The Earnings Illusion: How Working Capital Exposes Cash-Burning Companies

0:00So here's the truth. You can have a company that has great looking earnings and still have a business that's not generating cash at all. One of the easiest ways to spot this without being an accountant, obviously, is changes in working capital. It's basically the day to day reality of a business. Are customers paying on time? Is inventory moving? And are they paying their suppliers as they should? Or is something starting to look weird? Today, Andrew and I are going to break down in plain English what changes in working capital is and how you can use it in your day-to-day investing. I remember starting my first business.

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2:33Your path to financial freedom. Start now. Welcome back to the Investing for Beginners podcast. My name is Stephen Morris and across from me is the guru. The guru. Uh, when it comes to investing Andrew say there and today, Andrew, don't shake your head. No, did you just shake your head? No. I mean, don't do that. Um, today, today we are talking about changes in working capital and how, uh, how you can use that to make, uh, better decisions when it comes to your investments. So Andrew, just real quick, can we have like a 30 ,000 foot view slash definition of what changing changes in working capital is.

3:19Yeah, it's kind of like the necessary components of a businesses operations. So the cash that's going in the cash that's going out. Kind of like our checking accounts, the things that happen every single day to keep a business running. So basically, like we can have two different companies, they can have identical net incomes and then changes in working capital are ways we can pick apart those net incomes to see which one of these companies is actually making money. Yeah. It can tell us a lot. If a company is a bad capital allocator, sometimes it can be hidden in changes in working capital. so it's definitely a way where we can I don't know, Wall Street's not always rational so this, I don't want to be like, okay, this is the greatest thing to identify a bad company that there's ever been invented Wall Street can and has rewarded bad behavior, but sometimes you can see cases where changes in working capital can, like I said, kind of show you so one example would be where capital as being mismanaged or they're just being too aggressive with capital.

4:42Another thing it could signal is the strength of a company's power position in its industry. We can get into this, but basically, how much does its vendors need it? How much do they need their vendors? How much do their customers need them? How much do they need their customers? Sometimes you can suss that out in the changes in working capital, And that's kind of fascinating too. Yeah, I love it, Andrew. So I guess let's break it down. The simplest way I can think of is to basically put it into three buckets. So let's start with accounts receivable, which is basically booked revenue. It's cash the company is supposed to collect, but has not yet collected.

5:31What can we tell from looking at it, how the strength of a company or disadvantage of a company based on accounts receivable? yeah great question let's use a very recent very not controversial but like top of mind kind of company so i'm talking about microsoft i'm talking about chat gpt we don't have to dive into everybody's feelings about chat gpt and the ceo and all those things but it's widely known known that Microsoft's cloud unit is providing compute for OpenAI, the owner of ChatGPT. And so if you look at Microsoft's changes in working capital, accounts receivables at the very top, over the last three years they've gone from minus$4 billion to minus$7 billion to minus$10.5 billion.

6:30And so what that is saying is, to your point, Stephen, they are booking revenue, but they haven't collected that cash yet. And so sometimes that can signal kind of power dynamics between two companies. In this case, for OpenAI, some people have said that they wonder or worry about the ability for companies like Microsoft to collect on the money that a big AI an AI company that's using compute might owe and have to pay for. So that could be actually a risk, especially if you have different businesses where they have really big customers. Like, hey, this customer makes up 25 % of our revenues or something.

7:22There has been times in the past where companies have gone bankrupt or had really tough financial periods because they could not collect the revenue they earned. And so accounts receivable can sometimes identify, can certainly show a red flag to say, hey, maybe I need to do more research. Maybe the company I want to invest in is solid, but if their customers aren't solid, that could cause problems down the line. Very interesting. Is there any terminology or anything that we need to be aware of when it comes to accounts receivable that might throw people off when they see it? Yeah, that's another very good question.

8:07I don't have the exact terminology, but something around the lines of, I think, allowance for doubtful accounts. Basically, similar to a bank. A bank might have to estimate how much it thinks it might lose from its customers going over on a credit card or something and not paying that back, basically defaulting. So companies can do that as well. But I think one of the problems with something like this is if it makes up a big part of their revenue, I don't know how many companies want to put so much in an allowance to say, we think this big customer of ours is going to default. So I really think it's one of those that might kind of take a company and investors by surprise.

8:57So even though that's a metric we can look for, I don't know how, this is just my opinion, but I don't know how accurate a reserve like that would be, if that makes sense. Yeah, definitely. But I think to the flip side of that, if we look at CAT and their accounts receivable, they have a lot of withstanding payments, because it's waiting on project completion when it comes to the work they're doing in data centers and stuff like that. So that is a very large payment that's going to be coming due once the work is done. How do you look at something like that? Is that a red flag or is that something you're like, oh, that's great?

