For those who aspire to true value investing, learn the Cash Conversion Cycle — Mr. Yuuki Yanashita
The Cash Conversion Cycle is the topic in this issue's talk by Mr. Yuuki Yanashita, whose lectures on true value investing have been well received.
A must-read for stock investors.
May 2020, No.3 “Think Beyond Principles, Consider with Numbers and Practical Solutions — Optimal Capital Structure, CCC, Inventory as a Flow”
Hello. This is the last update for May.
As I mentioned before, I will publish a book with Kinzai.
That said, the base is the content of “The Thorough Lectures on True Value Investing,” with substantial additions.
As you know, “The True ~” currently covers Parts 1 through 4, but I plan to extend it to Part 5, and in addition to that I am including many in-depth explorations and digressions in each chapter, as well as many more company stories, so please read it.
That said, we haven't yet put in the first draft (sweat), so the release will probably be around September.
This time, I’ll preview a portion of the additions and tell a related story in advance.
Regarding optimal capital structure, in “The Thorough Lectures on True Value Investing,” it varies by business stage, specifically,
Introductory stage: E > D (or, avoid using capital leverage)
Growth stage: E > D (capital leverage should not be used much)
Maturity stage: E ≒ D (leverage should be used in moderation)
Decline stage: E < D (it's okay to use leverage)
This is how I explained it.
As you know, Japan's interest rates are at historically low levels, and the yields on short- to mid-term government bonds have turned negative.
Because of this, many companies with higher beta, meaning higher shareholder risk perception, have reduced their weighted average cost of capital by increasing debt.
This in itself is a correct managerial decision. It's good that financial awareness is high.
However, this alone does not determine whether the capital structure is optimal.
In short, currently the theoretical principle that debt is cheaper than equity by the present value of tax shields is overshadowed by the fact that the current very low interest rates have the larger influence; thus the impact on company performance is more driven by the current rate environment than by the debt cost vs equity cost.
Of course, as MM theory indicates, increasing debt raises the value of the firm by the present value of the tax shield, so this advantage should be enjoyed.
However, on the other hand, without debt, the risk the shareholders face is only business risk. Business risk is the variability of the future Free Cash Flow (FCF); adding debt (leverage) increases the volatility of FCF.
Put simply, times are good, they’re very good; times are bad, they’re very bad. Leverage means shareholders bear financial risk in addition to business risk.
Thus for companies with relatively small earnings volatility, using financial leverage to improve shareholders' risk-return is rational, whereas for companies with relatively larger earnings volatility, a proper capital balance is needed to avoid making shareholders' risk-return too high.
In other words, increasing debt does not necessarily reduce the cost of capital.
At the initial stage we emphasize the basic principles, but in practice it's not so simple to decide; the correctness depends on assumptions, context, and various requirements.
This is the same for CCC (Cash Conversion Cycle).
CCC is calculated as Accounts Receivable Turnover Period + Inventory Turnover Period - Payables Turnover Period, so the shorter, the better, basically.
It is a metric for capital efficiency showing the days from purchasing raw materials or goods to ultimately collecting cash. In other words, it is working capital, so the smaller, the better for efficiency.
And to shorten it, shorten the accounts receivable turnover period and the inventory turnover period, and lengthen the payables turnover period if possible.
However, if the inventory turnover period is too short, stockouts and opportunity costs occur.
Also, making the payables turnover period too long makes cash flow easier but can lead to increased working capital (borrowings) for suppliers, and they may pass the interest on to the purchase price.
In practice, it is common for the purchasing department to shorten the payment period to negotiate lower prices.
Furthermore, when CCC is negative like Amazon, it means cash inflows come before payments, so no working capital is needed. Growth in sales reduces working capital, thus increasing cash flow.
But there is also a downside to a negative CCC. In periods of falling sales, the negative working capital shrinks, meaning cash flow declines.
This mechanism led to the collapse of NOVA, the English-language school. At that time, there was a public uproar over prepaid tuition cancellations by students. During rapid growth, they redirected the cash obtained earlier to invest in new schools, fueling growth. According to this book, CCC was nearly minus 150 days in the fiscal year ending March 2004.
However, in a sales decline, prepayments fell significantly due to more mid-contract cancellations, accelerating cash flow decline, and NOVA faced liquidity problems and went bankrupt.
Thus, it is important not to be bound only to principles but to look at the numbers in context and understand what the numbers imply.
Speaking of working capital, for example inventory: rather than viewing it merely as stock, what happens if we view it as a flow?
If a company has 1 billion in inventory and ROIC is 5%, then
1,000,000,000 × 5% = 50,000,000, so the opportunity cost is 50 million.
