I am not writing this as an over-arching discussion of every possible way to look at working capital; there are many ways to view it in a business and I want to only have a simple discussion about its affect on a business.
Bruce Greenwald wrote in his book about how some businesses grow and create value as they grow. This is a great idea, that if a business were to grow within its “core competence”, in areas where it has competitive advantages, it would create shareholder value over time. He also drew the distinction on companies that grow and destroy value over time. It may seem counter-intuitive, but there are certain businesses that actually reinvest their earnings at such low returns that their shareholders lose money over time. The owners of the business would do much better if their earnings were paid to them directly rather than retained within the business to grow it further. So, let’s run with this idea for a little; I believe there is a certain place on the balance sheet where you can determine if a business should reinvest its earnings or just pay them out to its owners. That place would be the company’s working capital.
Working capital can be thought of as “the money required to operate a business”. It is defined as “current assets minus current liabilities”. It should be generally understood that it requires money to operate a business. In basic accounting, “current assets minus current liabilities” is taught as the ability of a business to stay solvent. What isn’t described, though, is the earning power of a business in relation to its working capital. If a business has, say, more current liabilities than current assets, in other words it owes more money than it has for the next year, but also has extremely high earning power, they can easily cover their short-term liabilities through their earnings. So, then you run into the question, “Why do I care whether working capital is positive or negative if it can be covered by a business’ earnings?” The reason you care is that you want to make money on your investments. I’ll show you how it works.
Let’s say you have Company A and Company B. Both companies are in the same industry on opposite sides of the United States. They are both looking to expand further in their geographic regions, and they both have the same number of stores. Here is a simple list of numbers about both companies:
- Have 10 stores
- Earn $10 million from each store every year
- Costs $15 million to open each new store
They are basically identical in every way possible. The only difference in the companies is that Company A requires $10 million to operate each store, whereas Company B requires $20 million. At first, as the companies set off in their respective directions on opposite sides of the country, nobody can really notice any differences between the two. Company A and Company B both earn $100 million in their first year (10 stores * $10 million each store). Now, let’s look at their expansion plans:
The way that Company A manages their inventory allows for them to require only $10 million in working capital for each store they own. Company A earned $100 million, and if you consider the $15 million cost to open a new store, they can open 4 new stores next year (4 stores * $15 million = $60 million; requires $10 million to run each one, total cost= $100 million to open 4 new stores). They use up all their earnings, but that is usually what happens in a new company trying to expand. End of the year: 14 stores.
Company B does not have the same inventory management skills and requires $20 MM in working capital for each store they own. They also earned $100 million this year, and are looking to grow as much as possible. They can only open 2 stores however (2 stores * $15 million= $30 million; requires $20 million to operate each one, total cost= $70 million). If they wanted to open 4 stores like Company A, they would need a $40 million loan, however they are not so ambitious and stick to two stores this year. End of the year: 12 stores.
The next year, Company A earns $140 million (14 stores * $10 million). This allows them to open 5 stores (cost of each store including working capital is $25 million). They even have $15 million left over for next year. End of year: 19 stores
Company B earns $120 million and has $30 million left from last time (only spent $70 of original $100 million). They get to open 4 stores this year (cost per store for them is $35 million including working capital). End of year: 15 stores.
As this process continues, you’ll notice that everything remains constant between Company A and Company B except for the required working capital to operate each store. This is actually such a major thing that it slows down Company B’s growth. This is because it takes much of the money that could have been re-invested elsewhere in growing the business and made it stick around to operate the stores. Basically, the cost of opening each successive store is not only the cost of the store itself, but also the “cost” of maintaining a certain working capital account to manage its operations.
This is a very important concept- the less money a business needs to operate, the more of the money it earns can be put elsewhere. It can go anywhere: buying back stock, paying dividends, growing, paying down the debt, acquiring other companies, raising employee pay, etc… It basically frees up more of a company’s cash. To make sure you realize what this means, it doesn’t matter so much how much money a company has on its balance sheet. Most of the time, the money held by a business is the amount needed to operate it; you simply could not just pay it out as a dividend. I often see investors talk about how much cash in on the balance sheet, but at the end of the day, it actually drags down returns because the cash is not being reinvested elsewhere.
There are many businesses people automatically know that generate a lot of excess cash: Wal-Mart, Coca-Cola, Home Depot, many of Berkshire Hathaway’s subsidiaries, etc… but nobody has really checked their working capital. Wal-Mart, you may be shocked to find out, does not need ANY money to operate; it has negative working capital. This is the largest business in the world and it does not need money to run. Does that seem strange? Perhaps, but I’ll show you one way a company can have negative working capital.
