Quality check to weed out company with an insatiable demand for capital.

Quality check to weed out company with an insatiable demand for capital.

Benjamin Graham and followers placed great emphasis on financial strength, liquidity, debt coverage and so on. It was the tune of the times.

Credit analysis today continue to check all manner of coverage (e.g. interest coverage) and debt ratios, but for most companies reporting a profit, it maybe overkill.

Here are a few checks to provide a margin of safety and a further test of whether the company has an insatiable demand for capital:

1. Are current assets (besides cash) rising faster than the business is growing?

This ties to the asset productivity and turnover measures but it is worth one last check to see whether a company is buying business by extending too much credit.

More receivables result from extending credit.

Losing channel structure and supply chain battles (customers and distributors won't carry inventory; suppliers are making them carry more inventory) result in increased inventories.

In a soft construction environment, distributors and retailers like Home Depot and Lowe's simply aren't taking as much inventory, pushing it back up the supply chain. The main supplier's risk is greater capital requirements and expensive impairments downstream.

2. Is debt growing faster than the business growth?

Over a sustained period, debt rising faster than business growth is a problem.

If the owners won't kick in to grow the business, and if retained earnings aren't sufficient to meet growth, what does that tell you? The business is forced to seek capital.

3. Repeated trips to the financial markets?

If the business continually has to approach the capital markets (other than in startup phases), that again is a sign that internally generated earnings and cash flows are not sufficient.

Once in a while it is okay, but again one is looking to weed out chronic capital consumers.

Two important things in the capital structure of the business

Capital Structure

When looking at capital structure, try to determine two things:

1. Is the business a consumer or producer of capital? Does it constantly require capital infusions to build growth or replace assets? Warren Buffett - and many other value investors - shun businesses that cannot generate sufficient capital on their own. In fact, one of the guiding principles behind Berkshire Hathaway is the generation of excess capital by subsidiary businesses that can be deployed elsewhere.

2. Is the business properly leveraged? Overleveraged businesses are at risk and additionally burden earnings with interest payments. Under-leveraged businesses, while better than overleveraged, may not be maximizing potential returns to shareholders.

Capital-intensive and Capital-hungry companies

CAPITAL SUFFICIENCY

Capital-hungry companies are sometimes hard to detect, but there are a few obvious signs.

Companies in capital-intensive industries, such as manufacturing, transportation, or telecommunications, are likely suspects.

Here are a few indicators.

1. Share buybacks

The number of shares outstanding can be a real simple indicator of a capital hungry company. A company using cash to retire shares - if acting sensibly - is telling you that it generates more capital than it needs. On the other hand, if you look at a company like IBM, ROE has grown substantially, and massive share buybacks are a major reason.

Warning! : When evaluating share buybacks, make sure to look at actual shares outstanding. Relying on company news releases alone can be misleading. Companies also buy back shares to support employee incentive programs or to accumulate shares for an acquisition. Such repurchases may be okay but aren't the kind of repurchases that increase return on equity for remaining owners. (Comment: to take a look at HaiO share buyback.)

2. Cash flow ratio

Is cash flow from operations enough to meet investing requirements (capital assets being the main form of investment) and financing requirements (in this case, the repayment of debt)?

If not, it's back to the capital markets. This figure is pretty elusive unless you have - and study - statements of cash flow.

3. Lengthening asset cycles

If accounts receivable collection periods and inventory holding periods are lengthening (number of days' sales in accounts receivable and inventory), that forewarns the need for more capital.

4. Working capital

A company requiring steady increases in workng capital to support sales requires, naturally, capital. Working capital is capital.