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b) Investments
In this section, we will talk about investments and you will need to pay special attention to what we are going to put behind this word.
What are investments ? Conceptually, one can see an investment as an asset which is not destined to be consumed immediately by the operating cycle but will be kept in order to facilitate the production process of the company; an investment necessitates a disbursement of money which is not to be immediately and entirely useful but which allows the company to “forego” some other purchases in order to increase its future expected wealth creation. A trivial example of an investment is the purchase of cars for a taxi company.
Why do we bother with such a definition in the first place ? Because there are some instances where it is not obvious to decide whether an asset is an investment or an operating charge; for instance, what do you think about R&D expenses of a fridge manufacturer ? Can we consider these as operating charges, i.e. as charges which are proper to a given fiscal exercise or as an investment, i.e. as expenses which can be capitalized and amortized over 5 or 10 years ? The accounting answer to this question is the following: when such expenses correspond to research expenses –meaning that no sure technological improvement will flow from the activities at the origin of the expenses-, they will be treated as operating charges (and thus will impact the EBITDA). On the other hand, when these expenses correspond to development expenses –meaning that they will allow for a clear technological advance in the near future-, they will be treated as an investment and will be capitalized and amortized as any fixed asset on the balance sheet.
The category of investments which has been developed so far is called Capital Expenditures (Capex). In the next two paragraphs, we are going to see how they shall be analyzed.
Analyzing Capital Expenditures
When analyzing capital expenditures, there are two fundamental questions that you are trying to answer:
- In which state are the fixed assets of the company ? In other words, are they obsolete or rather new ? To what extent do they allow the company to produce efficiently and more importantly to what extent do they allow the company to produce more efficiently than its competitors ?
An answer to this question can be found by comparing the company’s ratio (Net value of fixed assets / Historical value of fixed assets) to the benchmark of the sector, where net value represents the value after depreciation. As a rule of thumb, you can remember that fixed assets are generally worn down when this ratio is lower than 0.3, and can be considered as modern when this ratio is greater than 0.7.
With respect to the above, do keep in mind that having very modern fixed assets is not necessarily better than having reasonably worn down equipments: indeed, you need to find the right balance between your investment expenses and the gains implied by better equipments. Also, there are periods when the company may be influenced by other factors which are uncorrelated with the production process, for instance by inflation. When the company is sailing through a period of high inflation, it may be forced to invest massively, even if it doesn’t immediately need to in terms of production capacity. The reason for this is that it is more profitable to purchase fixed assets at a lower price today rather than wait for tomorrow when price levels will be much higher (since we are in a period of high inflation). If the company refuses to adopt this investment policy, then it will stand at a competitive disadvantage with respect to its competitors, who will be then able to produce at a lower cost.
-What is the investment policy followed by the company ? Is it very aggressive, does it aim at simply maintaining the current assets in place, or is it very timid ? Typically, companies follow a very aggressive investment policy when they are in a period of growth, while they tend to curb investments as they become mature and their products are in the declining phase of their life cycle.
In order to gauge the investment policy, what you need to do is compare the level of a given year’s D&A with the corresponding capital expenditures for the same year. If these two quantities are roughly the same, this means that the company is maintaining its fixed assets in place. If D&A are much higher than capex, this tends to signify that the company’s fixed assets are not getting renewed (i.e., they are becoming obsolete). On the other hand, when capex are much higher than D&A, this means that the company is massively investing into new equipments and probably stands in a period of growth.
Example: investigating the reasons why a company would want to under-invest
There are essentially two reasons why a company would want to drastically curb its investments, and you should be wary of both of them:
- The company stands in a period with little growth, and want to adapt its production facilities to the economic environment. The danger of such a measure is that it may be difficult to resume functioning at previous levels once the economic situation gets better and higher growth levels are back. On the other hand, maintaining a very aggressive investment policy during a period of slow growth is equally unreasonable and can be compared with gambling since the company can’t be sure that it will be able to resume producing at higher levels in the future. In conclusion, the right measure to adopt must stand somewhere in the middle.
- The managers want to “milk the cow”, i.e. distribute as much cash as possible to the shareholders and then run away from the distressed company. Such a practice is a nightmare for debtors who may see any hope to recover their money vanish into thin air (indeed, they would prefer managers to invest into profitable projects and thus give the company a chance to recover, which also means a chance for debtors to be paid back). Typically, debtors will try to protect themselves from such practices by including special restricting clauses in their contracts (such clauses are called covenants).
The question we want to tackle now is the following: are capital expenditures constitute the only type of investments ? The answer is no: there exists another type of investments called Working Capital. Working Capital corresponds to these funds which are immobilized for the company in order to conduct its activities under the form of inventories (including work in progress), receivables and payables. In fact, one defines Working Capital in the following way:
Working Capital = Receivables + Inventories - Payables
Working Capital corresponds to an investment in money due to the time lag which can exist between the moment when certain operations are conducted and the moment when the corresponding funds arrive: for instance, higher receivables mean that your clients are keeping a chunk of the money that they owe you, and this represents an investment on the long run (even though these clients pay you back, new ones will still owe you debt so that you can expect to have a stable level of receivables over time if your payment terms remain unchanged).
On the contrary, higher payables mean that you owe more to your suppliers, and this money that you owe them can be profitably used somewhere else in the company: in this way, this represents a negative investment.
Eventually, inventories (including work in progress) represent funds which are immobilized and thus cost you money (notwithstanding the storage costs, inventories also cost you the cost of capital). You can then formulate the same remark as before: even though inventories are rotating, there is still a certain level of them which can be supposed to be stable over time if you do not change your inventory policy.
From the above you can now tell that it is preferable for a company to have a negative working capital, because this will mean that it is able to have more funds at hands “that it should be having” and that it will thus be possible to inject them back into the operating cycle.
Example : the case of supermarkets
Why can supermarkets be considered as heaven when it comes to working capital levels ?
Having a look at the definition of working capital will show you that supermarkets tend to attain negative levels: indeed, customers always pay upfront and suppliers always grant generous payment terms because their bargaining power is very low (since a supermarket can choose between so many products to sell).
As for the inventory levels, the fact that suppliers are paid very late more than makes up for the value of inventories, which usually rotate very fast. At the end of the day, supermarkets enjoy a negative working capital.