Net Working Capital Analysis - Essay Example

Networking capital, sometimes termed to be the lifeblood of a business, represents a firm’s holding of cash and its investment in unsold or unfinished goods minus its debt with less than a year. It involves observing the cash flow of a business to make sure that it has enough cash so as to maintain normal financing operations. If the value of current assets is less than one and a half size of current liabilities, then the business would be short of working capital that will result in difficulty to meet its immediate debts. Businesses having difficulty in controlling their cash flow and working capital are said to have liquidity problems. Liquid assets are those assets that can be easily changed into cash such as stock, debtors, and short-term investments.

Buffett looks and analyses a business mainly with ‘owner earnings’ and ‘return on equity measures both in turn give an overall picture of cash flow available in a business and its operational efficiency. According to Buffet’s analysis method, it is very obvious that increased working capital can be viewed as cash outflow because the money that is owed by debtors to the business or occupied in stocks cannot be utilized for meeting any other payments, and hence no returns can be expected. Here, even though the working capital shows increases, the business can be viewed as inefficient as it failed to collect debtors on time.

Owner earnings = Net Income + Depreciation + Amortization – Capital expenditure – Additional
working capital needed

Capital expenditure, that is the money needed to spend on purchasing or upgrading plants or equipments, is deducted from net income and hence it forms an Economic Value Added (EVA) analysis. By adding depreciation and amortization back also it gives an accurate cash flow available to shareholders. This analysis method looks at the ability of a firm to generate cash for its residual owners. Even though, the decisive value of any business is its ability to generate cash, a business with high fixed assets to profit ratio needs a larger share of retained earnings to continue to be profitable than a business with low fixed assets to profit ratio.

Some businesses like real estate need more capital expenditure at the beginning and less later on. Meanwhile, manufacturing companies need normal expenditure regularly on upgrading of plant and machinery. It shows that ‘owner earning’ analysis is an attempt to provide a cross-business operational efficiency analysis. ‘Return on Equity’ looks at the return on the money contributed by and belonging to equity shareholders. It measures the ability of a business to generate a return on the operations of the business. Buffet’s business analysis tenets both ‘owner earning’ and ‘Return on equity’ thus looking at the networking capital and cash flow available in a business so as to ensure better returns for investments.