Think about yourself as a retail company. You must buy inventory from your suppliers and then sell it to customers. So you take your money and pay your suppliers the day you get your inventory and you then store it on the shelves until a customer buys it. This seems to make sense to you, and if you’ve never thought about this before, this is what would seem like common sense. The problem is, you end up waiting until a customer buys your inventory before you get paid. All of a sudden, Wal-Mart moves into your town and you’re out of business in two weeks. What happened?
You never tried to negotiate with your suppliers. Instead of paying them in cash the day you get your supplies, why not ask them if you can pay them after 30 days? This gives you 30 days to sell your inventory to customers and then you can use the cash you receive from your customers to pay back your suppliers. Read that sentence again- it is easier to explain in person than through a document. So, in essence, you are almost a middleman between your suppliers and your customers. If you can negotiate it to a point where your suppliers only get paid after you receive money for your inventory on your shelves, you never actually need to have cash in your bank account. You can simply allow your suppliers to finance your operations. This is what Wal-Mart does with their business and they do it so well that they never actually have to pay (on average) for their inventory until after it is sold and they make a profit. Their large structure allows them to almost bully suppliers into long wait periods until payment and allows Wal-Mart to use the money that would normally be used to operate the stores to grow their business, buy back stock, etc…
An interesting concept, isn’t it? In actuality, there are not too many businesses that run completely without any working capital. It is almost a magic trick similar to a car running without any gas; there normally has to be something in the tank, even if it is very little.
Li Lu first put this idea of working capital into my head during one of his speeches. He is the man replacing Buffett if you haven’t heard about him; he’s very interesting, I would recommend reading up on him. He claims- and after applying it in the investment world, I agree- that a great business will generate at least 50 cents from each dollar of working capital. This means the business wouldn’t need too much money to operate and management could use the profits for other activities.
The way you would calculate what I call “return on deployed capital” (working capital is basically the money deployed in the business so it can operate), you take operating profits and divide by the working capital. You use operating profits instead of net income because operating profits are what the business as an organization earned, regardless of tax regime or amount of interest payments. Great businesses I have listed on my blog all fall under this requirement of having above a 50% return on deployed capital, as well as every other thing I look for in a great business.
I have only heard Warren Buffett speak about working capital once. Granted, I haven’t gone through his writings again since I learned this lesson, but I am pretty sure I would remember it… anyway, doesn’t matter. He spoke about in context with one of his more famous purchases- See’s Candy.
See’s, he said, needed $8 million in working capital when he bought it. It earned $5 million in operating profits, leading to a 62.5% return on deployed capital. As See’s expanded throughout California and other parts of the West, it slowly needed more working capital (more stores = more money to operate). Buffett said that today, See’s needs $40 million to operate. The funny thing is, $32 million was the only amount of money See’s retained over the last 50 years. They sent something like $1.3 B back to Berkshire over the years for use in buying other great companies. This seems like an extreme example, but it is characterized in every single purchase of Buffett’s (I can’t comment on insurance companies or banks, they are too complex for me, but for companies like Gillette, Coca-Cola, Burlington Northern Santa Fe Railroad, or Wal-Mart, it certainly applies).
So, when Buffett speaks of “return on invested capital”, this is what I believe he means, not in returns on investments in fixed assets. It has never really been elaborated on (from what I can tell), but he must be assuming we either know what he is talking about or just doesn’t want us to know… or maybe I’m just slow, who knows?
So, when Greenwald spoke of companies that destroy value over time, they would be the Company B’s of the world; those who need so much working capital in relation to their earnings that it isn’t even worth reinvesting in the company.
One distinction I must make clear here, before ending, is about consistency. It means nothing if a business is earning a 60% return on deployed capital this year if they have extremely inconsistent earnings. Just because they are above this 50% hurdle some of the time doesn’t make them a great business. The whole idea is that you know they will consistently generate more money than they need to operate the business and therefore will deploy it elsewhere in the business. If it is inconsistent, you aren’t really getting any value out of it. I am not looking for exactly zero fluctuations in margins, but the operating margins should be relatively close to each other.
Just something to keep in mind; don’t blindly follow a principle without thinking about it a lot first. You will (most often) find, however, that the businesses with high returns on deployed capital are most often with so much less debt than the average company; this is because they generate more money than they need and use it to pay it all off very quickly.
Thanks, Li Lu, for explaining this concept in such easy-to-understand terms. You are an inspiration. The link to his discussion is here: ARTICLE. It is described as deployed capital in the notes. If you can find this video, watch it. I believe it has been removed.
Please comment; I would love to hear your thoughts on it, as well as any suggestions on where I may be incorrect in my description of working capital
Here is my report, click here to read it: Working Capital