Net working capital - proper use of financial resources

Analysis of the financial condition of the enterprise

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Common understanding of net working capital

Net current assets (NOA) or net working capital (NWC) is the difference between the current assets and liabilities of an enterprise as of a calendar date. In other words, the user of information about the enterprise, based on their availability, evaluates the ability to pay all necessary payments in a short time.

A negative value of the NCR indicates a critical financial condition and the threat of sanctions for late payment. An inflated balance indicates irrational use of available resources.

Topic 6. Financial resources of the enterprise

Topic questions:

1. Economic essence and classification of capital.

2. Own capital of the enterprise: composition and sources of formation.

3. Enterprise reserves.

4. Borrowed capital of an enterprise: composition and sources of formation.

The purpose and objectives of studying the topic:

disclosure of the processes of formation and use of financial resources of enterprises, consideration of the main sources of formation of financial resources; consideration of equity and debt capital; disclosure of the content of fixed and operational cash funds and financial reserves of enterprises.

After studying the topic, the following knowledge should be acquired:

the concept of financial resources of enterprises; the main sources of formation of the authorized capital of enterprises of various organizational and legal forms; content of forms and types of financial resources of enterprises; conditions for the formation and direction of use of fixed and operating funds of enterprises.

When studying the topic, you need to focus on the following concepts:

financial resources of enterprises; capital and assets; own and borrowed capital of enterprises; cash funds.

Theoretical material of topic 6

Normal value

To assess the financial stability and rational use of a specific business entity, it is necessary to analyze the actual information on the balances of the indicator as of reporting dates for recent periods, and the need for short-term financial resources in the future.

In the analysis, you can use the ratios of CLR to current liabilities or to net profit (NP) for the reporting period:

• K1 = CHRK / TO
• K2 = PE / ChRK

For most business entities, it is normal when K1 is within the range of 0.2-0.5 units. K2, in comparison over several reporting periods, demonstrates an increase or decrease in the efficiency of using CRC.

Important! The quality of current assets varies in terms of liquidity - the ability to convert them into a means of repaying payments. The higher the share of “fast” assets, the less reserve of CRC is needed.

From the point of view of financial stability, the best of them is cash (line 1250 of the balance sheet). They can pay off current obligations instantly.

Current accounts receivable (line 1230 of the balance sheet) are ready for use only after they are received into the company’s account.

In order to turn materials into money (page 1210 of the balance sheet), it is necessary to sell them, or first produce finished products, then sell them and receive money.

How to manage correctly?

The process of monitoring the balances of net current assets and their planning requires analysis of accumulated factual information and forecasting of future activities. For example, Progress JSC plans to increase profitable production volumes in the next three years. For this purpose, it is planned to use an additional issue of bonds and a long-term bank loan for a period of three years.

In connection with the increase in production growth, it is necessary to increase inventories (materials, raw materials), and purchase new technological fixed assets. The purchase of fixed assets from additional long-term sources will not affect the amount of net working capital; the purchase of inventories will increase its amount. But you should not purchase excessive amounts of raw materials and supplies at the expense of purchasing new equipment. Material resources must be sufficient to complete the cycle from the start of production to receipt of money for the products produced. Otherwise, the enterprise will not have time to pay off current obligations and accumulate illiquid raw materials and finished products.

It is also useful to calculate the need for urgent repayment of current obligations for short calendar periods (week, decade, month) in comparison with quickly liquid current assets (cash, quickly repayable receivables) in order to prevent facts of inability to pay urgent debts.

Competent management of the CRC, constant monitoring of their dynamics allows you to prevent cases of untimely repayment of current obligations (salaries, tax payments, settlements with regular suppliers), improve the structure of current assets, and calculate the volume of need for attracted additional long-term sources of activity.

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What is working capital and why is it needed?

Working capital in its broadest sense is the company's current assets minus current liabilities.

Both figures can be found on a company's balance sheet. For example, Severstal’s working capital at the end of 2021 amounted to $2072-$1123=$949 million.

In itself, this indicator is not very useful, since it only allows you to understand what is more: current assets or current liabilities. Formally, the excess of current assets over current liabilities indicates the financial stability and solvency of the company. However, this is not always true. For example, some retail representatives operate quite effectively with a negative WC value. The specificity of their activities is such that they have virtually no accounts receivable, which makes working capital negative. In particular, the working capital of X5 Retail at the end of 2021 amounted to -120.4 billion rubles.

If you make certain adjustments, you can get a more useful indicator - operating working capital. Operating working capital is that portion of working capital that is consumed during the production cycle. All the necessary components for its calculation can also be found in the balance sheet.

To calculate the indicator, a portion of current assets related to operating activities is taken: inventories, accounts receivable, advances issued and other assets that are consumed during the production cycle and ultimately become revenue. Such a large item of current assets as “cash and cash equivalents” is not taken into account, since the source of funds may not be operating, but financial or investment activities.

Similarly, from short-term liabilities, only those lines that relate to the production cycle are selected: accounts payable, deferred revenue, taxes paid (except for income tax) and other short-term operating liabilities necessary for the production cycle and ultimately turning into cost. Short-term debt obligations are not taken into account - these are the financial activities of the company.

The resulting indicator of operating working capital can be used to calculate various turnover ratios and study the effectiveness of managing the company's liquid assets.

In general, turnover ratios look like the ratio of revenue or cost to various components of current assets or current liabilities, respectively. The logic here is simple: in accounting, active accounts are correlated with revenue, while passive accounts are correlated with costs.