9:45How do you view something like that when it comes to accounts receivable? I love that example because it kind of shows how we can't just take blanket statements with accounts receivable and we have to think through what's the context. There's another metric that I think we can talk about. It's for Microsoft case, they call it unearned revenue. You might also see it as deferred revenue. And so depending on the contract, the project, you see this with defense contractors as well. other companies that might have the government as a customer. And then CAT, what you're talking about with the longer-term data center projects, the way they recognize revenue and the way they recognize accounts receivable versus a deferred revenue, that might all change and there might be nuance behind that.

10:35But those two metrics can, again, kind of tell you revenues or cash flows that they expect to receive. And it is a drag. I mean, you don't want to see this ballooning accounts receivable because it is a drag on the company. And if you have, like, let's take Microsoft as an example. I mean,$10 billion is not really much for them. they earned$100 billion last year. So we're only talking about like 10 % of profit. But if that was a bigger number, how do you reinvest as a company like Microsoft if a lot of your money that you're booking as profit is not cash flow yet? And so then you have to figure out other ways to raise cash.

11:25So everything depends on context. Everything has kind of levels to it. in general it's ideal for a company to not have this ballooning accounts receivable but if there's a good reason why if you're like a cat and there's these long term projects then we understand and the company can figure it out but hopefully when you look at these metrics you look at changes in working capital and the different components inside it hopefully it's creating like a narrative that you start to fill in yourself. So hopefully it creates questions for you to ask, and that can help you learn more about the business.

12:09Like if I think of something like Cat, and if I try to read their business overview, I may or may not pick up on what we're talking about. But for me personally, looking at the numbers and seeing how something like accounts receivable is changing, that communicates a lot to me. So we can use these metrics not just for finding red flags or saying company good or company bad, but we can also use the metrics as a teaching and learning experience and learn more about particular businesses by what's going on in their financial statements. Definitely. And I think if none come to the top of my mind, I guess I could Google it real quick, but I'm sure there are, you know, examples of businesses bankrupting themselves for that exact reason.

12:59Like they keep taking on these long-term projects. You know, we're going to get paid as soon as they're done. We're going to get, and it just keeps going. Like you said, ballooning to eventually they have no more operating cash and they have to start going into debt now. And then eventually that catches up to them in the long run and they end up bankrupting themselves. Like I said, I can't think of an example of a company doing that off the top of my head. But I'm sure if you Google it, you'll find plenty. So moving on to one of Andrew's favorite pet peeves, I guess, is inventory in a company.

13:38This is where you'll find that information. And why is inventory so? Because, I mean, I've heard you say great things about companies because of their inventory. and I've heard you completely destroy companies because of their inventory. Why is it such a big deal to you? Because Target, they screwed me over, man. Obviously, they didn't screw me over, but they messed up with their inventory and I paid the price. And it destroyed a lot of the capital. The stock went down. I don't think it's recovered since that 2021 peak. So really goes to show and inventory is really depends on the on the business as well.

14:25Like if you take a grocery company like a Kroger and they're selling. Well, I will usually use like the produce example, but these days even that's shaky inventory if you've been following the news at all. But yeah, inventory will numerically be the same. A dollar here, a dollar there. But the reality of that inventory is a lot different, uh, depending on what kind of business we're talking about. Right. So inventory, the way I look at it is it's, it's money that's gone out the door that has done absolutely nothing yet for, for the company. Um, and so, I mean, what are we looking for? Uh, when we're, we're looking at the changes in working capital, what are we looking for specifically?

15:17to identify if somebody has over leveraged in their inventory versus, and before we dive into, like, just like we were just talking, context matters. If you're looking at Walmart and they just spent like, you know, I don't know what they spend in inventory, but I'm just pulling a number out of there. We'll say they just spent 5 billion in inventory, which is a massive increase. Well, Is it, you know, August and September where they're getting ready for black Friday sales and Christmas sales? Then that makes sense that they're over leveraging on their inventory because that's good. They're expecting that to go right back out.

15:58So again, come when, as we talk about these things, context, you have to take that into account, like at least with like a retailer, like what time of year is it, um, you know, for, for a cat, uh, as another example, if it's winter time, in most of the United States, you might see their inventory go way down because they're not trying to sell tractors to farmers. Or maybe that's when you sell, I don't know. But you know, they're like, we got to take in like time of year, what's happening in the environment, the economy, things like that when we're looking at this. Anyway, Andrew, I'm sorry to get on my soapbox.

