Well-known to businessmen everywhere, but totally under-appreciated by investors, is the concept of working capital, the day-to-day operating cash flow that makes a business run. Turns out the Red Cross has a big working capital problem when it comes to text message donations. From Carrick Mollenkamp (WSJ), Americans pledge millions, but cash flow takes weeks:
Secretary of State Hillary Clinton, CNN, and users of Twitter Inc. have urged people to punch 90999 and then type in the word “HAITI” on their phones to send $10 to the American Red Cross. But the money won’t be routed from most U.S. wireless carriers to relief efforts until cellphone users pay their phone bills.
That could take 30 to 90 days, telecommunications officials estimate, well after the critical initial days in which humanitarian aid organizations are trying to deliver medical supplies, food and water to save injured earthquake victims and help others with their most immediate needs.
To run its operations, the Red Cross needs cash today. But text message donations don’t actually come through until users pay their cell phone bills and carriers pass through the funds. (To be clear, I’m not saying text message donations are a bad thing. They’re an ingenious way for relief organizations to leverage the billing relationships that carriers have with consumers. I gave $10 myself. Still, it provides a good opportunity to discuss cash flow issues that few understand.)
Businesses confront cash flow issues like this every day, yet investors typically ignore them.
Does a business require lots of investment up front to provide its good or service? If so, this can be a big and ongoing operational risk. Every Christmas season, retailers invest in inventory they hope is going to sell. If it doesn’t, they can end up in bankruptcy.
On the other hand, there are businesses that get paid before delivering their good or service. Many subscription businesses get paid up front only to deliver content later.
(The analogy isn’t perfect since the Red Cross doesn’t aim for profits. But it is in the business of disaster relief, which requires a cash investment up front.)
All else equal, it’s better to run a business that gets paid first. Risks that your product doesn’t sell, or that your customers don’t come through with a cash payment, are removed.
Warren Buffett has made his fortune in large part due to astute working capital management. His main business is insurance. He gets paid premiums up front but only pays out if his customers have a claim. In the meantime, he has control of the “float,” which he can invest to generate profits for Berkshire. Writing insurance policies that result in few if any claims has made billions for Berkshire shareholders.
Understanding working capital is also crucial to Buffett’s brand of value investing. If a business must invest capital up front, what is the average return on that capital investment? If the return on capital employed* is high — and the business is simultaneously selling for a cheap valuation — then odds are you’ve identified a stock that will outperform the market. (Joel Greenblatt wrote a best-selling book based on this two-part magic formula.)
And the lesson for charitable givers? Don’t wait for disasters to strike to give money. While the devastation in Haiti is certainly heart-breaking, we shouldn’t think it out of the ordinary. After all, Mother Nature regularly delivers an epic disaster — the Asian Tsunami in 2004, Katrina in 2005, the Sichuan Province earthquake 2008, Haiti 2010.
So consider giving at regular intervals, especially before disasters strike. And not just to the Red Cross. Presumably aid organizations can mobilize more quickly if they have working capital available in advance.
*There are different ways to calculate return on capital employed. Here’s one way:
Return = annual after-tax operating income = last twelve months operating income * (1 – tax rate)
Capital employed = Accounts receivable + inventories + prepaid expenses + net property, plant and equipment – accounts payable – accrued expenses – deferred revenue
ROCE = Return / Capital Employed. If a company has $100 million of after-tax operating income and $200 million of capital employed, then ROCE is 50%.
Even better than a high ROCE is a business that has negative working capital. For instance, if deferred revenue is really high because a business takes in cash before delivering its good or service, then capital employed is likely negative.