The Paradox of Large Working Capital in Mediocre Companies

1. A prosperous company would appear more likely to accumulate excessive capital than a nonprosperous one.

2. Strangely enough, this is not true. Most prosperous companies, in our dynamic economy, have been able to expand their business more or less steadily, and this expansion has supplied a satisfactory outlet for the retained earnings.

3. On the other hand, many concerns that have shown mediocre results over a long period of years will in one way or another end up by holding too much of their stockholders' capital.

• This is often the result of a persistently low dividend, together with some fairly large accumulation of profits in boom periods.
• Sometimes new capital is raised by stock sales which later turn out to be redundant.
• In frequent cases the accrual of substantial annual depreciation and depletion charges results in gradually transferring the fixed assets into cash, with a consequent excess of working capitals.

4. Consequently, the question whether too much capital is being used in the business becomes of practical moment to stockholders only in the case of nonprosperous companies. (After all, properous companies do not present problems to their stockholderss except in the matter of dividend policy.)

• It is an area in which the interests of stockholders and managements are likely to clash vigorously.
• The more dubious the company's prospects - which means generally the less satisfactory its past results - the more anxious management is to retain all the cash it can in the business;
• but the stockholders would be well advised to take out all the capital that can be safely spared, because these funds are much more valuable to them if in their own pockets, or invested elsewhere, than if left in a nonprosperous business.

Ref: Security Analysis by Graham and Dodd