Working Capital & Asset Turnover – Analysis – Part 1

03May10

I started out with analyzing Repro India to evaluate whether it will be a good investment (i.e. is it undervalued?) & also whether it is a good business. These two, as many of us know, are two different issues. Infosys was (and maybe still is) a good business in 1999-2000 but not a good investment. (Tidbit: Infosys 10 year cumulative returns is 166% vs 463% for Sensex excluding dividends). I believe that to become a good investor in the long run one must not only be able to understand whether something is a good investment, but also whether it is a good business.

Quote from Alice Shroeder of Snowball:

People talk about “intrinsic value” as though such a thing were calculable as a point estimate. Yet Warren recently discussed the value of Berkshire stock as a simple multiple of book value. I keep repeating that his way of thinking about valuation is simpler than many people believe. Where he spends his time is figuring out What Is a Good Business. This is the hard part. How much are the cash flows, and how sustainable are they. 98% of the investor’s time should be spent on the “Is It a Good Business?” question.

My analysis of the company ended up in trying to understand working capital, asset turnover and how these will have an impact on our investment. Repro India has a goal of achieving 4000 crores (1 Billion USD sales) in a few years time. They are at present at a sales level of 240 crores.

Lets see what it takes to achieve this goal.

Many equity analysts do not consider working capital as a serious piece to look at while considering a business. Working capital is a hidden investment in a business i.e. it is not an investment in the true sense since no assets are created physically but it does lock up capital. Locking up capital means reduction in return on capital which means reduction in return on equity. How does this work?

If we look at the Balance sheet, we will see broadly three uses of funds/capital: Fixed Assets (Gross/Net block/Capital WIP), Investments (usually a small portion), Net Current Assets (CA-CL which is the working capital). Lets say the working capital requirement of a 200 crore business is 50 crores. This means for achieving a sales of 200 crore, the company needs to lock-in 50 crores of cash in terms of accounts receivables, inventory etc. (It will benefit if it has accounts payable and other current liabilities since that will reduce working capital.) So, it needs this 50 crores of capital to run the business at this sales level of 200 crores. Please remember that this is apart from the fixed asset investments etc which is the other use of capital. Now, we can calculate how much working capital is needed as the company grows by historical analysis of level of sales to working capital. We must take care to use average working capital rather than year end working capital.

This calculation for Repro India yields the following:

The sales/average working capital ratio has been decreasing and seems to be hovering between 3 and 4. The average for last 4 years is 3.4 and for 8 years is 4.3. Lets fix it at 3.5. Hence for 4000 crores of sales, working capital needed by Repro would be 4000/3.5 = 1100 crores. So this means for Repro to go from 240 crores to 4000 crores in sales, it will need working capital investment of 1100-70 = 1030 crores i.e. approximately 1000 crores.

The next thing we will look at is asset turnover. This means what level of sales is achieved from assets (Sales/Total assets). This ratio is usually looked at as how much sales a company generates from its assets. This ratio can also be looked at as how much assets would be needed to generate a level of sales.

The asset turnover ratio of Repro India has been as follows:

The traditional asset turnover ratio includes working capital and is the ratio indicated in the 4th line as Sales/Average fixed assets. This is fairly constant hovering between 1.1 and 1.4 and the average is  1.3. This means that Repro would need 4000 crores/1.3 = 3075 crores of assets to generate 4000 crores of sales. If we calculate the asset turnover excluding the working capital investment the average is around 1.8 to 1.9 i.e. Repro would need fixed capital assets of 4000/1.9 = 2100 crores. Excluding 108 crores already present, we would need additional 2000 crores. If we add this 2000 crores with the working capital investment of 1000 crores calculated above, we get the 3075 crores figure (roughly) calculated above.

Hence, we can conclude that Repro would roughly need 1000 crores of working capital investment and 2000 crores of fixed asset investment to achieve a growth in sales from 240 crores to 4000 crores.

We can now compare this total investment needed of 3000 crores with the amount of earnings Repro is expected to generate in this journey to achieve 4000 crores to evaluate whether this would be possible easily or would Repro need additional debt, additional equity dilution etc i.e. it would face significant cash crunch. This analysis would help us evaluate what kind of businesses are easily scalable and which ones are not and most importantly what factors does the economics of a business play a role in it.

This analysis will not work for services firms or for non asset intensive businesses. The reason being the asset turnover ratio keeps on increasing in those cases (and usually such business are good if you can make a significant margin on your assets by keeping expenses (usually employee/admin) low). This analysis would also not apply to those companies which are in growth stage since asset turnover would not have stabilized. Asset turnover usually stabilizes for companies which cannot increase its sales any further without investing in assets. I believe a supermarket chain is an example. Repro India is a printing company and makes Annual reports for Indian companies and Educational books for African companies. It is an outsourcing business model based on cost advantages. Hence Repro has to keep investing in new printing facilities to increase its capacity and hence this analysis may work for its business. The CEO in a conference call has mentioned that its asset turnover has stabilized.

I will post part 2 of the analysis in my next post. Please feel free to correct any mistakes which I have made in my analysis.

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