16:39What are we looking for specifically when we look at this in changes in working capital? I'm not going to lie. Running a small business has been stressful lately, swamped in paperwork, different state agencies, and got all these expenses to track and everything. And it's hard to have visibility on these things. But I've stumbled on a better solution, kind of like a one-stop shop for my bookkeeping, my expenses, my P &L, my banking, my contractor payments, all of the messy pieces. It's called Found. It's for business owners like you and I. There's over 750 ,000 business owners who've chosen Found.

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19:39So it's so funny you mentioned Walmart as your example. and so what I would look for is if you look at Walmart's cash flow statement back in 2022 so it was really like 2021 going up to 2022 which is around the same time Target also just went crazy with inventory Walmart added $11.8 billion in inventory big number for them kind of like what we were doing with accounts receivable we can check how that compares to a company's profits because look like if there's no growth if there is obviously this never happens but let's say a company knew exactly like Walmart knew exactly what everyone was going to buy that year then they would buy that exact amount of inventory it would go exactly to revenue and the changes in working capital the changes in inventory would be zero because they put a bunch of money out for inventory and then they sold all of that through as revenue and got that as cash.

20:50So if there's a negative number there, basically that means they're spending more than they brought in in inventory for that year. It can mean either they are investing really heavily, which isn't always bad. If I know 2022 is going to be a bonanza year for us, then maybe doing$11 billion in inventory investment in 2021 is a good move. And so think of changes of working capital, which can make it sometimes frustrating, but this is just how it is. Think of it like deep breath in, deep breath out. Sometimes you'll see like, okay, we're getting ready for a bonanza. Deep breath in, we took all this cash out to invest.

21:36Deep breath out, it's all revenue. And now we have gushes of cash flow. And so when you look at changes of working capital, we want to look at the long-term, both the in and the out. And then we also want to look for anomalies like we're mentioning here. So yeah, you liked hearing me stutter. That's great. So in this case, going back to the 2021 for Walmart, $11.7 versus$13.9 billion. That's big. That's almost all of their profit. The stock did not crater like targets did, but I found it interesting if you look at their balance sheet. Their balance sheet stepped up because when you make those investments now, you have more inventory on your balance sheet.

22:27And like you were saying, it's just sitting there. So their inventory on the balance sheet went from like 40 to 55, something like that, roughly. And it just sat there over the last three, four years. So by itself, that's not a terrible thing, but it is interesting that they never fully sold that off. And it's okay. You're going to see inventory increase over time as your company grows, but that is kind of trapped assets that either they write it down in the future or it just kind of sits there and doesn't generate that cash flow. That's what we want as investors, right? That's what companies need.

23:11They need cash flow. And if too much of it is trapped in inventory, then you have a company that looks stronger than it actually is. Absolutely. I think, and I'm curious, is so like since target and walmart both did it around the same time i wonder because that's the time we're coming out of covid and all of that i'm wondering if they were expecting like uh i would imagine they were expecting like ah freedom and everybody just you know rushes the stores that didn't really happen and so then they're they're stuck holding the bag um which we can we we can dissect all of that at length and still never have a good answer but i mean that i definitely think that's super important to pay attention to because like andrew said um it's a it's to me it's a good easy way to identify uh a company's mindset um and how they are how they feel about what's happening in the future now are they making good decisions that that's left to be seen in target's case you know they didn't make a good decision um but they were definitely definitely they had op they were looking optimistically at the future i think during that time if that you know if my assumption is correct so um just just quick recap inventories basically you know, a gauge of what the company is bringing in and has not yet sold.

24:54So the final bucket that I want to talk about is accounts payable. And accounts payable are bills that the company has not paid. So this isn't money coming in. This is money that has to go out. So Andrew brought up ChatGPT. um on their on their uh on their balance sheet is going to say that they owe microsoft x amount of money um and that is uh to me like that's probably the most important thing to find is who do you owe and how much do you owe yeah um these things man like i remember first learning changes in working capital and I racked my brain for days, weeks it's just very confusing because it's like there's positive numbers there's negative numbers and it's not super clear when you're first getting started what those numbers actually mean so if you're getting stuck if it's way over your head it's okay, I think that's normal you can probably find great videos that explain it visually as well that might do a better job than we're doing here but But if you can understand maybe the basics of why this stuff matters, then the more and more you immerse yourself in it, you'll start to understand.