Investing that stock value into the business would have generated that much cash flow.
Of course, there cannot be production without inventory, so it would be ideal to generate more cash, but it is extremely important to keep these numbers in mind as realistic figures.
Well then, that's all for today.
As I mentioned before, I will publish a book with Kinzai.
That said, the base is the content of “The Thorough Lectures on True Value Investing,” with substantial additions.
As you know, “The True ~” currently covers Parts 1 through 4, but I plan to extend it to Part 5, and in addition to that I am including many in-depth explorations and digressions in each chapter, as well as many more company stories, so please read it.
That said, we haven't yet put in the first draft (sweat), so the release will probably be around September.
This time, I’ll preview a portion of the additions and tell a related story in advance.
Regarding optimal capital structure, in “The Thorough Lectures on True Value Investing,” it varies by business stage, specifically,
Introductory stage: E > D (or, avoid using capital leverage)
Growth stage: E > D (capital leverage should not be used much)
Maturity stage: E ≒ D (leverage should be used in moderation)
Decline stage: E < D (it's okay to use leverage)
This is how I explained it.
As you know, Japan's interest rates are at historically low levels, and the yields on short- to mid-term government bonds have turned negative.
Because of this, many companies with higher beta, meaning higher shareholder risk perception, have reduced their weighted average cost of capital by increasing debt.
This in itself is a correct managerial decision. It's good that financial awareness is high.
However, this alone does not determine whether the capital structure is optimal.
In short, currently the theoretical principle that debt is cheaper than equity by the present value of tax shields is overshadowed by the fact that the current very low interest rates have the larger influence; thus the impact on company performance is more driven by the current rate environment than by the debt cost vs equity cost.
Of course, as MM theory indicates, increasing debt raises the value of the firm by the present value of the tax shield, so this advantage should be enjoyed.
However, on the other hand, without debt, the risk the shareholders face is only business risk. Business risk is the variability of the future Free Cash Flow (FCF); adding debt (leverage) increases the volatility of FCF.
Put simply, times are good, they’re very good; times are bad, they’re very bad. Leverage means shareholders bear financial risk in addition to business risk.
Thus for companies with relatively small earnings volatility, using financial leverage to improve shareholders' risk-return is rational, whereas for companies with relatively larger earnings volatility, a proper capital balance is needed to avoid making shareholders' risk-return too high.
In other words, increasing debt does not necessarily reduce the cost of capital.
At the initial stage we emphasize the basic principles, but in practice it's not so simple to decide; the correctness depends on assumptions, context, and various requirements.
This is the same for CCC (Cash Conversion Cycle).
CCC is calculated as Accounts Receivable Turnover Period + Inventory Turnover Period - Payables Turnover Period, so the shorter, the better, basically.
It is a metric for capital efficiency showing the days from purchasing raw materials or goods to ultimately collecting cash. In other words, it is working capital, so the smaller, the better for efficiency.
And to shorten it, shorten the accounts receivable turnover period and the inventory turnover period, and lengthen the payables turnover period if possible.
However, if the inventory turnover period is too short, stockouts and opportunity costs occur.
Also, making the payables turnover period too long makes cash flow easier but can lead to increased working capital (borrowings) for suppliers, and they may pass the interest on to the purchase price.
In practice, it is common for the purchasing department to shorten the payment period to negotiate lower prices.
Furthermore, when CCC is negative like Amazon, it means cash inflows come before payments, so no working capital is needed. Growth in sales reduces working capital, thus increasing cash flow.
But there is also a downside to a negative CCC. In periods of falling sales, the negative working capital shrinks, meaning cash flow declines.
This mechanism led to the collapse of NOVA, the English-language school. At that time, there was a public uproar over prepaid tuition cancellations by students. During rapid growth, they redirected the cash obtained earlier to invest in new schools, fueling growth. According to this book, CCC was nearly minus 150 days in the fiscal year ending March 2004.
However, in a sales decline, prepayments fell significantly due to more mid-contract cancellations, accelerating cash flow decline, and NOVA faced liquidity problems and went bankrupt.
Thus, it is important not to be bound only to principles but to look at the numbers in context and understand what the numbers imply.
Speaking of working capital, for example inventory: rather than viewing it merely as stock, what happens if we view it as a flow?
If a company has 1 billion in inventory and ROIC is 5%, then
1,000,000,000 × 5% = 50,000,000, so the opportunity cost is 50 million.
Investing that stock value into the business would have generated that much cash flow.
Of course, there cannot be production without inventory, so it would be ideal to generate more cash, but it is extremely important to keep these numbers in mind as realistic figures.
Well then, that's all for today.
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