Weekly Thoughts


Cash Money

Here is something that caught our eye this week:

Working Capital vs. Growth

Our regular readers will know that our metric of choice is Free Cash Flow.  This is because the crux of our strategy relies upon our ability to purchase cash flowing businesses from retiring owners, and then, over the long-term, using the cash flows from those businesses to fund the equity requirements for growthwhether it be supporting internal growth initiatives or writing a check for our next acquisition.  Without free cash flow, our strategy stalls.

However, when it comes to Free Cash Flow itself, there is bit of a tension between working capital and growth.  A few of our companies either have or will experience significant increases in revenue over the next few months as contract bases increase organically and/or acquisitions are integrated.  This growth will have working capital and ultimately cash flow impacts that are important to understand and prepare for.

Fortunately, one of our companies has gone through just such a phase of strong revenue growth over the past twelve months, and we can learn from their experience.  Below is a chart of the TTM Earnings, TTM Net Working Capital, and TTM Free Cash Flow for this company for the last twelve months.

While net income has been increasing steadily all year, note that in the early spring working capital grew in lock-step due to the normal working capital intensity of the business and an investment in additional inventory to accommodate COVID related volume spikes.  While this growth dynamic is expected in theory, in practice it can be frustrating to see income statement metrics (earnings) move higher while free cash flow remains flat.  For example, by May, earnings had nearly doubled with little growth in FCF to show for it.

As you can see, the growth in working capital moderated considerably in the back half of the year, which has allowed the continuing growth in earnings to translate into FCF more efficiently.

The key point is that growth, particularly sudden growth, will very likely come with a spike in working capital that will cause a lag in FCF relative to earnings, and can even cause cash stress at the company depending on the starting point for the checking account.  Analyzing, anticipating, and ultimately optimizing the working capital intensity of the acquired revenue (whether sales or M&A driven), will ensure we move through any such phase as quickly as possible and toward the point where our growth really causes free cash to accelerate.  And that, dear readers, is where the magic happens.

Have a great week,

Your Chenmark Team

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