# Working Capital: Fundamentals as a Form of Money Management

The final major area worth analysis is working capital. This is the amount of cash available to pay for current expenses and to fund growth and dividend payments. In its most basic definition, working capital is the net of current assets minus current liabilities. But in a broader sense, it refers to the longer-term trend reflecting the company's management of cash.

The best-known working capital test is called the current ratio. This is an indicator derived by dividing current assets by current liabilities.
The outcome should be a positive value, meaning there are most liquid assets on hand that the company owes in the next 12 months. A current ratio of less than 1 is a sign of very weak cash management. The expectation of a current ratio of 2 or better means excellent cash management; but many well-managed companies maintain their current ratio somewhere between 1 and 2.

The current ratio is rounded to a whole number and one decimal place. For example, if a company reports current assets of \$1,462,000 and current liabilities of \$845,400, the current ratio is:
\$1,462,000 ÷ \$845,400.= 1.7
As with all fundamental tests, it makes sense to track current ratio for a full year. For example, in the case of General Mills and Caterpillar, current ratio over 10 years was:
Year GIS CAT Current ratio, 10 years 2000 0.5 1.5 2001 0.6 1.3 2002 0.6 1.3 2003 0.9 1.3 2004 1.2 1.3 2005 0.7 1.2 2006 0.5 1.2 2007 0.5 1.2 2008 0.8 1.2 2009 1.0 1.4

Both of these are consistent enough over time, although in the case of GIS, current ratio has often been below 1. However, the consistency in both companies is reassuring, if the analysis is limited to a study of only the current ratio. However, it is quite easy to manipulate this ratio by borrowing money and holding proceeds in cash. This raises the current asset level, but the offsetting liability is long-term and does not show up as a current liability (except the coming 12 months of debt service). This hides a potential problem: the rise of long-term debt. As long as the current ratio remains constant and is used as the sole test of working capital, this situation does not come to light.

#### Key Point

The current ratio is the best-known test of working capital, but it does not tell the whole story. The real long-term trend can only be understood by studying both current ratio and debt ratio.

With this in mind, a second test is needed. The debt ratio is a comparison between long-term debt and total capitalization. The debt ratio is a percentage, but it is normally expressed as a value to one rounded decimal place, without percentage signs.

For example, a company reports current long-term debt of \$41,200,000 and stockholder's equity of \$98,600,000. Total capitalization is a combination of these two:
\$41,200,000 + \$98,600,000 = \$139,800,000
The debt ratio is found by dividing long-term debt by total capitalization. The debt ratio is:
\$41,200,000 ÷ \$139,800,000 = 29.5
This company is capitalized 29.5 percent by debt and 70.5 percent by equity. However, it is not the relative portion of debt or equity that is conclusive, since the levels of debt capitalization vary by industry. What is important is how the debt ratio changes over time. Whenever you see a growing debt ratio, it is a danger sign. The more long-term debt a company is obligated to repay, the worse future working capital will be. As a growing amount of annual earnings have to be paid to bondholders and note holders in interest, less is left for payment of dividends to stockholders or to fund future expansion.

An analysis of General Mills and Caterpillar for the 10-year period ending in 2009 shows how the debt ratio evolved.
Year GIS CAT Debt ratio, 10 years 2000 94.7 66.9 2001 82.4 66.8 2002 57.5 67.9 2003 55.1 69.8 2004 50.3 68.0 2005 32.9 65.0 2006 21.7 72.0 2007 28.9 66.7 2008 35.4 77.2 2009 49.3 37.1

In the case of General Mills, the high debt ratio at the beginning of the period was troubling, especially considering that the current ratio was less than 1 for most of the period. However, the company cut its debt ratio by nearly one-half over the decade. Caterpillar, an industry in which high debt ratios are expected, maintained a consistent level with a sudden increase in 2008 and a surprising decline in 2009. However, the consistency of the company's current ratio, coupled with the debt ratio history, indicates sound cash flow management and healthy working capital.

#### Key Point

It is not the debt ratio in the current year that matters, but the long-term trend. When you see the debt ratio climbing every year, it spells trouble for future cash flow.

In addition to determining whether to buy stock in any one company, you also need to determine whether it makes sense to own stock directly, or to rely on management of a mutual fund to build a portfolio and to buy shares in the overall holdings of that fund. Alternatives: Stocks or Mutual Funds examines the role that mutual funds might play in your investment plan.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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