Working the Capital
Investors often look at working capital – the difference between a company’s current assets and its current liabilities – as part of the process of selecting candidates for investment. The arithmetic is easy and it can be illuminating to study trends in a company’s working capital position or to compare its working capital management practices with those of its peers. But such analysis can also devolve into a narrow appraisal of short-term liquidity yielding, at best, a coarse estimate of how easily a company can cover its near-term obligations. For more useful insights, particularly into a company’s operational processes, it helps to examine the components of working capital: what the company owes suppliers, what the company is owed by customers and, most important from an operational standpoint, how much is tied up in inventory.

Spend enough time comparing operational and financial data and you are likely to notice a simple truth: companies that manage their working capital well steadily become more valuable. Consider, for example, what happened when Allianz Capital Partners, a private equity firm, acquired Schmalenbach-Lubeca, a German packaging company, in 2000. Allianz soon realised that its acquisition, accustomed as it was to easy loans from its erstwhile parent, was managing its working capital poorly. The new owners set to work, methodically tackling each component of working capital. A few years later, they were able to sell Schmalenbach-Lubeca at a premium, a substantial part of which could be traced to two simple changes – replacing loans from the parent company with bank debt, which necessitated a disciplined approach to repayment, and optimising the balance between payments and collections, which improved cash flows.

Around the time that Allianz was overhauling Schmalenbach-Lubeca, Robert Nardelli was getting to grips with Home Depot. The company had grown rapidly in the 1990s – over the decade, $100 turned into almost $4,000 – but in the new millennium, growth had fizzled. In desperation, Home Depot’s board had turned to Nardelli, a veteran of GE’s power systems business. On the working capital front, the situation he faced was grim. An example was the way suppliers were selling the same things at different prices to nine different divisions. As one director put it, “We ordered $40 billion worth of merchandise with a system consisting of paper and pencil.” Nardelli’s tenure ended abruptly, so it is difficult to assess the efficacy of his strategy, but it seems safe to say that procurement and, by extension, working capital, was better managed when he left Home Depot than when he arrived.

Home Depot is based in the US, but to see what good working capital management can achieve, we need travel no farther than China. When the Hong Kong-based Lenovo group acquired IBM’s personal computer division in 2005, it paid $1.2 billion. To make the acquisition succeed, Lenovo had to find savings swiftly. The board challenged senior vice president Qiao Song: could he save $150 million in direct spending by building a new procurement team? He would have 18 months to pull this off and, while he was at it, deliver savings of $300 million more in annualised running costs. How Qiao Song succeeded is a story in itself. For our purposes, one message stands out – working capital management (particularly procurement) was crucial to Lenovo’s achievement.

It should be obvious by now that there is more to working capital than what a routine appraisal of near-term liquidity is likely to reveal. The next time you’re studying a company, look closely at the components of working capital. Interview suppliers, if you can. Get a feel of the company’s procurement practices. If the company works through distributors, make inquiries among local representatives. As Lenovo’s Qiao Song told an interviewer recently, “Rapid increase in size meant we would need additional structure and more stringent processes in order to handle greater volumes.” Only with carefully designed practices, like strong working capital management, is the company – and your investment in it – likely to grow.

Shreedhar Kanetkar welcomes your comments. Write to [email protected]

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