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Assess a firm's working capital, its capital spending and how it is financed

CFA® Level I · Equity Investments · Company Analysis: Past, Present, and Future · EQ.16.c

The idea

Growth has to be paid for, and this is where earnings and cash diverge. Working capital needs are gauged from receivable, inventory and payable days; a business that collects late and pays early ties up cash as it grows. Capital investment is compared with depreciation to see whether a firm is merely maintaining its assets or expanding them, and with revenue to judge capital intensity. Capital structure, the mix of debt and equity, determines financial risk and the cost of capital: more debt raises returns on equity in good years and the risk of distress in bad ones. Together these determine how much of reported profit becomes free cash flow available to investors.

A practice question

From the question bank, with the reason each wrong option is wrong.

Pelling Textiles has days sales outstanding of 40, days of inventory on hand of 60 and days payables of 35. Its cash conversion cycle is:

  1. 135 daysWhy not: Adds payables days instead of subtracting them; supplier credit shortens the cycle.
  2. 15 daysWhy not: Subtracts inventory days instead of payables days, reversing the roles of the two items.
  3. 65 days — correct

Cash conversion cycle = DSO + DOH − DPO = 40 + 60 − 35 = 65 days.

A harder one

Orwin Plastics has gross debt of 900, cash of 150 and EBITDA of 250. Its net debt to EBITDA ratio is:

  1. 3.6xWhy not: Uses gross debt, ignoring the cash balance that could be used to repay debt.
  2. 3.0x — correct
  3. 4.2xWhy not: Adds cash to debt rather than subtracting it.

Net debt = 900 − 150 = 750. Net debt / EBITDA = 750 / 250 = 3.0x.

The hardest tier

Cradley Components reports capital expenditure of 200 and depreciation of 80. Using depreciation as a proxy for maintenance capex, its growth capex is closest to:

  1. 200Why not: Treats the whole of capital expenditure as growth, ignoring the part needed to replace worn-out assets.
  2. 120 — correct
  3. 280Why not: Adds depreciation to capex instead of subtracting the maintenance portion.

Growth capex ≈ total capex − maintenance capex ≈ 200 − 80 = 120.

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