Profit Manipulation: Gross Working Capital
We penalise companies where there is a large and/or growing amount of gross working capital relative to industry peers. The relationship between gross working capital and sales is a means of monitoring how a company generates its operating cash flow. We prefer companies that maintain a small and stable working capital relative to sales. However, fluctuations in working capital can be cause for concern:
Manufactured cash flow: Increases in current assets, such as receivables, can be a sign that a company is experiencing deterioration in terms of trade. Normally, this would be reflected in a drop in operating cash flows relative to profit but in especially difficult situations companies attempt to pass this burden onto their suppliers through extended payment periods. As such, operating cash flow is arguably manufactured, thereby flattering a company’s financial position. In the worst cases, a company might disguise interest debt as working capital (by failing to disclose that they are interest bearing), in order to generate operating cash flow. As such, significant increases in gross working capital are cause for concern. For more reading, please refer to our report, HIDDEN DEBT: And Manufactured Cash Flow (25 May 2016).
Working capital traits vary more by industry than by country of domicile. The real estate industry has the largest gross working capital at approximately 2x sales. This is usually due to large inventories which might be financed by customer presales and/or extended payables with contractors. At the other end of the scale, retailers tend to have smallest amounts of gross working capital at 30-40% of sales, as shown in Figure 15. Customers pay with cash at the point of sale, translating into a low level of receivables. Meanwhile, retailers are notoriously slow in paying their suppliers which results in significant payables.
Gross working capital tends to fluctuate at around +/-10% of sales on a year to year basis, as shown in Figure 16. In general, companies with the largest amount of working capital tend to experience the greatest fluctuations. It’s no surprise then that the real estate developers which have the highest working capital at 200% of sales, tend to see the largest fluctuations at around +/-40% of sales in any given year (we have had to rescale the chart to exclude the property developers).
Gross working capital by country of domicile is shown in Figure 17. China has the largest gross working capital at 75% of sales, followed by Italy. Meanwhile, the US and Russia have some of the lowest amount of gross working capital at 40-43% of sales. Much of the discrepancy by market is likely due to the composition of companies. For example, China is likely dominated by low value-added companies with poor working capital cycles compared to higher valued added and efficient companies in the US. However, there are also likely to be significant differences in the supply chains within each country. For example, we know that China has experienced significant deterioration in terms of trade over the past five years which has led to such high gross working capital.
Our accounting screen is set to trigger a red flag when gross working capital/sales exceeds the 80th percentile (i.e. they are very high) relative to GICS industry peers, and/or when there is an abnormally large increase in working capital relative to the normal rate of change amongst industry peers over one and three years. This latter red flag is triggered when the deterioration in gross working capital to sales exceeds the 80th percentile relative to the change experienced by industry peers between 2010 and 2015.