For example, the inventory turnover ratio (the ratio of annual revenue to the average annual inventory volume) reflects how many times per year inventory manages to be transformed into revenue. If we divide 360 ​​days by the resulting figure, we will find out how many days it takes for inventories to be transformed into revenue. The higher the turnover (the fewer days), the better - less inventory needs to be stored => lower costs for renting warehouses.

The same thing, but in reverse, works with the turnover of short-term liabilities. The lower the accounts payable turnover ratio (the ratio of the annual cost to the average level of accounts payable), the better - the company defers the payment of money => can use these funds for its own purposes.

Turnover ratios reflect the effectiveness of working capital management, so they can be used to find the best performing companies that can outperform the market.

Let's look at the example of Russian ferrous metallurgists: Severstal, MMK, NLMK. The main and largest components of operating working capital for them are: inventories, receivables and payables.

According to 2 out of 4 coefficients, MMK looks better than its competitors. Based on the accounts payable turnover ratios, we can conclude that MMK was able to build its relationships with suppliers in such a way that they are ready to provide more favorable conditions. The company has also effectively built a system for managing warehouse capacity and inventory volumes. Specifically in the case of metallurgists, the item “reserves” is the most significant in working capital, here MMK receives a noticeable advantage. Good turnover ratios reflect the company's ability to use less cash in the production cycle.

At the same time, Severstal's receivables turnover ratio is higher than its competitors, from which we can conclude that the company works more effectively with clients. In addition, this ratio is almost 2 times higher than that of MMK, which was reflected in the final result of the operating capital turnover ratio.

Working capital is important for cash flow and FCF

Operating working capital is important for studying a company's cash flow and FCF, which is used as the basis for calculating dividend payments for some companies. Also, free cash flow is a key link in DCF valuation models to find fair value.

The main essence of the relationship between working capital and FCF is as follows:

An increase in working capital leads to a decrease in FCF

A decrease in working capital leads to an increase in FCF

The following logic works here. The company builds inventory or pays off accounts payable for cash, cash flow from operations declines, and FCF declines. Conversely, a reduction in working capital means that inventories are being sold or debt to suppliers is growing, and the company is releasing cash, due to which FCF is growing.

If, when calculating turnover ratios, we took data from the balance sheet, then from the point of view of cash flows, it is more correct to take data from the Cash Flow Statement (CFS), since in this form the enterprise reflects the movement of money. Most companies specifically highlight changes in working capital in a special section. But if the issuer, for example, does not disclose the change in WC in the ODDS, then you can also use the balance sheet data, although they will give a certain error.

To study cash flows, as well as from the balance sheet, components related to the company's operating activities are taken, and their changes over the period are used. We need to understand how the change in WC affected cash flows for the period. Using ODDS for these purposes is very convenient, since it reflects exactly the change in working capital over the period.

Let's look at a specific example: ODDS M.Video based on the results of 2018.

The increase in M.Video's inventory goes to the ODDS with a minus sign, since it reflects that cash has decreased. At the same time, the increase in trade payables is positive, since only liabilities increased, and the cash remained in the company’s accounts.

Cash after changes in working capital became higher than before them (RUB 27,416 million versus RUB 22,342 million). This means that M.Video Group reduced working capital and increased cash flow from operating activities - due to which FCF increased. For comparison, in 2021 the situation was different - the company greatly increased its accounts receivable, which led to an increase in working capital and a decrease in FCF.

As a result, we can say that M.Video’s free cash flow for 2018 increased by RUB 5,074 million. by reducing working capital.

What conclusions can be drawn

Reducing working capital is good for FCF: inventory sold => more money => FCF increased => dividends can be increased (or in the case of M.Video, debts can be paid off). However, here it must be taken into account that too strong a decrease in current assets can lead to a deterioration in the financial stability of the enterprise and cash gaps when the company is unable to promptly meet short-term obligations.

In addition, you need to understand whether the company has achieved a reduction in working capital by increasing the efficiency of its management or whether this is a short-term effect and already in the next reporting period the WC value will normalize and FCF will decrease. Here you can pay attention to the ratio of revenue to operating working capital over time. If the obtained values ​​stand out from the overall picture in the absence of an objective reason, then this is a reason to understand in more detail the reasons for such a discrepancy.

Increasing working capital is bad for FCF: inventories have increased => money has been spent => there is nothing to increase dividends from. Nevertheless, in general, this situation is not always negative for the company.

Working capital usually increases as revenue increases. Since the company has to increase production to increase sales, this leads to an increase in current assets (for example, more inventory is needed). The problem may be that the company's revenue is growing slower than its working capital. In such a situation, the company “freezes” more and more cache each time in the production cycle, which cannot be called qualitative development.

In another case, the increase in working capital can be considered a short-term investment. For example, at the end of 2021, MMC Norilsk Nickel increased its working capital by almost 5 times, explaining this by paying off accounts payable to Rostec and accumulating reserves. The accumulated reserves were sold off when copper prices rose, and Norilsk Nickel made additional profits. That is, the accumulation of copper in warehouses was not a decrease in operational efficiency, but rather an investment of money in current assets: the company increased its reserves now with the aim of making a profit in the near future. This was a one-time effect, after which Norilsk Nickel’s working capital normalized and cash flows were released.

Moreover, if a company consistently increases working capital, but financial results do not improve, then most likely it has problems with capital turnover and you need to be more careful with such an issuer.

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