The Working Capital Cycle
The working capital cycle shows how efficient a company is at converting cash into goods and back into cash again. Needless to say a company with a very efficient capital cycle has a competitive advantage over a company with a lousy working capital cycle.
To understand the working capital cycle better picture a company with oodles of cash. This cash is then spent to purchase raw materials/inventory, etc. The finished stock is then sold. However, we live in a credit world so monies are not necessarily received straightaway. Any monies due are thus booked under trade receivables.
As we can see, the working capital cycle needs to combine the length of the inventory/sales process as well as cash recovery from clients. Therefore we need to calculate two ratios.
The first ratio is called the inventory turnover ratio. This ratio examines how efficiently assets are managed. It looks like this:
(Inventory / Sales) X 365
For Johnson & Johnson (JNJ, Financial) the ratio looks as follows:
(5,378 / 18,792) X 365 = 105 Days
JNJ holds their inventory for 105 days before selling it. The company wants this figure to be as low as possible.
The second ratio is the trade receivables ratio. It measures the time it takes for people who own the company money to pay.
(Trade Receivables / Revenue) X 365
Again, for Johnson & Johnson the ratio is as follows:
(9,774 / 61,587) X 365 = 58 Days
It takes JNJ’s trade receivables 58 days to settle their accounts and pay what they owe. Again, the lower the number is the better.
In order to calculate a company’s working capital cycle we simply add the two ratios together.
In Johnson & Johnson’s case the working capital cycle takes 163 days.
The usual ratio caveats must be taken into account.
These include:
· Use the annual report only since quarterly or half yearly reports skew the figures due to limited P&L activity.
· The ratios must be compared to the company’s historical performance as well as those of industry peers.
· The balance sheet is a snapshot in time and represents the companies figures at their best.
· Ratio analysis is vulnerable to creative accounting.
The working capital cycle shows how efficient a company is at converting cash into goods and back into cash again. Needless to say a company with a very efficient capital cycle has a competitive advantage over a company with a lousy working capital cycle.
To understand the working capital cycle better picture a company with oodles of cash. This cash is then spent to purchase raw materials/inventory, etc. The finished stock is then sold. However, we live in a credit world so monies are not necessarily received straightaway. Any monies due are thus booked under trade receivables.
As we can see, the working capital cycle needs to combine the length of the inventory/sales process as well as cash recovery from clients. Therefore we need to calculate two ratios.
The first ratio is called the inventory turnover ratio. This ratio examines how efficiently assets are managed. It looks like this:
(Inventory / Sales) X 365
For Johnson & Johnson (JNJ, Financial) the ratio looks as follows:
(5,378 / 18,792) X 365 = 105 Days
JNJ holds their inventory for 105 days before selling it. The company wants this figure to be as low as possible.
The second ratio is the trade receivables ratio. It measures the time it takes for people who own the company money to pay.
(Trade Receivables / Revenue) X 365
Again, for Johnson & Johnson the ratio is as follows:
(9,774 / 61,587) X 365 = 58 Days
It takes JNJ’s trade receivables 58 days to settle their accounts and pay what they owe. Again, the lower the number is the better.
In order to calculate a company’s working capital cycle we simply add the two ratios together.
In Johnson & Johnson’s case the working capital cycle takes 163 days.
The usual ratio caveats must be taken into account.
These include:
· Use the annual report only since quarterly or half yearly reports skew the figures due to limited P&L activity.
· The ratios must be compared to the company’s historical performance as well as those of industry peers.
· The balance sheet is a snapshot in time and represents the companies figures at their best.
· Ratio analysis is vulnerable to creative accounting.