26:23So we can also use this kind of logic with accounts receivable, but let's stick with accounts payable like you are mentioning. And we'll use the chat GPT example again. So if OpenAI has this money that they owe to Microsoft, but Microsoft's being very friendly to them and saying, hey, if you need to push these terms back, it's okay. Then that works like cash flow for OpenAI. It's short term, but it still gives you that extra year of cash that you can go deploy and grow your business. And so that's what you'll see on the cash flow statement. It's going to raise the cash flow of a company when they're able to extend this account's payable.

27:11So if you look at a company like Chipotle, I pulled them up. It's very interesting because very recently they had accounts payable come down, but 2024 accounts payable$8 billion, 2023$5 billion. So they had been for some period of time able to get cash flow from accounts payable. And what that really can show you is how important are you to your, so if you were paying out, that would be your vendor, right? So how important are you to your vendor? And I own Chipotle stock, by the way. Like, I'm all about Chipotle. I know they pride themselves in their suppliers and being farmers and all of those things.

28:05But if you have a company where, let's say, you're a very valuable customer to your vendor, then you might say, hey, if you want to do a deal with me, you let me pay you later in the game. right and that's not i mean that's not necessarily an evil thing if um if a customer comes to you and says you know hey i'm gonna change your life and and make you a multi-millionaire but you gotta wait an extra six months to get the money for that one person who's becoming a multi-millionaire that's that's worth it every day of the week right um and so you get like kind of these win-win situations where a bigger company can manage cash flow and do things with cash flow that allows them to grow their business more efficiently, more effectively, better for shareholders.

29:07And at the same time, can support smaller vendors and really make an impact in their businesses as well. And so the best relationships, the best business relationships is both parties winning and the customer who's down the line from the vendor and like a Chipotle, they should win as well. But those are the situations where you would have winning situations. And so for the company who's bigger, who's more efficient, they can extend accounts payable, becomes a source of cash for them. They can reinvest in other things. And these are all things that provides free cash flow for a business and allows it to do more things and can make a difference.

29:58But that difference isn't always apparent, but at least in the classroom, it makes sense and it's logical. What are your thoughts on accounts payable? And do you ever look at it when you're looking at the stock? Yeah, absolutely. Because I mean, everything we just went through, you know, accounts receivable inventory, all that can make a company look really strong, really great. And then you get to accounts payable and all of a sudden you realize that while there they have, well, it looks like they have this much in revenue and this much coming in, yada, yada, yada. then all of a sudden you realize, well, crap, even if they sell all their inventory, if everyone that pays them pays them like they should, they're still either zero or negative.

30:51And there have been several companies, I won't call anyone out, that I've seen in the past that have been in that case. And it's like, man, I'm glad I kept scrolling because otherwise I could have been left, screwed because I bought the stock and not realized how much they owe. I mean, because it's basically a different form of debt. And it can cripple a company's cash flow pretty quick. Yeah, that's a really good point. It can definitely be abused. And that's why some of the other checklist items we like to talk about, which probably are more boring than paint drying on a white fence. But the liquidity metrics, the current ratio, current assets, current liabilities, that stuff matters because that can check whether this accounts payable thing is getting out of hand or not.

31:58Definitely. I think all of this is, like you said, it's confusing. um and i i can you know i'm sure you all figured out i'm not freaking albert einstein over here so um i was just as confused as everybody else when i started learning all of this and the immersion is literally how i learned it um and and then just having you know things like this podcast you know having people i could go to like andrew um and ask questions like that But ultimately, that's how I learned. But it was a really slow process of just a whole lot of questions. And like, this makes absolutely no sense. So if you don't mind, Andrew, I want to see if we can paint, now that we've kind of described what we're looking at, maybe paint it into a working picture.

32:53So when we're talking about using this to identify growth versus growth Maybe we'll call it distress. A company with inventory and their accounts receivable may be on the rise, but the business is expanding and we're starting to see that normalize. that could be a maybe not a green flag but that can be a flag a marker showing you that that they were in this stage and moving into the next stage versus a company that i would say is in distress which i just mentioned their inventory is on the rise their accounts receivable are at an all-time high and their accounts payable are also continuing to rise.

33:54Like that, that's a solid sign. Like, Hey, this company, like they might be in trouble. I should maybe not say no to it, but definitely keep an eye on it. See, I see how it's going to work before I start to invest. Yeah. It's, um, it's tough to paint a very broad paintbrush. when you mentioned earlier no companies come to mind about failing from growth I believe Nike I feel like every time we bring up inventory I always bring up Nike but go read the book Shoe Dog if you're curious about this because it's like a very easy memoir that was written about this story he talks about like Nike was growing too fast we almost suffocated because we didn't have enough cash because his business model is I have to breathe out or breathe in, invest a bunch of capital, breathe out and get a bunch of cash.