Hi all-
I've been thinking a bit about approaching companies from the investor perspective and am curious about the considerations an investor makes regarding a company's working capital profile.
People usually say if a company's current assets are greater than current liabilities, this is a good thing because it means it has the means to reasonably cover all upcoming current liabilities. But if a company has a high positive working capital balance because it takes a long time to collect payments from customers, I wouldn't necessarily consider that to be a good thing, right?
The crux of my question is - how do you approach net working capital from the perspective of an investor trying to understand a company? I of course get this will be industry-specific (e.g. software companies will have high deferred revenue balances), but any insights on how you think about this high-level would be super helpful
Thanks!!
Hard to be comprehensive because understand working capital for a business is very model specific, but - in the LBO business, we care about free cash flow, and reliability of cash flows. Therefore, I want to be in businesses that 1) don't have to reinvest all of their EBITDA into working capital to grow and 2) have working capital dynamics that behave stably, ie, no large fluctuations in NWC drivers, some seasonality is okay as I can size my revolver appropriately but don't want huge fluctuations throughout the year.
Working capital has actually become much more interesting over the last few months as formerly stable businesses have started to behave more erratically due to COVID. Classic understanding of how working cap should behave - like a declining business will see AR come down and be a source of cash - get thrown out the window when everyone in an industry isn't paying their bills. Not that you should be modeling for COVID scenarios when thinking through future LBOs, but definitely interesting if you are following public equities and credits (or managing a private equity portfolio).
Could you explain this, "a declining business will see AR come down and be a source of cash"? Is it because as a business declines, presumably there are less new revenues coming in and the existing AR balance provides a source of cash as those payments eventually come in?
bro...decrease in assets = increase in cash
edit: this will likely be taken out of context because anon edited the comment
a declining revenue business will see its AR shrinking, which means the business will be collecting AR greater than it is growing the AR balance, hence a source of cash.
I'm kind of confused how this works for software / subscription companies where you would have a large deferred revenue balance. Wouldn't a large deferred revenue balance lead to a lower current ratio (large current liability balance in the denominator), even though deferred revenue doesn't actually represent a payment the company will have to make in the near-term (like accrued expenses)?
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