebound. I also demonstrate the positive impact of strong working capital management on returns on invested capital.

Understanding significance of net working capital in equity analysis

Changes in net working capital (NWC) are a key element in calculating enterprise free cash flows in a DCF analysis. The relationship between the two is negative: a decrease/(increase) in net working capital increases/(reduces) cash flows, thereby reducing/(increasing) the need for borrowing.

Although the importance of net working capital is widely understood, clarity on the calculation of net working capital is lacking. One point of debate is whether net working capital should include non-current assets and liabilities other than receivables, payables and inventories. For the purpose of this analysis, I define net working capital as the difference between, Cash and Cash equivalents, inventories and accounts receivable versus accounts payable. This is because these items better reflect the company’s skills in managing net working capital. Besides, forecasting non-current items like accruals, prepayments and deferred tax items is challenging, and these items are widely outside management’s control.

I believe that net working capital should be seen in the context of revenues, as sales and working capital are interconnected. In the chart below, I examine net working capital as a percentage of revenues of the Ghanaian Consumer Goods Sector. All companies in the sub-sector have positive investments in net working capital, where the sum of receivables and inventory exceeds trade payables. Interestingly, whereas Unilever has shown a stable working capital management, African Champions has experienced an increased volatility in WCM. Over the six year period Unilever recorded an average working capital of about 18.83% of sales compared to 33% for PZ Cussons and 25% for African Champions.

Comparing Cash Conversion Cycles: Ghanaian Consumer Sector

Cash Conversion Cycle (CCC) is a key metric for analyzing how well a company is managing working capital. CCC attempts to measure how long each monetary input is tied up before it is converted into cash via sales. Unsurprisingly, a company with a lower CCC is more efficient because it turns its working capital over many times, which allows a higher value generated per money invested. In practice, this metric is calculated as the amount of time needed to sell the inventory (DIO) plus the amount of time needed to collect receivables (DSO), less the length of time the company is expected to take to pay its trade creditors (DPO). The following graph demonstrates how Ghanaian Consumer companies perform on this metric; there are huge variations from company to company within the same sector.

Based on 2010 year-end ratios	Calculation	AFRICAN CHAMPION	UNILEVER	PZ CUSSONS
Days sales outstanding (DSO)	Receivables / (Sales / 365)	153	52	67
Days inventory outstanding (DIO)	Inventory / (COGS / 365)	30	43	154
Days payables outstanding (DPO)	Payables / (COGS / 365)	112	137	132
Cash Conversion Cycle	DSO+DIO-DPO	72	-42	90

I argue that viewing the cash conversion cycle in a trend rather than to look at a single period number is a much better approach in understanding the performance of a firm`s Working Capital Management. A downward trend is positive, indicating that the operating cycle is shortening, while an upward trend is negative, indicating that the cycle is lengthening (i.e., tying up cash for long).  Clearly Unilever stands out as it has nearly halved that of PZ and close to 1.7x times African Champions for the year 2010.

In analyzing the cash conversion cycles, it is recommended that analysts look at a group of companies in a particular industry over time. Note, however, that even within a single sub-sector, business characteristics such as breadth of product range and distribution structure can differ; this impacts working capital metrics. The chart below confirms the improvement in working capital management by PZ Cussons and Unilever over the past few years with decline in working capital management by African Champions.

 Net Working Capital in the context of Return on Invested Capital

Better use of NWC reduces invested capital and leads to higher capital turnover ratios and consequently to a higher ROIC. This is especially the case if NWC is material relative to the overall invested capital of the company. To get a better proxy for returns, I use the formula ROIC = EBIT/Invested Capital. To obtain invested capital I sum the net value of property plant and equipment and other assets including intangibles.

The charts suggest a positive non-linear relationship between returns and net working capital, but this seems to be explained by by underlying economics only if net working capital is material versus overall invested capital.

I emphasize once more my argument that analyzing net working capital is crucial in forecasting cash flows and returns. In looking at the Ghanaian Consumer Sector, the major observation is that historical laggards Unilever have shown dramatic improvement in networking capital management. This is not the same case at African Champions and PZ Cussons although there have been modest improvement over the last three years for both companies. It makes it easy to see through how working capital management could be used as a source of competitive advantage if properly managed.