Analyzing Working Capital - The Key to Successful Investing in Net-Nets

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Mark Lin
Nov 01, 2012
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Net Current Asset Value = Current Assets – Total Liabilities


Current assets comprising cash, marketable securities, accounts receivables and inventories represent the most liquid of assets on the company’s books, convertible to cash in the shortest of times. In a liquidation scenario, accounts receivables are collected, and marketable securities and inventories sold for cash to pay off liabilities.


Two “versions” of net-nets have evolved from teachings by Benjamin Graham in his two books “Security Analysis” and “The Intelligent Investor.”


The first version of net-nets revalues NCAV:

+100% of face value of cash

+75% of face value of receivables

+50% of face value of inventories

-100% of face value of all liabilities


The second version of net-nets takes all NCAV at 100% of face value, but advises investors to buy at P/NCAV

Both versions of net-nets try to incorporate a margin of safety for the collectability risk of accounts receivables and the saleability of inventories to a certain extent.


Caveats on Buying Net-nets


Collectability Risk of Accounts Receivables


Accounts receivables are near-cash in nature as long as they do not become bad debts, i.e., customers default on payment. Assess the collectability risk of accounts receivables for the company in terms of the trend in account receivable days, the credit payment terms for customers, the credit strength of major customers, the adequacy of current provisions for bad debts and the potential for further write-downs on the receivables. For example, some ship charterers locked-in good terms with their customers during the shipping upcycle. Now in the shipping downcycle, when the same customers are unable to pay, it will be reflected in ballooning accounts receivables on the charterer's books.


Salability Risk of Inventories


Under normal conditions, the costs and selling prices of inventories are relatively stable. In reality, rising raw material costs, changing customer preferences and lack of bargaining power with suppliers & customers could lead to overstocking, loss-making finished products, and eventually write-downs on inventories.


Value of Short-Term Investments Should Be Discounted


Short-term Investments such as stocks, bonds, hybrid securities and structured products are typically mark-to-market with huge volatility in their prices and values.


Others


Cash must be “unencumbered and non-restricted.”

Cash must be “non-operating and excess.”

Cash balances are real.

Off balance sheet liabilities and hybrid securities must be included as debt .

The core business must not be loss-making.


In Closing


In all forms of asset-based valuations including net-nets, all liabilities are taken to be real and the extra intellectual work is expended in assessing the true net realizable value of all assets on the balance sheet and uncovering off-balance-sheet liabilities.


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